Sunday, 13 July 2014

US Bonds – helpful for precious metals short-term but medium-term risk

The major fundamental factors in our fair value models for the weekly metal prices were mixed this week. The major role played the outlook for US interest rates and stock markets for the precious metals.

Base metals were mixed but digested well the Chinese trade data, which showed a slower than expected increased of Chinese exports of 7.2% yoy compared with a 10% rise predicted by the consensus. Thus, the export surplus came in lower than expected at $31.6bn. Analysts reported that the import of metal was already affected by the probe of Qindao warehouses as banks are now more cautious with providing letters of credit to metal importers.

As far as US interest rates are concerned, two reports had an impact on markets. The first was a forecast revision by the chief US economist at Goldman Sachs. It took Mr. Hatzius a long time to wake up and to understand the messages, which the FOMC sent out with the quarterly short-term projections and dot charts. The message of the Fed was for quite some time that the first rate hike will take place most likely in mid-2015. But Goldman Sachs predicted against all odds that the first hike would not occur before Q1 2016. Now, also Goldman Sachs forecasts the first increase of the Fed Funds target rate for 2015. As the Fed prepared the markets for quite some time, this forecast revision should not have had any impact on markets. However, traders and analysts argued that the US stock market traded lower after the longer weekend due to the Goldman Sachs forecast revision. Another hint that the Chicago school theory financial markets are not information efficient is not worth a cent, neither an economics noble laureate.

The second report had been the minutes of the recent FOMC meeting, which were released on Wednesday. The interesting news of the minutes is that the majority intends to terminate the bond purchasing program with the October FOMC meeting. This implies that the purchases of US Treasury paper will be reduced not at the current speed of $5bn in October but by $10bn. However, ending QE3 by the end of October 2014 has also implications for the timing of the first rate hike by the Fed. Chair Mrs. Yellen stated several times that the first hike might take place about 6 month after terminating the bond purchase program. Therefore, the FOMC might decide already at the April 28 -29, 2015 FOMC meeting instead at the on at the end of June next year to increase the Fed Funds rate.

If the FOMC decides in April 2015 to hike the Fed Funds rate, then there are five more meetings scheduled were the committee could lift the key interest rate to a more normal level. Thus, also the level for the Fed Funds indicated by the dot charts of 1.25% by the end of 2015 gets more likely. However, the Fed Funds futures only price in a rate of 0.75%. From our point of view, fixed income markets are currently too optimistic for the outlook of Fed Funds by the end of next year. But adjusting expectations for the short-end will usually also have an impact on the long end of the US Treasury curve. Thus, 10yr US Treasury notes appear to be expensive at the current yield of 2.52%.

It might still take some time until the fixed income markets realize that the implied rate for the Fed Funds by the futures traded at the CME are too low compared with the signals send out by the Fed. However, once the market starts to correct its expectations, the potential impact on metal prices will be negative. On the one hand, rising US interest rates and yields increase the opportunity costs of holding metals. On the other hand, this development could reduce the attractiveness of commodity financing trades in China and thus, reduce the Chinese demand for metals used in commodity financing, which is not only limited to aluminum and copper, but also includes precious metals.

But that precious metals rose further during the past week, is the result of the “shoot first and ask later” mentality among traders and investors. On Thursday, Espirito Santo Financial Group (ESFG), which holds a stake of 25% in Portugal’s largest bank Banco Espirito Santo (BES), decided to suspend trading in its shares and bonds due to “material difficulties” at its largest shareholder Espirito Santo International (ESI), which is controlled by the Espirito Santo family. After BES shares fell by 19%, Portugal’s stock market regulator halted also trading in BES shares. Rumors swirled through markets that BES were in financial difficulties. As a result, not only the shares of BES and ESFG plunged, but it dragged also the Portuguese stock market and also other markets in Europe and the US lower. Furthermore, contagion spread also to the market for government bonds of the Eurozone. Yields on peripheral bonds jumped and Greece was only able to sell have the amount intended at an auction. The plunge of stock markets and soaring yields on peripheral Eurozone government bonds triggered a flight into save havens, which included also precious metals beside US Treasuries and German Bunds. During Thursday night, BES declared that its exposure to ESI would not put the bank at risk of running short of capital to assure investors about its financial stability.

This declaration led to a stabilization. However, according to reports published on Thursday, it should have been clear, that the problems of ESI are institution specific and not a general problem of the Portuguese banking sector in total. The flight to safe havens might support these assets for some time as investors might prefer to get more evidence that the Portuguese banking sector is not in troubles. Thus, in the short-run, the precious metals might be well supported by the safe haven status and as a mean to diversify the risk of holding equities. But the outlook for the US bond market in the medium-term indicates that the all-time high is far out of sight for gold and silver.  

Sunday, 6 July 2014

Against the Fundamentals, but not the Flows of Funds

Last week, precious metals closed higher than the Friday before. However, all fundamental drivers included in our fair value models were negative. But investors have rediscovered commodities and the rise of some base metals also supports the precious metals.

Among the economic data, the focus was on the purchasing manager indices for many countries. The Markit flash estimates prepared the markets already for weaker PMIs for many countries in the Eurozone. Thus, it was not a surprise for the market that the final index confirmed the trend, especially as also the EU data on business confidence come in lower. In the US, the ISM manufacturing PMI also edged lower while the consensus of Wall Street economists expected a small increase. However, the lower ISM did not harm the recovery of the US stock market as some components of the ISM manufacturing PMI pointed to better index readings next month.

But not each decrease of a purchasing manager index translates into weaker economic activity. The first misunderstanding is the threshold level of 50. The PMIs are so-called diffusion indices based on surveys. The percentage of negative responses is subtracted from the positive ones. If the number of positive and negative replies is the same, the raw index is zero and the value of 50 is added to obtain an index oscillating around a positive number. However, the responses are not weighted by the size of the company. Regression analysis between economic activity and manufacturing PMIs show that the critical value is in most cases below the 50 threshold.

Furthermore, the time series properties of the PMI are different from those of financial assets. The vast majority of assets in financial markets follow a random walk, which could be described by a geometric Brownian motion. However, oscillating indicators like the PMIs are mean-reverting and their behavior could be described by an Ornstein-Uhlenbeck process. Even with a slow speed of adjustment to the mean, declines during the phase of economic expansion occur and are not necessarily already a harbinger of a slowdown.

In China, the official manufacturing PMI remained above the 50 threshold. However, the more widely followed HSBC manufacturing PMI fell below the 50 threshold in January and now rose again above 50 in June. This surprise already provided support for copper after the release of the flash estimate and lifted copper further up this week.

The US labor market data came in far stronger than predicted by even many optimistic forecasters. The number of new jobs created rose to 288,000 and also the figure for the preceding month was revised higher by 7K to 224,000. The unemployment rate was expected to remain unchanged at 6.3% but dropped to 6.1%. And average hourly earnings increased again by 0.2% on the month. Thus, the labor market report points to an acceleration of the US recovery after the GDP drop due to the weather in the first quarter. This has lifted the US stock market to new highs for the S&P and Dow Jones indices. Also the US dollar appreciated against the major currencies and the US dollar index rose. Furthermore, the US bond market declined and yields on the 10yr US Treasury note rose by to 2.64%. All these factors are usually negative for precious metals.

Stronger economic data is normally supportive for the price of crude oil as it indicates a rising demand. However, demand is only one side of the equation. It was developments at the supply side, which lead to falling oil prices. In particular the news that the Libyan government reached an agreement with rebels, who handed over ports with oil terminals, send the price of crude oil lower.

In 2013 and also in some parts of this year, a stronger US stock market was negative for precious metals. The rise of the PGMs could be well explained with a stronger economy, translating into higher demand from car makers, and the supply loss due to the strike in South Africa. But why does gold and silver now rise when the major fundamental drivers are negative?

First, correlations are not causations and many factors can have an impact on the relationship between two variables. This explains well, why correlations fluctuate widely if correlation is measured over a shorter time period like 20 or 30 days. There were also periods when the stock markets and gold moved in the same direction before.

Second, the behavior of investors is not constant. Their assessment of future performance perspectives changes. Also the perception of risk is variable. In 2013, investors were convinced that stock markets offer a better return outlook and they shifted funds massively out of commodities into stock markets. The precious and base metal prices declined from the levels prevailing at the start of last year. However, now, two developments have changed the outlook. Many investors get more cautious towards equities. The valuations do not look as attractive compared to last year. Volatility has dropped. This is often regarded as a sign of complacency by investors. However, fund managers are now aware that low volatility spells danger.

Analysts at the end of last year were predicting that supply of many metals would rise and would shift the supply-demand balance towards lower prices on average in 2014. In this blog, we pointed out for copper that the development of warehouse inventories were not compatible with the narrative told by analysts but also official organizations. Indonesia impost export regulations, which had a strong impact on the supply of some metals. Nickel was the first base metal reacting with rising prices. But also lead and zinc prices recovered during the first half. Now also copper recovered and is trading again above the 7,000$/t level.

Therefore, we conclude that an increasing risk-awareness towards equities and the improved outlook for commodities has induced investors to allocate again more funds into commodity markets. Unfortunately, the LME has delayed further the publication of data comparable to the “Commitment of Traders” report compiled for US exchanges by the CFTC. Thus, there is only data for copper traded at the CME available for base metals. At the start of the year, speculative investors were net long 10,363 futures contracts and by the end of the first quarter, this turned into a net short position of 32,975 contracts. But during the second quarter, the net short position was reduced significantly to 1,764 contracts as of July 1st. In gold, the non-commercials were net long just 766 Comex gold futures at the start of June. Within one month, the net long position rose to 40,299 contracts, the highest level since early December 2012. Also the gold holdings of the SPDR Gold Trust ETF rose by almost 20 tons after hitting a low of 776 tons in late May.

If our conclusion about the behavior of large investors is correct, it has two implications for precious metals. First, firmer equities are not a reason to sell gold as some investors also buy gold as a hedge against the case that equities might reverse direction. Second, the improved economic outlook for the US and China leads to more funds flowing back into commodities. This is the kind of tight that lifts all boats. But as piano player Sam sung in the famous movie Casablanca: “Those fundamental things apply, as time goes by”. Thus, the stronger US recovery should lead to the first Fed rate hike in the middle of 2015 and rising yields will support the US dollar and weaken US Treasury paper. Both should weigh on precious metals and other commodities in the medium-term.

Sunday, 29 June 2014

Loans backed by falsified gold transactions

What started in the copper market with the probe of alleged fraud at Qindao warehouses in China now spreads to the gold market. Bloomberg reported on Thursday that China’s chief auditor discovered 94.4 bn yuan ($15.2bn) were collateralized by falsified gold transactions. Although already widely suspected by many people, this was the first official confirmation that also gold is used in Chinese commodity financing deals. Goldman Sachs reports according to the media that up to $80bn false-loans may involve gold. Thus, the question is: how do these false-loans influence the spot gold market?

To answer this question, it is first necessary to analyze how commodity financing deals work. There are two possibilities. In the first kind of commodity financing transactions, the owner of the commodity uses warehouse receipts to get credit from banks. The proceeds from this collateralized loans can be invested in higher yielding assets before redeeming the debt. This transaction is only economical if the return on the investment is higher than the interest rate on the loan. Due to restrictions, this is currently the case for investments in the Chinese shadow banking system.

The second transaction involves the import of the commodity. The Chinese buyer places an order with a foreign company to buy the commodity. Then the buyer applies for a letter of credit from a lender, which is used to import the commodity. With opening the letter of credit, the buyer obtains the consignment, which he can sell in the domestic market. Again, the importer of the commodity can use the proceeds for investing onshore before paying back the original loan. As many commodities are traded internationally in US dollars, this type of financial deal involves cross-currency transactions. Funding costs in US dollars are quite low and the foreign exchange rate risk is limited due to the yuan exchange rate regime, which allows only limited daily fluctuations. In addition, as long as the yuan strengthens against the US dollar, the yuan appreciation even contributes to the return in local currency for the Chinese importer.

In the first type, if the loan is based on a falsified gold transaction, then the warehouse receipt is a fake. This implies that the lender has made a loan but the collateral is worthless. The lender could demand from the borrower to provide the promised collateral. Alternatively, the creditor could cancel the loan agreement and demand the repayment of the credit. For the borrower, it might be probably easier and cheaper to liquidate the domestic higher-yielding investment and to redeem the loan. Buying the gold in the spot market requires to have the funds available to pay the seller. Obtaining a loan in this situation is probably far more expensive. In addition, interest payments on the original loan are still due.

Therefore, the direct impact on the spot price of gold should be rather limited. Those who obtained a loan based on false-gold transaction are more likely to liquidate the investment and redeem the loan than purchase gold to provide the collateral. However, the process of selling the higher yielding investments probably leads to price pressures for those investments, which might induce other investors to purchase gold as a safe haven.   

In the case of the second type of commodity financing transaction, there should be a discrepancy between the gold import statistics and the volume of consignments. In international trade finance, after a letter of credit was opened, the bank of the exporter sends the documents to the bank of the importer. The importer’s bank examines the documents, makes the payment to the bank of the exporter and hands the documents to the importer. If the consignment is faked, the buyer of the consignment will notice the fraud with a delay of only a few months if the commodity never arrives at the port of destination. Furthermore, ships can be tracked easily nowadays. Thus, the chances of discovering a falsified gold transaction involving gold imports are higher. Therefore, it is more likely that a faked gold transaction occurs with warehouse receipts instead of consignments.  

In the case of a falsified consignment, it is also rather unlikely that it will lead to a higher demand for gold in the spot market. The buyer of the consignment would have to prove who faked the consignment. This could be either the exporter or the importer. Identifying the party who faked the documents is a time consuming process. But even if the buyer succeeds to obtain a legal title against the criminal party, it might be worthless in the case this counterparty went bankrupt in-between.

While the amount of commodity financing based on falsified gold transactions is impressive, the impact on gold prices should be rather limited. Unwinding the financing deals does not involve buying or selling gold as a necessary condition. However, other assets, i.e. those purchased with the proceeds from commodity financing might come under pressure. This is especially the case if lenders demand more and secure collateral or terminate the loan agreement.

Sunday, 22 June 2014

Precious Metals rally after FOMC Meeting

While precious metals traded sideways ahead of the FOMC meeting, the four metals rallied as the US dollar weakened against the major currencies after the meeting. Gold jumped above 1,300$/oz. and silver above 20$/oz. However, we regard the reaction in the precious metals and foreign exchange markets as overdone.

The FOMC kept the Fed Funds target rate unchanged at 0.25% or lower and reduced the total volume of bond purchases by another $10bn. This should not come as a surprise. The Fed did not provide any hint that the majority of FOMC voting members would accelerate the speed of tapering. Even with the committee recognizing “that growth in economic activity has rebounded in recent months”, the stronger growth compared with the first quarter is not a convincing argument to change track in monetary policy. Also the improvement in the labor market is not sufficiently strong enough to justify a faster termination of bond purchases. The FOMC still regards the unemployment rate as elevated. Furthermore, the committee states “inflation has been running below the Committee’s longer-run objective, but long-term inflation expectations have remained stable”. Thus, also the second target of the Fed does not provide a justification for reaching the end of bond purchases faster than previously indicated.

The FOMC also presented its economic projections. It lowered the projection for GDP growth in this year from 2.8 – 3.3% to 2.1 -2.3%. At a first glance, this might look like a major revision in expectations for the current quarter and the second half of 2014. However, for the GDP in the final quarter of 2014 to be 3% higher than in the same quarter of the previous year, GDP has to grow at an average quarterly rate of around 0.75%. But due to the negative weather, US GDP declined by 0.25% quarter-on-quarter, which translates into a drop of 1.0% annualized. Taking this decline into account, the revised projection still implies an average quarterly GDP growth of around 0.75% for the other 3 quarters in 2014. Thus the new projection neither reflects a more pessimistic nor more optimistic view of the FOMC members on the underlying expansion of US economic activity. Also the revisions for the unemployment and inflation rate are only minor.

There was criticism that the decision to taper further by $10bn was inconsistent with the revision of GDP projections. However, as shown, the FOMC has not changed the projection for average quarterly growth for the remaining 3 quarters. Furthermore, the revision of the GDP projection has led to accusations that the Fed would always overestimate GDP growth. The FOMC presents a range of GDP growth, nevertheless, there remains an imponderability in any forecast of a random time series. And in the case of the Q1 GDP growth, the weather had a stronger impact on economic activity than on average during the winter months. Even meteorologists did not predict such a long cold period before the start of the winter season. Therefore, the FOMC is not to blame for overestimating the GDP growth in Q1.

But also the expectation of faster end of bond purchases are not rational based on the expectation of a recovering US economy. The projections of the FOMC for the dual mandate variable are only modified slightly. Also the underlying expectation for average quarterly GDP growth remains almost unchanged. However, for terminating bond purchases faster the FOMC would have to expect stronger economic activity than previously assumed. Just forecasting a recovering after the decline of GDP in Q1 is not sufficient.

The dot charts are sometimes misinterpreted. But they give a good indication about the direction of monetary policy and the possible Fed Funds target rate at the end of the corresponding year. There is still no majority expecting a rate increase in 2014. Thus, the middle of 2015 remains currently the most likely date for the first rate hike. However, there appears to be no majority for increasing the Fed Funds target rate beyond 1.25% by the end of 2015. The dot chart from the March FOMC meeting showed that the majority did expect the Fed Funds rate to be only lifted to 1.0%. Thus, the FOMC got a bit more hawkish as far as the outlook for interest rates is concerned. But the Fed Funds December 2015 future just prices in a hike to 0.75%.

From our point of view, the risk is clearly that the FOMC might hike the key interest rate more than the market prices in during the second half of 2015. This should be supportive for the US dollar against the euro and the Japanese yen. However, the Bank of England might increase the base rate earlier. But overall, the indications provided by the FOMC do not support arguments for a weaker US dollar. Thus, the FOMC policy outlook is also not positive for the precious metals.

But there is not only a danger for precious metals of the Fed monetary policy outlook for 2015 via the influence of the US dollar on precious metals. At the current yield of 2.62% on 10yr US Treasury notes, there is hardly any downside potential left unless economic conditions weaken surprisingly and would derail the FOMC policy projections. A rise of the Fed Funds target rate to 1.25% within the next 18 months should also lift yields higher at the medium- to long-term maturity range. Given the outlook provided by the FOMC, 10yr US Treasury yields in the range between 2.75 – 3.0% appear more appropriate and 2.62% looks as expensive. A rise of US Treasury yields also increase the opportunity costs for holding precious metals. Thus, also the medium-term outlook for the US Treasury market is a negative factor for gold and silver. 

Therefore, we come to the conclusion that the outlook for precious metals is not as positive as the market believes after the FOMC meeting. As long as the US economy develops as the FOMC expects, the risk for precious metals remains more biased to the downside. Only negative surprises, which would lead to a change in the outlook for the Fed policy, could make gold more attractive in the medium-term. However, geo-political developments could lead to demand for gold and silver as safe havens. How the situation in Iraq develops is hard to predict.   

Sunday, 15 June 2014

Roller-Coaster for the PGMs

It was a roller-coaster week for the PGMs. After a government mediation failed to reach an agreement between the unions and mining companies to end the longest mining strike in South Africa, palladium rose further to 862.5$/oz. Thus palladium traded higher than in late February 2011 and reached the highest level since February 2001. Also platinum rose, but remained below the high of the year, which was reached at 1,493.90$/oz on May 22.

However, after reports emerged that a wage deal might be in reach, both PGMs came under pressure and posted strong losses. It was a bit of buying the rumor and selling the fact, but it is at the time of writing just a hope that the mining strike will be over soon.

According to GFMS, the demand for palladium exceeded supply in 2013 by more than one million ounces. South Africa contributed 2.35 mil ounces to the total mine production of 6.4 mil. Ounces. Scrap recycling added another 1.9 mil ounces to the total palladium supply. With the long lasting strike, the mine production in South Africa is expected to fall significantly short of last year’s level. Thus, overall palladium supply should be lower in 2014 than in 2013. In late April, GFMS estimated that 0.6 mil ounces were lost due to the strike. Thus, when workers return back to work, the total loss could come close to 1 mil ounces. At the same time, the recovery in the European automotive sector points to an increased industrial demand. Therefore, the supply deficit might rise to 2 mil ounces or above.

From the high reached last Wednesday, palladium lost more than 50$/oz. In the short run, the price of palladium might retreat further. However, with the outlook for a higher excess demand, palladium should be well supported.

One question often asked was about the size of the price increase since the start of the year. Many commentators had expected a stronger rally given the duration of the strike. One possible answer is that palladium consumers hedged their demand right in time with options. In this case, the short seller of the option only needs to buy incremental amounts of palladium according to the change in the option delta to remain hedged. Another possibility is that consumers expected that prices would decline again after a wage deal is reached. They can secure physical palladium by lending from holders of palladium inventories, which do not need the metal for immediate consumption. These are mainly financial institutions and investors.

The rise of palladium to a new multi-year high had also a positive impact on gold and silver. All four precious metal have a common usage in the jewelry industry. Thus, they are to some degree substitutes. A rise of the price of one metal relative to the others is increasing the attractiveness to use one of the other metals as a substitute. Thus, the rise of the PGMs increased the attractiveness of gold in the jewelry industry. This explains that the rally of the PGMs at the middle of the week also pulled gold and silver higher. Also quantitative models (VAR) show that there is a stronger link between gold and platinum prices and a stronger link between silver and palladium.

Then the question arises, why did gold and silver prices increased further while platinum and palladium plunged? From our point of view, the answer is the recent geo-political developments in the Middle-East region. With the ISIS terror group gaining control over Mosul and moving towards Bagdad, the markets got surprised. Oil markets fear that the rebels gain control over Iraqi oil exports. Stock markets fear a negative impact on global growth and turned lower, with weaker than expected US economic data being another reason for taking profits. Thus, gold and silver remained in demand as a safe haven, while the PGMs sold off.    

Sunday, 25 May 2014

Where Is the Copper Supply Surplus Gone?

Only less than two months ago, the International Copper Study Group forecasted at its semi-annual meeting in Lisbon that after four years of supply deficit, the copper market would swing into a surplus. While the ICSG estimates that the apparent refined copper consumption exceeded supply in 2013 by 282 thousand tons. For this year, the ICSG forecasts a supply surplus of 405 thousand tons. This swing in the supply/demand-balance by 687 thousand tons is due to an increase in mine production, which leads also to a rise of refined copper output. For this year, global mine production is expected to increase by 4.7% to 18,904 thousand tons. Refined copper production is forecast to rise faster than mine production by 6.5% to 22,362 thousand tons. The global copper consumption is predicted to increase by only 3%, which is less than global GDP growth, to 21,957 thousand tons.

A swing in the supply/demand balance of the magnitude predicted by the ICSG should be reflected in the development of copper stocks. According to the recent figures published on May 22, 2014, by the ICSG in the press release for the Monthly Copper Bulletin, global copper stocks increased by a total of 102 thousand tons in the first two months of 2014. Inventories held in the warehouses of the three major exchanges (LME, Shanghai and CME) dropped by 25.2 thousand tons in the same period, which is in a clear contrast to the estimate of the ICSG for the first two month. Since March, the fall of inventories accelerated. Despite some temporary inventory builds at some exchanges, copper stocks are currently down 228 thousand tons YTD. This plunge of copper inventories at exchange warehouses since the beginning of March is in such an obvious contrast to what one would expect given the forecast of a 405 thousand tons supply surplus.

Certainly, copper inventories are not only held in exchange warehouses. Producers and consumers of copper also hold inventories, but one would expect that these holdings are more determined by economic activity and opportunity costs. If we take this into account, it appears rather unlikely that producers and consumers have increased their inventory holding by the amount to explain the difference between the change in the supply/demand-balance and exchange warehouse inventories.

Furthermore, if producers hold more inventories, then one would expect that they also want to hedge the inventories, especially when the majority of forecasters predict a change in the supply/demand balance. This should lead to a considerable increase of open interest and falling copper prices. However, when copper reached its low of the year so far in March, the LME copper futures open interest was up only 7 thousand contracts compared to the end of 2013. In addition, copper at the LME remained in a slight backwardation in mid-March. But copper prices were in contango at the Shanghai Futures Exchange. LME open interest in copper futures rose far stronger since mid-March to more than 340 thousand contracts at the start of this past week. This rise in open interest was accompanied by a recovery of the copper price. This argues that not producers are hedging against further falling prices due to a supply glut but consumers hedge future demand. However, this behavior would be only rational if consumers doubt that forecasts of a supply surplus depressing prices are correct.

The other explanation is that the copper supply surplus is held in bonded warehouses in China and had been used for financing deals. In April, we analyzed the development of the copper price in Shanghai and the inventories held at SHFE warehouses. In 2012 and 2013, a structural break took place and inventories at SHFE warehouses rose stronger as a model based on the development between 2009 and 2011 would have predicted. However, this development had not a major impact on the price of copper. Other factors explained the price development far better. It could not be ruled out, that the higher SHFE warehouse inventories were the result of stocks moved out of bonded warehouses.

Thus, doubts remain that the excess production of refined copper was absorbed by stocks held in bonded warehouses in China for serving as collateral in financing deals. Furthermore, it could not explain the decline of stock held in exchange warehouse inventories

While total exchange warehouse inventories decayed since the start of this year, stock held in LME warehouses declined by 195 thousand tons and remained almost unchanged in CME warehouses. At SHFE warehouses, inventories rose until the plunge of copper prices, and then also sunk from 213.3 to 92.7 thousand tons, which translates to a fall of 33.2 thousand tons since the end of 2013. It had been reported at the end of April that China’s State Reserve Bureau bought copper. However, according to the sources of the reports, the SRB bought from bonded warehouses. But this does not explain the fall of copper stocks at SHFE warehouses, unless the SRB also bought silently since mid-March copper in huge amounts held in bonded and exchange warehouses.

We have data for cancelled warrants only for LME warehouses. At the LME, the free available copper stocks plunged to a mere 92,650 tons at the end of this week. This is the lowest level since early April 2008. Copper is in a backwardation at the LME and the SHFE, which indicates that copper is tight and not abundantly available as estimates about a supply surplus would suggest. Our quantitative model for global total refined copper supply and consumption indicates that consumption would further exceed supply in this year. Structural changes can have a significant impact, which quantitative models do not incorporate immediately. Thus, we would not rely solely on quantitative forecasting models. However, the development of copper inventories in exchange warehouses, the backwardation and the results of the quantitative model increase our skepticism that the copper market will swing to a supply surplus in the magnitude forecasted by the ICSG. 

Sunday, 18 May 2014

The End of the Silver Fixing

The announcement of London Silver Market Fixing Limited that it will terminate to administer the London silver fixing with the close of business on August 14, 2014, should not come really as a surprise. After Deutsche Bank already declared to withdraw from the fixings of gold and silver, only two bullion banks remained in the group conducting the silver fixing. When this decision was made public by Deutsche Bank, FCA board member, Mrs. Tracey McDermott, stated that the UK regulator could intervene if there were too few participants left in the London silver fixing.

In the media reports about the announcement, no reason was stated why London Silver Market Fixing made this decision. However, it is quite easy to guess what the major reason behind this move is. The risk of financial penalties by regulators or pending lawsuits – especially outside the UK - just got too high. In the USA, CFTC commissioner Bart Chilton called for investigations into the London fixings for some time already without having provided any evidence for manipulation of the London fixings or for misconduct by the bullion banks involved. Also the head of the German watchdog BaFin, Mrs. Koenig, accused Deutsche Bank of wrongdoing without presenting facts. The London fixing was discredited by foreign regulators. But now, they made a disfavor to many producers and consumers of silver.

In this blog, we have pointed out a few times, that the fixings of gold and silver are not comparable with the setting of the Libor benchmark rates. The London fixings are a price discovery procedure, which is based on real trading activities and not on estimates of what the market price might be. Furthermore, the bullion banks do not know how their clients might change the quantities they commit to buy or sell if a new price will be called in the fixing process. In addition, the procedure applied in the London fixings had also been used in the past at regulated exchanges.

The LBMA issued the following statement: “As part of our role as the trade association for the London Bullion Market, the LBMA has launched a consultation in order to ensure the best way forward for a London silver daily price mechanism. The LBMA will work with market participants, regulators and potential administrators to ensure the London Silver Market continues to serve efficiently the needs of market users around the world. As part of the consultation process, the LBMA will be actively approaching market participants requesting feedback.” Furthermore, the LBMA conducts a survey in the process of market consultations. Thus, the current system of price fixing in the silver market is coming to an end, but the search for an alternative system is taking place already.

What might be possible alternatives to the current London silver fixing? Silver is also quoted by many financial institutions on quote screens at Bloomberg or ThomsonReuters terminals or electronic foreign exchange trading platforms. One possibility would be to use those quotes sampled at a random time within a specified time span. Thus, traders would only know the time span, but not the exact time stamp. Then the quotes in the lower and the upper 25% percentile could be discarded and from the remaining quotes the average would be published as the new benchmark indication. However, such an approach would have the same weaknesses as the Libor benchmark procedure.

From our point of view, any substitute for the current London fixings should be based on real trades and not on quotes. Liquidity in the market is not the same at every point in time but varies during the day. Thus, a new reference price should be found when the liquidity is usually high in the market and this is the case in the afternoon London time. Furthermore, a new benchmark price should be found by trading taking place at one central location. In addition, the price should be set in an auction style procedure.

Spot trading in precious metals is usually OTC trading, but for the fixings, it is concentrated at one place where the price is discovered in an auction style procedure. If the current system has to be replaced without abandoning the advantages of high market liquidity, supply and demand concentrated at one location and auction for price setting, then moving the fixing to a regulated exchange is probably the best solution. This could be an electronic exchange but also an open outcry system. The LME is already fulfilling the requirements for a fair and transparent price setting for cash and forward transactions in base metals. There are ring sessions with settlement prices for transactions in the morning and afternoon. Moving the London fixings of precious metals to the LME ring trading might be the best alternative. Producers and consumers would be able to obtain the best price for larger quantities in trades at a regulated exchange. The procedure would be transparent and the precious metals market would still have benchmarks satisfying the requirements for reflecting the true market price.