Macquarie Research notes that chinese domestic prices for the majority of the commodities it covers are now above their import substitute prices, in general reflecting relative strength in demand and government stockpiling. Also, base metals continued to rally strongly on Friday as optimism remained dominant following Thursday’s G20 meeting and consequent ‘global’ stimulus announcement. Copper closed at $1.94/lb ($4,275/t), its highest close since October 30 last year. Global equity markets, commodity prices and commodity country exchange rates (which have historically been good predictors of commodity prices) have all shot up since mid-February. Not unrelated to this, some of the lead indicators have bottomed, consistent with Macquarie’s assumption that industrial production will bottom globally in 1H09 before recovering in 2H09, driven mainly by China.

Macquarie says “most of our contacts in the ‘real’ world of buying and selling commodities, facing ongoing bleak orders (there are no orders! is a common statement) and low levels of activity, cannot believe what is happening.

“In historical context, the recent commodity price rally (to-date) is minor. [However], we can point to a number of factors to explain the rally in commodity prices (some of which are strongly interrelated and/or driven by the same variables):

• The positive influence from equity markets. With investors not wanting to miss the turning point and with most we speak to not being heavily involved in this rally, we are wary of the potentially self-fulfilling rallies in the stock market
• Plans by the Federal Reserve announced on March 18 to buy back US government debt triggered concerns about reflation and a re-direction of money towards assets leveraged to such a story (commodities). Since this announcement, the US dollar has depreciated sharply, also supporting prices
• Substantial global fiscal (and, hopefully, successful monetary) stimulus of about $5 trillion (according to the G20 summit attendees)
• Signs of bottoming in China, including the sharp spike in the Chinese PMI (purchasing managers index) to 52.4, a 14.1% YoY increase in Chinese floor space under construction in January and February, a strong pickup in money supply growth and a reported flat electricity generation in March YoY. There were also some tentative signs of a bottoming in the US PMI (new orders up strongly) as well as in other major economic PMIs.

“Although the broad-based depreciation of the US dollar been partly responsible for the large appreciation in major commodity currencies against it, some market participants are pointing to the fact that appreciating commodity currencies are a solid forward predictor of the direction of commodity prices. The academic literature generally supports this, with Y Chen, K Rogoff, B Rossi (2008) recently finding that “commodity currency exchange rates have remarkably robust power in predicting global commodity prices.”

“There are factors that make us cautious about reading too much into the recent rally in terms of our short-term stance (we have already been incorporating a 2H09 rebound in China and a world ex-Chinese rebound in 2010 in our numbers for some time).

“Fiirst, we have not heard from any of our consumer contacts that there has been a significant pickup in orders. This anecdotal evidence ties in with the fact that physical premiums for the base metals are still weak and that non-futures traded commodity prices (steel, iron ore, thermal coal, ferrochrome, manganese ore) are either still falling or not rising. Second-quarter orders and demand remain as weak as, if not weaker than, first quarter levels, and non-Chinese demand is 30-60% lower YoY for most commodities, a horrendous collapse.

“Second, we fear that any revival in demand will be matched by an equally robust recovery in production. Many of the industries we follow have slashed operating rates from 95-100% in mid-2008 to only 65-75% – and even lower, in many cases – at the moment (the US steel industry is operating only just above 40%).

“We are also concerned that price rallies will be shortlived as supply comes flooding back into the market.

“The steel price is clearly giving different signals to copper prices as to the outlook. Indeed, we are wary that the copper price is in some ways giving a false signal considering that the price is in large part being driven by SRB buying and shortages of copper scrap and not by end-use recovery.

“Looking at the open interest data, we can see that both short covering (late-February, mid-March) and new long positions (late-March) have been associated with the ~30% rally in copper prices since mid-February.

“Although there is undoubtedly some euphoria about the actions being taken by monetary and fiscal authorities to address global problems, we think the extent of the actions reflect how bad things actually are.

“We are concerned that short-term disappointments and doubts may eventually kill this premature rally, although we hope that signs of improvement may be more-solidly based during the second half of 2009.”