Freeport-McMoRan: Why the Current Rally Could Be Unsustainable
Federal rate hike
A large amount of the copper in China is believed to be tied up in financing deals. In a typical financing deal, importers in China open a letter of credit (or LC) with foreign banks by paying a portion of the total import costs. Chinese importers then sell the copper and get cash. The typical payment time for LCs is three to six months.
In essence, this means that Chinese importers get access to cheap US dollar (UUP) funds. The basic premise behind these deals is the arbitrage between interest rates in China and the developed world.
Financing deals form part of China’s shadow banking channel. The chart above shows the key components of China’s shadow banking channel.
Rate arbitrage
The funds raised through these financing deals have been invested in China to earn higher investment returns. However, with Chinese equity markets in free fall and property markets in the grip of a slowdown, profitable avenues to invest money have narrowed.
To add to these woes, China’s currency devaluation has increased the real cost of borrowing in these financing deals.
Another catastrophic event for copper financing deals could be the anticipated federal rate hike. Higher rates would further increase the borrowing costs in copper financing deals.
There are fears that copper tied up in these financing deals could enter markets, further pressuring already strained demand-and-supply dynamics.
The federal rate hike, if it were to happen, could further pressure copper prices in the short term. Any fall in copper prices would be negative for copper producers including Freeport-McMoRan (FCX), Turquoise Hill Resources (TRQ), and Teck Resources (TCK).
Currently, Freeport forms 2.13% of the Materials Select Sector SPDR ETF (XLB).
Meanwhile, copper’s long-term fundamentals could be better than the short-term outlook. We’ll discuss this in detail in the next part of our series.
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