Fed twists again, like it did last summer

The FOMC meeting disappointed markets and was the trigger for another sell-off in precious metals markets. Also weak economic data contributed to the plunge. Silver lost more than 6% on the week and was again the most volatile precious metal. But also the other three precious metals lost more than 3% compared to the preceding weekly close. However, we regard the reaction of financial and commodity markets after the FOMC meeting as overdone. QE3 remains on the agenda, but for later this year.

“Come on, let’s twist again like we did last summer”. This line from an old Chubby Checker song might also have been the appeal of Fed chairman Bernanke at the two-day FOMC meeting this week. The majority followed Ben Bernanke, only Jeffrey Lacker dissented as usual. The FOMC extends “operation twist” until the end of this year at the current pace. The total volume of operation twist will be 667bn USD by the end of 2012, which implies an increase of 267bn USD from the original volume of 400bn USD. However, market expectations had been irrational. Thus, markets did not like this song, which had been popular during the childhood of Ben Bernanke. Markets priced in a remake of quantitative easing, performed by the FOMC already twice.

The stage is not set yet for a third version of quantitative easing, but probably will be towards the end of 2012. The FOMC has revised down its forecast for GDP growth by half of a percentage point. This might not be the last downward revision in the current cycle. The regional surveys of the New York and the Philadelphia Fed plunged strongly. Also the Markit PMI for the US, a rather new survey, declined from 54.0 to 52.9 according to the flash estimate. This indicates that also the ISM manufacturing PMI is likely to decline towards the 50 threshold.

German chancellor Merkel agreed at a meeting last Friday in Rome with the leaders of Italy, France and Spain on a 130bn euro economic stimulus program, which will be discussed at the EU summit on June 28. However, Mrs. Merkel still rejects any proposal, which is suitable to break the link between public debt and banking crisis in the eurozone. German politicians believed that the strong domestic economy would mitigate the economic crisis in other eurozone countries. However, they have to wake up and to realize that it was only a dream. As the Markit PMI for the manufacturing and service sector as well as the ifo-index show, also Germany gets pulled down by the recession in the rest of the eurozone.

Fed chairman Bernanke stated rightly that the debt crisis in the eurozone has a negative impact on the US economy. The resistance of German chancellor Merkel and Bundsbank chief Weidmann, based on ideology and a lack of sound economic understandings, prevents a solution of this crisis. Therefore, Europe will remain a drag on US GDP growth for the time being.

According to the compromise reached last summer to lift the debt ceiling, the two parties have to find a compromise on reducing the federal budget deficit. Otherwise, at the start of 2013, automatic measures will kick in. This would imply a headwind from the fiscal policy in the magnitude of 5% of US GDP. It appears as rather unlikely that Republicans and Democrats will reach a compromise ahead of the presidential elections taking place on the second Tuesday in November. Thus, the risk is rather high that the US economy might fall over a fiscal cliff. For this possible case, the Fed has to keep the powder try.

Despite the billions of US dollars already spend for operation twist, it does not appear to be very effective in stimulating the economy. Since the FOMC decided to implement operation twist, the yield on 10yr US Treasury notes declined by just 25bp to 1.62% (constant maturity yield according to Fed data base) as of last Friday. However, for business fixed investments the relevant yield is not the one on US Treasury paper but on corporate bonds. The Moody’s yield index on seasoned corporate bonds with a BAA rating declined over the same time horizon by a mere 13 basis points to 5.05% (source Fed). Thus, the spread of corporate bonds over 10yr US Treasury notes widened by 12bp. In financial markets, a look at spreads instead of absolute yield changes is very widespread. Therefore, the spread widening might be regarded even as negative for corporate issuers. To promote investments in plants and machinery by companies or in residential housing, selling US Treasury paper and reinvesting the proceeds in corporate and mortgage bonds would probably have a stronger impact on economic activity.

As written last week, we expected the FOMC only to extend operation twist at the June meeting. However, implementing the third round of quantitative easing is still on the agenda, just not for now. Further monetary stimulus is still on the agenda as the FOMC stand ready to act when needed. Therefore, the Fed might embark on QE3 later this year. Weaker economic data could thus spark a new round of speculation on QE3, which would be supportive for precious metals. Range trading with days of high volatility might remain the name of the game in precious metals markets for some time.

Greek election and FOMC in the focus

All precious metals posted gains this trading week. The fundamental drivers were positive on balance and weaker than expected US economic data fuelled the speculation on QE3. Whether this will be repeated this week remains quite uncertain.

The poll stations for the general election in Greece were still open when this article had been written. The race between the New Democracy party, supporting the austerity measures implemented by the previous government, and the radical left-wing Syriza, which promised to cancel the treaties with the troika, is too close to call. A preliminary result is expected before markets open on Monday morning. There have been reports that finance ministers, central banks and also eurozone head of states would be holding phone conferences to prevent a panic in markets.

The best outcome would certainly be a victory of the New Democracy party with sufficient seats to form a government, at least with the PASOK party as coalition partner. In this case, Greece would continue the austerity policy agreed with the troika and would stay in the euro. In this case, the euro is expected to strengthen against the US dollar.

A government lead by Syriza would not be received positive by financial markets. A Greek exit might not be imminent as party leader Tsirpas always stated that his party would remain in the euro, but aims of getting rid of the austerity policy imposed. However, if Greece will not meet its obligations, the troika of EU, ECB and IMF will probably no longer provide any funds. Greece would default and would eventually decide to leave the euro.

The precious metals are expected to react with rising prices in the case that the conservative party would form a new government. A new government led by the radical left-wing parties might sent precious metals prices lower. However, in the case that central banks flood the markets with liquidity if Syriza wins the Greek election, a decline of precious metal prices might be short-lived.

Also the two-day FOMC meeting taking place on Tuesday and Wednesday will most likely have an impact on the price of precious metals. Weak economic data released lately had been positive for precious metals as the market speculated on further quantitative easing measures by the FOMC. We also pointed out the likelihood has risen with the recent US labor market report. However, we only expect that the FOMC will continue “operation twist”. This operation is designed to be neutral on the balance sheet of the Fed. Purchases of longer-dated US Treasuries are funded by selling US Treasuries with a rather short remaining life. The risk is that the markets have already priced in a balance sheet extension instead of only a prolongation of “operation twist”. In this case, the precious metals might head lower again.

On Monday, the G20 meeting takes place in Mexico. The crisis of the eurozone and the lousy crisis management by the European politicians, especially by German Chancellor Merkel, is probably still high on the agenda. The G20 meeting has more potential to disappoint financial and commodity markets again than to provide a positive surprise.

The coming trading week in precious metals is most likely dominated by political factors. Volatility might remain high. However, the uncertainty about the political developments makes a sound forecast about the market direction more like predicting the outcome of tossing a coin.      

Rising volatility of gold

Most precious metals ended the week lower despite favorable fundamentals. What has been remarkable is the rise of volatility. After starting the month of June with a trading range of more than 80$/oz, gold consolidated. However, at the end of this week, gold traded on two consecutive days in a trading range of 30$/oz or more. With the events ahead, especially the election in Greece and France next Sunday as well as the bailout of Spain, the volatility is likely to remain elevated.

After several weeks of falling stock markets and crude oil prices as well as of a stronger US dollar, a countermove took place last week. The US dollar index declined while the S&P 500 index posted a gain and crude oil (WTI) ended the week slightly higher. This environment was initially positive for precious metals. Gold had to digest the strong advance of the first trading day in June, but managed to reach a higher high compared to the preceding week. However, three factors led to an increased volatility and they all are related to banks. Two central banks had been perceived as being negative for precious metals, while news of an EU finance minister phone conference on a bailout of the Spanish banking crisis caused a recovery later on Friday.

China’s central bank had already reduced the reserve requirements, which banks have to hold. Last week on Thursday, the People’s Bank of China cut the key interest rates by 25 basis points. The initial reaction in stock and commodity markets had been positive. However, the sentiment changed on Friday with the start of trading in Asia. Normally, if an economy slows down it is only a question of time that the central bank starts to ease the stance of monetary policy. The PBoC made the first step by reducing the reserve requirements. Therefore, cutting the key interest rates is only a natural follow-up action. Rate cuts are normally seen as positive and this was the initial reaction in European and the US markets. However, Asian investors and traders got scared by the move of the PBoC. They assume that the Chinese central bank has superior knowledge about the state of the Chinese economy and interpreted the rate cut as an indication for a stronger slow-down of GDP growth than the markets had already priced in. But this assumption is not well founded. Monetary policy is based on forecasts and the forecasts of government institutions are not superior compared to those from the private sector. Nevertheless, after the first rate cut since 2008 took place; the PBoC is likely to cut rates further in due time and eventually GDP growth will accelerate again in China. This should be supportive for precious as well as for base metals in the medium-term.

The reason for the spike of gold on June 1^st was the weak labor market report making further quantitative easing measures by the Fed more likely. Also statements from some FOMC members made during this week pointed in this direction. However, the expectations some traders and investors had about the testimony of Fed chairman Bernanke were just absurd and irrational. The Congress is not the place where the Fed chairman announces monetary policy measures. Decisions are made by the FOMC and are communicated by the FOMC statements. Furthermore, the Fed is an independent central bank. Informing the public during a Congress testimony could easily create the impression that the Fed decision was taken on political pressure. Therefore, the fact that Ben Bernanke just repeated the language of the official FOMC statement that the Fed would be ready to act if needed is by no means an indication that further steps of quantitative easing would be off the table. The likelihood for QE3 or an extension of “operation twist” beyond the scheduled termination at the end of this month has not changed by the testimony of the Fed chairman. Only financial markets reacted irrationally. The implication for precious metals prices is that speculations of further Fed easing measures are likely to re-emerge, which would be positive for gold in particular but also for the other precious metals.

At a phone conference on Saturday, the EU finance ministers agreed to provide up to 100bn euro help for the Spanish banking system. However, there are still some open questions. First, Spain has not yet asked the EU officially for help as it only declared its intention to ask for assistance. The Spanish government has also not specified how much financial aid it would not for its banking system. The government waits for two independent audit surveys, which should be presented some time before June 21. Thus, the risk prevails that financial markets speculate that he amount of 100bn euro would be insufficient to stabilize the Spanish banking system. Second, it is also open which EU facility would provide the funds. In the case the EFSF would have to lend the money, Finland will demand that Spain provides collateral (as Finland also insisted in other EFSF bailouts). The preference among the EU finance ministers is that the EMS should provide the funds. However, this requires that the ESM treaty is ratified right in time and that the EMS could start operations as scheduled on July 1. If financial markets welcome the agreement of the EU finance ministers, precious metals might profit from a recovery of the euro against the US dollar and of stock markets. However, if financial markets regard the agreement as disappointing, gold might be heading down again.

Another risk factor for precious metals is the general election in Greece taking place next Sunday on June 17. Opinion polls released during this week, could have a significant positive or negative impact on precious metals prices, depending on which party is leading in the polls. But as it is probably a close race between the conservative New Democracy party, which backs the austerity policy, and the radical left-wing Syriza party, which rejects the austerity policy. Thus, volatility in the gold market is likely to remain high during the coming trading week.   

Hope for QE3 versus eurozone debt crisis

Hope for QE3 versus eurozone debt crisis

Many traders and investors distrust technical analysis and regard it as reading tea leaves. However, from our point of view and many years of experience, we are convinced that it is an indispensable tool in the tool box of a market analyst. The fundamental analysis pointed to fall of gold and silver below the support of the lows made during the two weeks before. But with the technical analysis in mind, we also pointed out that support might hold and that this could lead to a significant rebound. Gold reached the low of the week already on Wednesday and technical buying drove gold higher. Silver reached the weekly low on Friday. But both metals rallied at the first trading day of the month. Gold rocketed 5.2% from the low of the day and reached the highest level in about four weeks. All precious metals managed to end the week higher.

If the rebound of precious metals were based only on a technical reaction triggered by short-covering of positions, the recent rally could peter out very soon. For a lasting recovery, the sentiment among market participants has to change. Unfortunately, the weekly CFTC data on the “Commitment of Traders” does not provide any useful hint. The data are for the week ending Tuesday, May 29. However, the rebound in gold and silver took place after this deadline. Thus, the decline of the net long positions in gold futures held by large speculators from 151,151 to 110,712 contracts can not be regarded as proof that large speculators are still negative on gold. We will have to wait for the next CFTC report to see whether the non-commercials have reduced the net long position further while gold rallied. The holdings at the SPDR Gold Trust ETF remained unchanged until Thursday, but increased by 3.6 tons on Friday. This provides an indication that the sentiment has changed.

Each week, Bloomberg is polling analysts about the outlook for some commodities during the coming week. The bullish and bearish replies declined both for gold. While the balance between bulls and bears is still positive, it has declined too. At a first glance, this would also argue for a still pessimistic sentiment for precious metals. However, again two reasons argue to treat this survey with caution. First, it is not public knowledge when the poll is taken. Thus, analysts participating in the poll might have already provided their answer before the jump in precious metals set in last Friday. Second, our quantitative research of the Bloomberg commodity sentiment polls showed that the balance between bullish and bearish replies follows the price move over the current week. Changes in the balance are not correlated with the price change over the next week. In some markets however, the Bloomberg sentiment indicator has turned out to be a reliable contrary opinion indicator. Unfortunately, gold is not among those markets.

The usual fundamental factors driving the prices of precious metals can not explain that all four metals closed the week higher than at the Friday before. Stock markets had a very negative week and also crude oil prices fell on worries over the outlook for the global economy. The US dollar strengthened further. Beside the weaker than expected economic data out of China, the unsolved debt crisis in the eurozone is weighing on stock and commodity markets as well as on the euro. Spain presented a smart plan to recapitalize its banks by an equity for government bond swap. Markets turned sour after the Financial Times reported that this plan had been rejected by the ECB. However, this report was denied by the Spanish government and the ECB, both stating that such a plan had not been officially presented. Criticism came also from German politicians and commentators. But Germans should not forget that they also recapitalized banks by government debt following the currency reform after World War II, which led to the introduction to their still adored Deutschmark. Germany is still blocking any proposal made by the EU Commission to solve the crisis quickly, as the federal government can borrow at record low levels and investors even pay for buying short-term notes. Furthermore, the export-driven German economy profits from the weakness of the euro. Germany benefits from the crisis in the rest of the eurozone currently. Thus, despite all the appeals, it is unlikely that Germany is giving up the beggar the neighbor policy and contributes to solving the crisis by accepting proposals presented by the EU. Therefore, the debt crisis could still weigh on financial markets and could remain a burden for precious metals.

What has changed is the outlook for the monetary policy of the Fed. While some voting members of the FOMC reject calls for further quantitative easing the majority was ready to act if needed. On various occasions, the US bond market already reacted as the if-clause was not included in the FOMC statement. However, US economic data released last Friday increase the odds for at least extending “operation twist” beyond the scheduled termination at the end of this month. The non-farm payroll figures for March and April had already been disappointing. But due to the moveable Easter Holiday and the possible distortion caused by seasonal adjustment procedures, these two reports were not sufficient for the FOMC to opt for QE3. Also the figures for previous months had been revised up and the unemployment rate declined. This all has changed with the May labor market report. The change of non-farm payrolls remained even below pessimistic forecasts and came in at only 61,000 new jobs being created. Furthermore, the numbers for the preceding two months had been revised down. In addition, the unemployment rate climbed back to 3.2%.  Also the ISM manufacturing index declined from 54.8 to 53.5 and the GDP growth in the first quarter had been revised down to 1.9% annualized. It appears that the eurozone debt crisis and its impact on stock markets has worsened the business sentiment globally and has led in the US to hesitation to hire more workers. Therefore, the probability for further quantitative easing by the Fed has risen. At the next FOMC meeting, a decision to prolong “operation twist” should not come as a surprise.

The plunge of safe haven government bond yields to record lows last week provides support for gold as opportunity costs declined. Thus, it is especially for central banks cheaper to hold gold instead of US Treasury paper as a hedge against US dollar exchange rate fluctuations. Also, gold got more attractive by the increased likelihood for further Fed monetary stimulus measures. However, the unsolved debt crisis in the eurozone is still a negative factor for the usual fundamental factors of precious metal prices. Thus, gold might be torn between the supportive outlook for QE3 and the burden of otherwise negative fundamentals. But after such a strong rise last Friday, it would be normal that gold pares a part of its gains, especially against the backdrop that one of the main trading centers is closed for two bank holidays to celebrate the Queen’s Diamond Jubilee.