Market Analysis

In supporting that last argument in Part One, it is observed that China is reducing its holdings of US-dollar treasuries — it has been a net seller for the last two months. According to the U.S. Treasury department’s Web site, in November 2010, the country lent the U.S. $895.6 billion, which was down 3.6 percent from the same period a year earlier. “China has shortened all their maturities to less than 5 years and now they are not as strong in the auctions,” argues Chuck Butler, president of EverBank. Speculation is bubbling that the country is shying away from the dollar to make more room for another asset; could that be gold?

But others have poured scorn on the idea. Jon Nadler, senior analyst at Kitco.com, argues that China loves growth too much to switch to a gold standard, and “forget about 8% growth.” If China supports its currency with gold then it will be forced to limit the amount of money in circulation, which could hurt the economy. “This is a far-fetched dream by the gold bugs,” he has said.

Putting the yuan onto a gold standard may not be the intended outcome, though; we would suggest an alternative objective might be to soak up excess liquidity in the economy and hence reduce inflationary pressures. Encouraging citizens to buy cars, white goods and electronics is good for industry, but the rate of growth has been so rapid aided and abetted, one should add, by the stimulus measures introduced by Beijing in the aftermath of the financial crisis and has since largely wound down that it has brought price inflation with it. Raising interest rates and bank reserve requirements has the desired effect of slowing demand, but at the additional cost of raising costs for industry. Giving the population something else to speculate on apart from property prices could be the intent. Nor can we see how encouraging the public to buy gold furthers the aims of a currency reserve standard — India has been the largest importer of gold for many years, most of it bought by the general public, yet the rupee is a long way from the front runners as the next reserve currency.

Whatever Beijing’s intent, it has undoubtedly supported the gold price over the last year and that policy is, like so many other metals, likely to impact gold prices this year and next to an even greater extent.

–Stuart Burns

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Just why are the authorities in Beijing so actively supporting widespread purchases of gold and financial gold instruments? China has also been telling its citizens to buy gold, promoting different gold funds, giving investors access to overseas products and launching a global gold contract based in yuan by the Chinese Gold & Silver Exchange. On the face of it, this seems like a strange position to take; at the very least we have come to expect governments to be neutral on their citizens’ investment choices, sometimes downright negative such as raising interest rates to dampen property or stock market bubbles, but rarely so overtly supportive towards investing in speculative and volatile commodities. One has to ask: what would the social fallout be to a collapse in the gold price, and would there not be some resentment in being so aggressively encouraged to buy?

China’s desire for gold is not solely reserved for the man and woman on the street. According to a Reuters article, gold imports into China soared in 2010, turning the country, already the largest bullion miner, into a major overseas buyer for the first time. The same article said China imported 209 tons of gold in the first 10 months of last year, versus 333 tons by India for the whole year, making China second to India the largest gold market and accelerating fast enough to take top slot this within a year or two. The US by comparison bought 233.3 tons.

Theories abound as to why China is buying gold both for its central reserve (which now stands at 1054 tons, or about 1.8 percent of it central bank reserves), and encouraging its citizens to hoard gold as well. The front-runner is that China is on a drive to have the yuan accepted as the world’s reserve currency and amassing gold will improve investor confidence, if you like a return to a gold standard. If that were really the plan, China would have a profound impact on the gold market. As TheStreet.com points out, China holds $2.85 trillion in foreign reserves, which means the country would need to buy roughly 66,000 tons of gold to fully back its currency. Even if the country raised its holdings to just 3 percent, the country would need to buy 1,000 tons. The article goes on to point out that technically, a full gold standard isn’t an option. Under the IMF’s first amendment to Article IV of Agreement, ratified in 1978, participating countries are not allowed to peg their currency to gold, but that doesn’t undermine the attraction of carrying large gold reserves as an expression of solidity.

(Continued in Part 2.)

–Stuart Burns

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While there’s considerable focus on silver regarding what returns it can gain as an investment asset and as a hedging tool both valid applications, amidst sovereign debt risks and currency devaluations it’s helpful to zero in on the fundamentals of silver and how it plays next to gold, its precious cousin, and the more industrial-focused platinum and palladium. In light of China urging its citizens to buy gold (more on that key topic in a two-part series from Stuart on Monday), where does silver stand in all of this?

If there’s anything to say of silver’s performance in the ETF market, it’s all good. According to Bloomberg data compiled up to Feb. 11 and presented by ETF Securities in a recent presentation, silver has outperformed most of the other precious metals, key commodities such as Brent oil and equity benchmarks like the S&P. In terms of spot returns, the one-week return for silver stood the highest at 3.1 percent, compared to gold (0.7%), platinum (-1.7%) and palladium (-0.4%). The 12-week returns for silver stood at 91.9 percent, second only to palladium (94.5%).

Back to the fundamentals, however: investment and industrial demand, although playing off each other in different directions through the years (as the graph below shows), may be at odds with supply of the metal the rest of the year and beyond. (Just today in London, the silver spot price broke $32 per ounce, a 30-year high.)

Source: GFMS, compiled by ETFS

Although Will Rhinds, head of ETFS’ US operations, recently told MetalMiner in an interview that he sees no noticeable shortage of silver. “If people believe the mine supply of silver will fall this year, then some people can extrapolate that into something more extreme, he said. “But from our vantage point, we don’t see any signs of a visible shortage.

At first blush, that could seem to be at odds with the most recent outlook, presented by ETFS senior analyst Daniel Wills, who pointed out the relatively steady 2 percent growth of silver mine production from 2000 to 2009 may not be enough to offset the 86 percent decrease in above-ground stocks in 2009. Granted, Wills spoke based on data trends through 2009, while Rhinds may have more recent insight.

Source: GFMS, compiled by ETFS

Whatever the supply situation at the current moment, it’s inevitable that we’ll be seeing unprecedented broadening of the silver demand spectrum beginning this year, if the above graph of demand sources is any indication, going by Wills’ conclusions. With high inflation concerns across the globe and sovereign debt risk in Europe (but let’s not count out Japan and the US as well), and with miners increasingly looking to hedge their metal buys, this period may make for an interesting silver environment. (The gold-silver ratio dipped below its 50-year average at the end of 2010 the last time it was that low, Reagan was in office.)

–Taras Berezowsky

*For a much broader picture of the silver and gold investment environment, you can attend a free conference: Phoenix Investment Conference & Silver Summit on February 18-19, 2011.

Details contained in the referenced link.

Not to be confused with its nearly homophonic cousin that connotes monetary child support post-divorce, antimony, the minor metal used in flame-retardants and microelectronics, has been showing remarkable movement upwards lately. Prices are up 230 percent since April 2009, says Reuters, when fears of depression forced inventory supplies to dwindle. (That is the dip you see in the graph below.)

Source: metalprices.com

The price stands at $13,600/$14,200 a ton this week. That’s a 45 percent increase since last August.

The environmental havoc that antimony smelting can bestow is not to be underestimated, especially its effects on human health. That is why, in large part, supply constrictions have caused the price to rise. (To a smaller extent, the Chinese Lunar New Year celebrations affected the market in the short-term.) According to a Reuters report, the Chinese government began shutting down “small or illegal antimony smelters in the Hunan province last year as it bore down on stricter environmental cleanups and supply management. Evidently, “hundreds of illegal antimony smelters were shut down in the city of in late March last year. Smelting is the more of the culprit behind supply tightness the metal concentrate itself is extracted from stibnite ore, and is a byproduct of copper, lead and silver mining. (China produces about 90 percent of the world’s antimony; Lengshuijiang itself is responsible for 60 percent of global production.)

Compiled from USGS data

As my colleague Stuart Burns wrote last September, contaminated soil, air and water and high incidences of lung diseases and heart problems has put Lengshuijiang in Beijing’s cross-hairs; the city “has been declared one of 44 cities that are Ëœnatural-resource exhausted cities.’ As Stuart opined, this environmental crackdown could have forced a bit of demand decrease a good thing for Lengshuijiang citizens, if no one else as alternatives to antimony would be used.

However, back in January of this year, Reuters was reporting that a partial cause of supply constriction was increased consumer demand in European markets (which is surely not reflected in comparative GDP numbers; against slightly more robust annual rate increases in US and China throughout 2010, the European Union GDP posted the most lackluster percentage gains quarter-to-quarter.) Nonetheless, when paired with Chinese environmental restrictions, it’s easy to see why antimony prices are at historic highs.

The rare earths regulation frenzy has also affected antimony and other metals like it. China’s Ministry of Land and Resources recently announced the closure of 280 illegal mines, and reports show that 2010 licenses for “rare earths, tungsten, tin, and antimony fell to 116 from 400 in 11 provinces and regions in China, according to a Feb. 11 MineWeb article.

This, ultimately, is bad news for antimony buyers and consumers, as the metal’s applications are found in an increasing number of devices. Antimony is essential to make sure that the plastics used in computer casings and TVs don’t melt. But we are seeing certain indications that sky-high antimony prices can’t last. For example, China’s exports of the metal increased 13 percent in 2010. The key to tracking the metal’s forward-looking activity will be to keep an eye on how China’s environmental ministry is keeping the smelters in check.

–Taras Berezowsky

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Back in early January we posted our expectations for the steel market throughout the course of this year. And though we called for higher steel prices throughout the year, we thought pricing would come in the form of a roller-coaster. Whereas we don’t anticipate any short-term dips in steel prices, the ferrous scrap markets have taken a breather so to speak. According to ISRI’s latest report, “Scrap Price Bulletin did report falling composite ferrous scrap prices this week, with No. 1 dealer bundles down $16/gt for the week to $465.17, shredded scrap down $21/gt to $454.83 and No.1 HMS off nearly $20/gt to $420.83, while other sources were reporting even bigger drops in both domestic and export ferrous scrap prices.

Despite these scrap price dips, all of the current pricing, however, appears higher than historical averages so we would not suggest steel-buying organizations will see any steel price drops in the near term. In fact, The Steel Index suggests lead times for all forms of steel (with the exception of HRC which has held steady and rebar which continues to decline) have lengthened, further suggesting that recent price increases will likely stick at least for the short term. Another indicator we track involves domestic capacity utilization. For the week ending February 12, the AISI (American Iron and Steel Institute) reported capacity utilization had increased from 74.0 during the week of February 5 to 74.8%. These utilization rates appear higher (slightly) than domestic capacity utilization during 2010, which hovered in the low 70% range, though global steel production averaged 73% throughout the year.

The Steel Index reports domestic HRC pricing in the upper $820+/ton range and CRC pricing in the $910+/ton range. These represent 15+% increases for HRC and over 13.5+% increases for CRC for the past four weeks. And though HRC and CRC prices have also risen in China, (The Steel Index reports HRC at $685/ton and CRC at $795/ton vs. our own MetalMiner IndX HRC at $704/ton and CRC at $825/ton) the discrepancy in prices between the domestic and Chinese markets would suggest we might expect to see an increase in import activity (of course the discrepancy between our own MetalMiner IndX pricing which reflects local China pricing and not export pricing, makes for an altogether different analysis).

Source: US Data From Steelbenchmarker and The Steel Index, China data from MetalMiner IndX(SM)

MetalMiner IndX(SM) is a free service. You can sign up here to view daily prices.

We will continue to monitor key steel input costs and related trends for further steel price direction.

–Lisa Reisman

Much of the hoopla surrounding the copper, tin and nickel ETPs released last December stems from the convergence of the speculative concerns of traders versus industrial buyers’ demand for the metals. And although the ETFs themselves have drawn a lot of media attention, it’s still relatively a small part of the industrial supply/demand equation. The truth is, while explosive growth in emerging markets spurs never-before-seen price increases in commodities such as food, energy and base metals, investor interest in commodity ETFs has grown proportionally, with raised concerns about hedging against losses and behavior that appears reminiscent of the precious metals market.

“The cyclical recovery story is a big one, said Scott Thompson, co-head of European sales for ETF Securities in a conference call Thursday. “Demand [is] coming from China and India, from infrastructure and real asset investing, and that is what clients look at when investing in industrial metals.

Thompson’s basic mantra (and that of ETFS) is to obviously raise interest in and buy-ins of their products, which include the first physically backed base metal ETFs. In drawing the pros and cons between physical vs. futures investment, he makes the case that because returns on futures contracts have historically been exposed to more volatility, it may be the best time to invest in the physical metals. (Arguably, Thompson said, the best time to traffic in futures contracts, using copper as an example, is when the market is in backwardation i.e. when you’re gaining positive roll yields due to lower futures prices against the spot.) The two graphs shown below highlight the difference in volatility in carry costs and returns for copper, respectively:

Courtesy ETF Securities; data from LME and DJ UBS indices

Courtesy ETF Securities

Storing the physical metal has always been a sticking point in making the sell to investors it simply seems cumbersome. The main reasons Thompson gave for physical investment centered on knowing in advance from the LME warehouses what your metal storage costs will be. So if that transparency is one’s investment goal, along with having access to an LME-regulated and audited environment, and playing it safe with low variation year-to-year, then perhaps physically backed is the way to go, he said.

From our perspective, the fundamentals for copper look good, although some investors seem to be getting more cautious on the short-to-medium term outlook due to inflation-related issues in China, including housing prices slightly slackening demand for base metals. Reuters reported recently that ETFS’ physical copper stocks dropped significantly last week, falling by 35 percent since the end of January, to 1,350 tons total. (This is reportedly still “only a fraction of LME inventories, which stand at 400,000 tons of copper.)

Interestingly, tin activity is what’s hot, as Andy Home wrote in another Reuters article, saying that ETFS’ tin holdings recently doubled to 405 tons and overall LME tin stocks rose nearly 9 percent in contrast to perceived global supply shortages, but that “LME tin stocks are going to start coming under pressure sooner or later. Home continued: “Tin may prove to [be] the first battleground for diminishing metal availability between traditional users and a new breed of base metals investor.

What Home hits on there is what truly hits home. (I couldn’t resist a bad pun and cliché, all in one sentence!) In all seriousness, we’ll begin to see these two markets physically backed and futures-oriented coming together in complex ways in the coming year and beyond, according to Scott Thompson. With scrutiny of risk assets increasing, he expects greater coverage of “more cyclical commodities as well as some foreign exchange and equity trends coming out over the next couple of months.

–Taras Berezowsky

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As with many of the ferro alloys, ferro chrome (FeCr) is at least in part a power play. Electricity makes up a significant percentage of the final product cost but so do coal prices, or to be precise, coking coal prices. Coking coal and electricity are required to reduce a chrome ore, generally chromite (an iron magnesium chromium oxide) to form an iron-chrome alloy with between 50 and 70% chrome and varying levels of carbon depending on the source material and technology used.

Source: HSBC

FeCr demand was hit catastrophically by the credit crisis with demand falling dramatically, as this graph from HSBC shows. As if that wasn’t enough, South Africa, producer of between a quarter and a third of the world’s FeCr, has suffered chronic power problems in recent years, limiting production volumes and doubling power costs. Rising steel demand, however, is driving price increases, although prices are currently US $1.25/lb, half what they were at the peak in 2007 but double the low in May 2009 of US $0.68/lb, according to metalfirst.com. CRU Group is predicting demand growth of nearly 6 percent per annum over the next five years and Heinz Pariser, a ferrochrome and stainless steel industry researcher, said “By the end of next year, we will possibly be between $1.80 to $2 a lb.”

Source: HSBC

Much of that demand growth is dependent on China; even conservative HSBC is predicting a substantial growth in Chinese stainless steel production as this graph shows.

HSBC’s figures support those quoted above — the bank is looking for global FeCr growth of 5 percent year-on-year in 2011 followed by 7 percent in 2012. Longer term, they are expecting stainless growth of 6.5 percent through to 2015 which will spur similar demand growth for FeCr.

On the supply side, cost pressure on South African producers is only going to get worse as the state power company Escom increases electricity tariffs, as the SA Rand appreciates (adding costs to producers), and labor rates rise. HSBC estimates the current floor price at around US $1.0/lb, but if coking coal prices continue to rise, this will add further pressure. The general consensus is that even at current prices, producers are not making much money. Inventory levels in China, itself a major producer, are reasonably plentiful but elsewhere in the world they are lower. In 2008 Escom had a power crisis around March and many expect the same to happen this year. Domestic production of all energy-intensive ferro alloys has been restricted this year in China due to weather-related power problems in Henan province, according to SteelGuru.

Although steel and ferro alloys producers are seeking to diversify sources (Posco in India, according to the India Times, and ENRC in Kazakhstan, according to Reuters), for the next couple of years at least, South Africa and China will be the sources where supply disruptions will have the most impact on prices.

Source: HSBC

For that reason HSBC are not alone in predicting higher prices through the next couple of years with capacity investments only beginning to kick in with increased supply from about 2013 onwards.

–Stuart Burns

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The rumor machine is in full swing as to what is happening to aluminum inventories. As a Commodities-now report advised last week, a total 342,000 metric tons of aluminum were delivered into the LME system and the headline stocks figure rose by a net 250,575 tons last month. That negated much of last year’s 350,000-tonne decline and at first sight suggested the market must be awash with metal.

But if that were the case, physical premiums would be collapsing as suppliers fought for buyers in an oversupplied market. In practice, Reuters reported the premium for duty paid metal in Rotterdam was still US$ 190-210 per metric ton over LME cash, steady with the level seen in the final quarter of last year of US$ 195/ton.

So one explanation could be that this is a reverse flow of what we saw last year, namely a gradual draw-down of visible LME stocks with a build-up of off warrant stocks in cheaper non-registered warehouses. But why would metal flow back into LME warehouses when they are renowned for being more expensive? Melanie Burton at Reuters suggests the long-term finance deal is dead anyway, as the 3-month forward premiums for aluminum have shrunk from US$45/ton last year to about US$12/ton this year; see graph below from the LME.

Source: London Metals Exchange

US$12/ton does not leave enough headroom to cover storage, insurance, finance and see a profit. One warehouse source is quoted as saying it costs $12/ton per month to store metal in an LME warehouse. Even allowing for the steepening of the forward curve 12 months out, the premium is still insufficient to cover the costs if stored at headline LME-approved warehouse rates.

One theory doing the rounds appears to be that the movement into LME-registered warehouses has more to do with the new owners moving their stock into their own premises. Vlissingen’s LME warehouse saw a near four-fold rise in inventory to 246,000 tons this year following the purchase of Pecorini Metals by Glencore last September. Other large banks and traders such as Goldman Sachs and JP Morgan Chase also purchased LME-approved warehouse firms last year and some of the movement may well be a decision to keep the rent outlay in-house rather than with a third party.

Nevertheless, the question remains what will happen to inflows of metal from a market that is widely considered to still be in surplus if the finance deals are no longer viable to soak up new production. The answer, as so often in the metal markets, lies in China. The markets are closely watching what is happening to SHFE inventories and Chinese smelter production; both have been falling this year. The SHFE news commented just prior to the New Year close-down that they expected demand to rise after the holidays, but smelters’ output would not immediately follow causing further rises in prices and draw downs in inventory. Macquarie Bank reported a big draw-down in mostly off-market inventory in China during H2 2010 to the tune of 870,000 tons. If smelters are encouraged to come back on stream, price rises may be reversed but if not (and the arbitrage window between the SHFE and the LME opens), then imports could result. That at least would find a home for production elsewhere that earlier would have been destined for finance deals or roll-overs. In the meantime, falling SHFE inventories may be the only dynamic supporting recent rises in the aluminum price — how long it lasts remains to be seen.

–Stuart Burns

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(Continued from Part One.)

Of more concern is the risk of core inflation in emerging markets. As these Credit Suisse graphs show, the output gap in developed countries is still large, although closing, while the output gap in emerging markets is likely to be positive from the beginning of this year; that is, demand is above the supply-side potential.

Data is from Bloomberg and Credit Suisse research.

Emerging market central banks are acting to curb this rise in core inflationary pressures by raising interest rates across Asia in particular and, linked with expected lower rises in commodity prices in 2011, is expected to lead to CPI, peaking by mid-2011 before easing later in the year. Credit Suisse is predicting base metals to increase further with copper up by 20 percent in 2011 and precious metals up, led by palladium increasing by a third, but the rise will be less than in 2010. Importantly, agricultural products will increase in 2011 by less than in 2010, with USD increases of 10-20 percent partially offset by appreciation of emerging market currencies, either deliberately (as in the glacially slow increase in the Chinese RMB) or the domestically unwanted appreciation of the convertible Brazilian Real. Notably the bank expects crude oil prices to remain constrained around current levels, as OPEC increases output and new or refurbished fields open up in Iraq and West Africa.

Some fear that rising metals prices will in themselves restrict growth by acting as a “tax on consumers and investment, but the bank believes this depends what is driving the rise in prices. If, as in this market, the price rises are driven by demand rather than a failure or disruption in supply there is a difference, before you flood in with comments then the global economy will absorb the increases, although ultimately a degree of inflation will result. Of more concern in the agricultural markets is the imposition of price caps as in China or trade restrictions as in Argentina that will reduce the effectiveness of the price mechanism in the adjustment process. The risk is that in implementing policies that control prices in the short term, governments inadvertently reduce incentives for higher production in the medium term and in so doing exacerbate the imbalance, resulting in considerably higher food prices in the longer term.

The takeaway is that both metal and agricultural prices, though likely to increase further in 2011, are showing signs of abating and that, providing emerging markets in particular do not overreact, the impact on core inflation will be low and headline or CPI inflation should decrease later in the year. Let’s hope they are right.

–Stuart Burns

One of the most significant influences on metal prices, both precious and base metals, over the last year has been concerns about inflation. Precious metals and increasingly copper are seen as hedges against inflation, pushing metal prices up. Concern that some emerging markets are cooking up inflationary pressures means every credit tightening or interest rate increase is viewed as an impending slow-down depressing prices. The result has been that inflation figures are closely watched and both foreign exchange and metal prices are sensitive to even small percentage point moves in perceived changes. But what is the reality about inflation pressures? Are they out of control in emerging markets, and indeed are commodity prices to blame for rising prices in the wider economy? Credit Suisse recently produced a review of the impact of rising commodity prices on inflation both in emerging and mature markets and made projections on where they expected both inflation and prices would go in 2011.

First and foremost, we need to distinguish between core and headline inflation. Core inflation is a measure of consumer price increases after stripping out volatile components such as energy and food. It is indirectly a measure of the gap between capacity and utilization both in industry and services. Taken in the economy as a whole, this is a good measure of the direction of inflation in the future. If the gap is small, that means the economy is running near to capacity; inflationary pressures are strong as demand for labor and resources gets close to what is available. Headline inflation as defined by investorwords.com is price inflation that takes into account all types of inflation that an economy can experience. Unlike core inflation, headline inflation also counts changes in the price of food and energy. Because food and energy prices can rapidly increase while other types of inflation can remain low, headline inflation may not give an accurate picture of how an economy is behaving. Headline inflation is more useful for the typical household because it reflects changes in the cost of living and is therefore popular with the media it makes more interesting headlines!

Unquestionably, headline inflation has been on the rise, energy in the form of oil prices in particular, metal prices and most importantly food prices have been on the rise. In emerging markets, food prices are the most sensitive as a much higher proportion of income is spent on food than in developed economies. Typically food makes up some 30 percent of the Consumer Price Index (CPI) basket for emerging markets compared to only 13 percent in developed ones. Emerging market authorities are therefore particularly sensitive to food prices as they represent a source of social unrest. Arguably, the initial unrest in Tunisia was in part due to the impact of food and energy price increases on the poor.

A key facet of the current global inflation environment is that we have a two-speed world. In developed markets there is a considerable gap between capacity and demand; the resulting headroom means core inflation is low and likely to remain low for the next 12-18 months, if not more. But for emerging markets, limited economic slack means rises in core inflation are a higher risk, while social sensitivity to headline inflation driven by rising food and metal prices is compelling Asian and resource-rich countries to act early in raising rates and tighten credit.

Source: Credit Suisse

Not all commodity prices have risen equally, as this graph form Credit Suisse illustrates. As the paper explains, the initial impact of commodity price increases on inflation is heavily dependent on which items are increasing and the stage of development of individual countries. Although metal prices are not a component of CPI inflation, it does have a muted impact down the road as component and project costs increase. The dilemma for many emerging markets, though, is that commodity price increases are a global phenomenon, so attempts to constrain the domestic economy by credit tightening or interest rate rises have minimal impact on global commodity prices apart from the psychological impact on investors who buy into commodities as part of the China bull run play; for them, any constraints on China’s growth is a reason to sell commodities or at least to not bid up any further. Hence the sell-offs we saw in late 2010 when China raised rates and reserve requirements.

(Continued in Part Two.)

–Stuart Burns

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