November 29, 2016 / 2:01 PM / 9 months ago

Bubbling lead market signals the return of irrational exuberance: Andy Home

An engineer checks machinery used to extract lead concentrate from ore at the Novoangarsky lead and zinc ore dressing plant on a former riverbed of Angara river near the Siberian settlement of Novoangars, Russia, August 17, 2016. Picture taken August 17, 2016.Ilya Naymushin

LONDON (Reuters) - What on earth is going on in the lead market?

This most unglamorous of industrial metals has just burst into bullish flames.

On the London market the price of lead for three-month delivery jumped by $150 per ton, or seven percent, between the Thursday and Friday close.

It has surged another $140 on Monday morning to hit a five-year high of $2,565.50 per ton.

This is a rally made in China, where the Shanghai Future Exchange's (ShFE) contract has gone super nova with both price and open interest hitting their highest levels since lead started trading in 2011.

Or maybe that should read "another" rally made in China because Shanghai lead seems to have been caught up by the speculative craze sweeping across the whole commodities spectrum.

What's interesting about lead, though, is that there is no fig leaf of rationality to explain its stratospheric take-off.

Rather, it acts as a warning that irrational exuberance is back with a vengeance in the metals markets.

DESPERATELY SEEKING A NARRATIVE

Animal spirits are running rampant across China's mainland commodity markets.

In the metals-trading space this really started with ferrous contracts such as Dalian iron ore and Shanghai steel rebar, but the bullish wave has rolled into the likes of copper, aluminum and zinc.

It is human nature to try to "explain" such dramatic moves by finding a narrative in which to wrap them.

The emerging storyline is one of stronger-than-expected Chinese construction and the promise of more infrastructure spend to come.

You can add a seasoning of the "Trump factor" to the mix in the form of the U.S. president-elect's own promise to copy the Chinese model of spending on roads and railways as a way of stimulating growth.

The problem when it comes to lead, though, is that however many new roads, railways and airports are built in either China or the United States, it won't make a jot of difference to lead's usage profile.

The world has spent the last several decades engineering lead out of just about everything other than automotive batteries due to its toxicity.

There is future potential for lead batteries to grab a slice of the grid storage market but, for now at least, lead is all about trucks and cars.

The global vehicle fleet will continue growing and so too will the amount of lead used to power it, even the hybrid and electric components, but there has been no new policy announcements by either Beijing or Donald Trump to suggest any step-change in that growth rate.

On the supply side, lead is taking some collateral hits from the closure and mothballing of zinc mine capacity. The two are sister metals insofar as they often occur in the same deposits.

But even as the raw materials chain tightens, there is little evidence of flow-through to the refined metal market.

Stocks of lead held in London Metal Exchange (LME) warehouses are little changed so far this year.

China's trade with the rest of the world is largely flat with a slight bias to exports, particularly of lead in fabricated form.

The International Lead and Zinc Study Group (ILZSG) is forecasting significant supply shortfalls in the refined zinc market both this year and next.

But when it comes to lead, the outlook is one of supply-demand surplus to the tune of 42,000 tonnes this year and 23,000 tonnes in 2017.

Graphic on Shanghai lead price, open interest and volume:

tmsnrt.rs/2frYoQ8

SHANGHAI SURPRISE

Lead's fundamental story, in other words, is pretty boring.

True, there should be some seasonal lift over the northern hemisphere winter as more car batteries fail and need replacing.

But since we're already entering the "battery kill" season, any preemptive stocking by battery manufacturers should already be in the price.

All of which explains why the London lead price has spent much of the year shuffling sideways.

No-one was expecting much price upside any time soon.

That much is evident from the LME options market.

Open interest on call options, which confer the right to buy at a fixed price level at a future date, often acts as a thermometer of bullish spirits.

But the highest open strike price on lead call options in December is $2,400 per ton, a level that has already been blown away by Friday's action.

And the highest call option strike price with open interest across the whole of the first half of next year is $2,500 (150 lots in March).

It's just no-one told the Chinese how boring lead was going to be.

The Shanghai lead contract has seen almost 1,442,670 lots of turnover so far this month, already exceeding the previous record of 1,021,210 set in August 2014 and dwarfing the monthly average of 330,800 in the first 10 months of this year.

Market open interest has rapidly increased from 51,132 lots at the end of September to 75,460 lots as of Friday, also an all-time record.

As open interest has surged, so too has the price, signaling the same bullish exuberance that has rolled across the rest of the commodity universe in mainland China.

IRRATIONAL EXUBERANCE

While such exuberance can be partly explained by the continuation of and activation of pro-growth policies in China and the United States respectively, lead doesn't lend itself to such rationalization.

Lead's own lack of supporting fundamental narrative should act as a warning sign that there is more than a little irrationality in all this exuberance.

"Irrational exuberance" was a phrase coined by former Fed Chairman Alan Greenspan in a speech in 1996.

"How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions?" Greenspan was at the time referring specifically to Japan's lost economic decade of the 1990s but his comments are now remembered for foreshadowing the bursting of the dotcom bubble a few years later.

And they appear particularly relevant again to the bull mania gripping China's commodity exchanges.

Everyone agrees that these sharp rallies have been too much too soon. Some day of reckoning, it follows, must be coming.

But the problem for those trying to trade against the rising trend is that, to quote another famous economist, this time John Maynard Keynes, markets "can stay irrational longer than you can stay solvent".

It still doesn't mean lead's eye-watering rally is rational, though.

(The opinions expressed here are those of the author, a columnist for Reuters)

Editing by David Evans

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