How Bernanke Built a Metal Mountain

Industrial companies irked at Wall Street over the availability of warehoused metal have their eyes on the wrong target. The real culprit is the Federal Reserve and its continued easy-money policy. When that policy ends, metals prices could sink.

Metal is piling up in London Metal Exchange-licensed warehouses as inventory is quick to enter but slow to leave. In some cases, it’s taking more than a year to get aluminum out of storage once you ask for it.

The inventories aren’t swelling because people don’t want the metal. They do — prices are historically elevated, just above $1,800 a metric ton, and some metal users have filed suit against the LME and some Wall Street banks in frustration that they can’t get delivery fast enough.

This has left the market in an unusual situation: high supplies and high prices. The last time prices were around this level (excluding the financial crisis period of 2008-09) was in the first half of 2005, when aluminum inventories averaged fewer than 600,000 tons, about a tenth of the current level.

What happened to the usual inverse relationship of prices to inventories? The Fed’s low interest rates, that’s what. “The major cost in commodity markets is the cost carry,” says Steve Hanke, professor of applied economics at Johns Hopkins University. More simply, the cost of holding inventory is the combined cost of borrowing money to buy the metal and the cost of storage, itself tied closely to the cost of borrowing. That’s true of all metals.

But it’s particularly true with aluminum because of its low density, says Catherine Virga, director of research at New York-based commodities consulting company CPM Group. Financing aluminum is more expensive because the rental costs are higher, she explains.

In other words, a ton of aluminum takes up more space than does a ton of copper. And copper prices are nearly four times higher than aluminum. When interest rates are low, that difference doesn’t matter so much because the cost of storing the metal is lower. That leads traders to take a buy-and-hold strategy.

U.S. benchmark interest rates near 0% also allowed banks and commodity traders to use borrowed money to take advantage of the gap between prices of the metal for immediate delivery and for future delivery. Traders could take a loan, buy metal on the physical market, warehouse it, and sell it at a higher price on the futures market, earning enough to pay back what they borrowed and still profit.

So what? Expect prices to change dramatically when interest rates rise.

“When the price of something goes up, you start rationing it more carefully,” Hanke says. In all likelihood, owners of the current massive inventories on the LME will likely reduce their holdings, he says.

There is another factor at play here. When interest rates rise, the economy tends to slow. That’s why central banks adjust the cost of borrowing—to moderate the economic ups and downs. It’s just a matter of time.

“The real-economy effects of higher rates can take many months to play out,” according to a recent report from Credit Suisse.

That said, any rate hikes by the Fed could be a good way off, and the Fed’s quantitative-easing program isn’t likely to end before 2014 at the earliest.