Gold flies high as Helicopter Ben is ready for take-off

The Fed was the major factor for the development in metals markets last week. Not only gold and other precious metals rose, but also the base metals advanced. A market report from Reuters stated that the comment about inflation would have triggered demand for inflation sensitive assets. In another report, an analyst is quoted saying that “the association with deflation is panic, then that flight to quality and liquidity is worth something”. Thus, what is the real reason for the firm metals markets after the FOMC meeting and what will be the future perspectives?

Two paragraphs of the FOMC statement are important to assess the monetary policy of the Fed:

1)       Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability. With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate.

2)       The Committee will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate.

(For the complete FOMC statement see Federal Reserve).

Unlike other central banks, the Fed is not looking at a broad measure of consumer prices. The FOMC members are smarter than the members of the ECB council and know that they can not fight the impact of weather conditions on consumer prices. Thus, the Fed is focusing on core inflation excluding the rather volatile segments of food and energy. The favorite index is not the urban CPI, which gets more attention in financial markets and in public, but the core personal consumption expenditure deflator. The core PCE has risen in the second quarter by 1.5% yoy after 1.8% yoy in the first quarter of 2010 (for the core PCE). The recent CPI data, the still rather low capacity utilization as well as the moderation of GDP growth indicate that the core PCE is at risk of declining further. All price indices have some measurement weaknesses. Thus, price stability is usually associated with a rise by close to 2% yoy and not just remaining unchanged. In this respect, there is no difference between the Fed and the ECB, the target for the Bank of England had been set by the Chancellor of the Exchequer (finance minister) at 2.5%. Thus, the first paragraph quoted clearly expresses the concerns of the Fed that aggregate demand might be too weak to prevent a dip into deflation.

The second quote underlines that the Fed would be ready to act to prevent deflation. It does not provide the slightest hint that the Fed would embark on an inflationary policy. In the likely case that the Fed would implement a new round of quantitative easing, there would be no rational reason to buy metals as a hedge against inflation. The Bank of Japan is applying quantitative easing since almost one decade and is still in an uphill fight with deflation. Thus, quantitative easing is by no mean a guarantee for an accelerated rise of inflation indicators.

 In the case of outright deflation, which Japan is currently experiencing, there is no reason to buy gold or other metals as a store of value. In addition, contrary to the above quoted comment from an analyst, gold does not provide any additional liquidity advantage. Physical possession of gold is associated with storage costs. Even at the very low interest rates offered on short-term Japanese Government paper, holding government paper provides superior real return perspectives. Even paper currency beats gold and other metals as a store of value in a deflation.

However, there is one major difference between Japan and the US, which plays a crucial role for the demand for metals. The Japanese yen is an important currency, but the status of the US dollar as global reserve currency is unrivaled. As the most important metals are priced in US dollars, the external value of the US currency plays a crucial role for the price trends in metals markets. A new round of quantitative easing by the Fed will have an impact on short-term interest rates and government bonds along the whole yield curve. Falling interest rates increase the incentive to use the US dollar as funding currency in carry trades and to invest in higher yielding assets in other currencies. The US dollar is likely to depreciate with quantitative easing, except a new financial crisis would trigger again a flight into the safe haven and to unwinding of carry trades. For the Fed, a weaker US dollar would have the positive impact that it would help to achieve the target to prevent deflation by higher import prices. For commodity investors, it would be supportive as commodity prices often rise stronger and more than compensate the impact of a weaker US dollar. And it is exactly this perspective, which was the main driver for precious and base metals following the release of the FOMC statement.

We are skeptical that the Fed would be successful with implementing further quantitative easing. Increasing the Fed balance sheet could be even counter-productive for three reasons.

First, as several academic studies demonstrated, the yield curve is one of the best indicators for future economic activity. A steepening of the yield curve signals that the outlook gets brighter and economic activity usually picks up with a time lag of around 6 – 12 month. Two measures of yield curve steepness are often watched to assess the outlook for GDP growth, the spread between the yield on 10yr US T-Notes and the 3m T-Bill rate or the difference to the 2yr US Treasury yield. In any case, the scope for quantitative easing to lead to a steeper yield curve is rather limited. The 3m T-Bill rate is at 0.19% and the yield on 2yr US Treasury paper is at 0.44% currently. Thus, quantitative easing might probably lead a flattening of the US yield curve, which would send the wrong signal to businessmen that GDP growth would moderate even further.

The second reason is related to the first one; however, it does not refer to spreads along the US Treasury curve but to spreads compared to other segments of the US bond market. Buying treasury paper by the Fed is likely to lead to wider spreads of other instruments over the government paper. A widening of spreads of mortgage bonds could send the wrong signal to financial markets as they might regard the spread widening as another sign of renewed pressure on the housing market. This could also lead to a deterioration of consumer confidence and lower consumption spending. For business fixed investment, the level of capital costs should be the more important factor. However, increasing spreads of corporate bonds over treasury notes could signal to corporate treasurers that the market would view investment plans as more risky. The board might decide to postpone investments, which would then be another dampener for aggregate demand.

The third argument refers to the relationship between yields and savings. Contrary to conventional textbook theory, lower yields would not necessarily lower savings, but could lead to a higher savings ratio. It affects the corporate as well as private household sector. Many companies sponsor pension schemes. As yields decline, those pension schemes get underfunded. While the value of current bond holdings rises as yields drop, the capital gains are not always sufficient to compensate for the lower income earned from new investments. If the duration of the portfolio is lower than that of the pension obligation, underfunding emerges. Quantitative easing is expected to drive yields lower and thus, to increase the underfunding of pension schemes. Companies would have to invest more funds in their pension schemes to meet future obligations. In Japan, the low interest rate level had severe implications for private consumption and the US might face the same problem. People already in retirement rely to some extend on their savings for their consumption. If the yield on these savings declines, they have to reduce consumption. Similar to the problem of companies, the active work force might have to increase the saving ratio in order to reach a certain level of wealth for future spending once they retire. Thus, the falling bond yields, which are probably pushed further down by quantitative easing could have the adverse and undesired effect that companies and private households increase their saving and spend less.

All in all, quantitative easing bears some considerable risk of even depressing aggregate demand and thus, increase the deflationary pressure. And it is doubtful whether a depreciation of the US dollar as a result of quantitative easing would be sufficient to compensate the negative factors mentioned above. The Fed might then increase the balance sheet expansion to fight deflation. The demand for the industrial use of metals might decline, but a weaker US dollar could still be enough to push metal prices up.