Copper has been among the weakest performing commodities this year, as shown in the graph below. This follows a 17% price fall in 2014.
Copper’s fair value bears a strong negative relationship to theUSD, the strength of which is a major contributor to the commodity’s price weakness this year.
The past week has seen continued weakness (price down 1.4%), a move however below the decline in fair value of 2.1%. The fair value is assessed using a multiple regression analysis of the copper price on 22 driver variables including interest rates, stock indices, other commodities and exchange rates. The database is six years of daily prices.
The contribution of each driver variable to the decrease in copper’ fair value last week is shown in the graph below. A significant contributor to the fall was the strength in the US dollar index (up 1.9% over the week), to which copper’s fair value is negatively correlated. The fair value was also pulled down by the easing in the overall commodity index (down 0.7%).
An excess of price decrease over fair value decrease would normally be a signal to go short copper. Taking positions based on disparities between price and fair value change over the last 90 days would have yielded a marginal gain.
Our assessment of copper’s fair value using the multiple regression model lies well below the current price, suggesting that the commodity is overvalued on fundamentals. Taking positions in copper based on this signal of under/over valuation would have generated a return of 28.4% with volatility of 22% over the last 90 days.
We have also developed a signal based on the lead given by the change in the Baltic Dry Index (BDI) of raw material shipping freight rates. This index is widely seen as a leading indicator of world economic growth, with increases viewed as bullish and conversely. Based on the relationship between the BDI and copper price over the last six years and the 2% drop in the BDI over the last month, a short term decrease in the copper price is more likely than not.
Trading this signal would have yielded a 20% per annum gain with volatility of 22% over the last six years.
Relationship to USD and volatility
The graph below shows the sensitivity of copper’s fair value to the drivers on which the fair value is based –
As can be seen, copper is negatively correlated to the US dollar. Our fair value indicators suggest some marginal short term upside in the US dollar index, which would not be supportive of the copper price.
The USD may undergo some volatility this week if the jobs data comes in some distance from consensus. Given the high sensitivity of copper to the USD evident in the above graph, this could translate into volatility in the copper price.
The next week has historically been of above average volatility - looking back over the last three years at copper’ price changes for the week surrounding the nonfarm payrolls print, we find a volatility of 22% vs volatility for all weeks over the period of 17%.