Precious metals expected to perform positive in Q4

Precious metals are still in consolidation but held quite well during the past trading week. This is a positive indication given the fact that the debt crisis in the eurozone is back in the spotlight and fears over economic growth had a negative impact on the main fundamental drivers of precious metal prices. Thus, the chances are still good for a positive final quarter in the precious metals market.

In this blog, we pointed out several times that precious metals perform better when the risk appetite of investors increase and that a flight into the safe havens of government bonds is a burden for metal prices. This has been the case again last week. There were two factors, which caused a rise of investors’ risk aversion around the middle of the week. Both were not rational.

The German ifo-index surprised with another decline while the consensus among economists predicted an increase after the ECB presented the details of the OMT program for purchasing government bonds in the secondary market and the German constitutional court paved the way for the ratification of the treaty to create the EMS. However, the recession in many countries of the eurozone had a negative impact on the assessment of the current business conditions and the expectations for future developments. This initially weighed on stock markets. However, on Tuesday, the S&P 500 index pared the loss of the previous day and was also trading above the close of the previous week when suddenly the risk aversion of investors rose again. The triggers were two statements. First, asset management company Blackrock stated that the rally in the US stock market were over. This prediction of one of the biggest funds managers already led to some profit taking. However, more devastating was the statement by Philly Fed president Charles Plosser that he voted against QE3 because it would be ineffective and would lead to inflation.

The market reaction on the comments by FOMC dissenting voting member Plosser is another demonstration that the Chicago School theory of rational financial markets is falsified by the reality. Animal spirits, as first described by John Maynard Keynes, also play a major role in financial and commodity markets. Traders and investors in the stock market did not recognize the contradiction of Mr. Plosser’s comment. First, if Mr. Plosser were right that QE3 would not stimulate economic growth then the US GDP would grow further below output potential. In this case, production capacities and the labor force would not be fully utilized. Even if the unemployment rate and the capacity utilization rate would stagnate then there would be no risk of rising inflation, quite the opposite! However, if QE3 were leading to rising inflation rates then GDP growth would have to accelerate, capacity utilization would have to reach full employment levels and the unemployment rate would have to fall quickly towards the natural rate of unemployment. Thus, a rise of inflation rates would require that QE3 is highly effective in reaching the target of the FOMC. Furthermore, at the Jackson Hole seminar in late August, Fed chairman Bernanke presented sufficient empirical evidence that QE I and II were already working and contributed to stronger GDP growth compared to a situation without quantitative easing. Therefore, markets reacted irrationally on the Plosser comments and acted more according to the shoot first and ask later behavior.

Also irrational was the reaction of markets on the protests against austerity measures in Spain and Greece, which partly turned violent. Even a failure of Germany in an auction of 10yr Bunds and a successful auction of Spanish government paper could not prevent a flight into the safe haven of Bunds and US Treasuries combined with weaker stock markets. However, governments in Western democracies don’t bow to pressure of demonstrations. Investors are wrong to compare the situation with upheavals in Arabian countries. The Spanish government passed the 2013 budget with the required austerity measures, which are mainly spending cuts, on Thursday. This led to some relief among investors and the euro recovered against the US dollar. Also the result of the stress tests of Spanish banks did not bring negative surprises, which calmed further the nerves of jittery investors.

The Fed is likely to be successful again with QE3. Thus, we expect US GDP growth to pick up again. Also Spain will ask for a rescue by the EFSF/ESM sooner or later, which will also trigger buying of Spanish government bonds with maturities of up to 3 years by the ECB. Furthermore, also China is expected to take measures to stimulate GDP growth. This all should be positive for the major fundamental drivers of precious metal prices. Therefore, we expect that precious metals to perform also positively in the final quarter of this year. 

Precious metals consolidate recent gains

According to data from ThomsonReuters, gold and silver ended the trading week around the levels of the previous week, while the PGMs came under some stronger pressure with losses of more than 3%. The performance of gold and silver is remarkable as the major fundamental drivers were all negative. This indicates that among the precious metals complex, gold and silver are likely to perform well during the final quarter of this year while the PGMs might lag behind.

After the implementation of QE3, the increase of risk appetite did not last long. The turnaround towards buying the safe haven government bonds was triggered by Asian investors. After markets were closed in Tokyo on Monday, Japanese investors were buying US Treasuries on bargain hunting. Also the geo-political tensions between China and Japan increased the appeal of US Treasuries as a safe haven. Some commentators argued that the increase of inflation expectations was overdone and thus, US government bonds were an attractive investment. Last week, we wrote that fears of a strong rise of inflation rates were overdone. However, this does not imply that US Treasuries are an attractive investment at current levels. As long as nominal yields are below the inflation rate, investing in conventional US Treasuries destroys wealth in real-terms.

We also regard the recent movement of the spread between yields on conventional and inflation-linked US Treasuries not as overdone. Furthermore, it is also not contradicting our assessment that QE3 is currently not inflationary. Nevertheless, if QE3 will be successful, an increase of GDP growth could have an impact energy prices. A change in relative prices could lead to an increase of head-line CPI inflation above 2% while core CPI inflation remains well behaved. However, for an investment in bonds with fixed nominal coupons and redemption, it is the overall price development that matters. This is again an argument against investing in conventional US Treasury paper, UK Gilts or German Bunds as long as yields are below inflation rates.

However, last week, crude oil prices came under strong pressure after having rallied the weeks before on hopes for QE3. On Monday, Brent and WTI futures at the ICE and NYMEX exchanges plunged more than 3$/bbl within a minute without any obvious reason. During the course of the week, crude oil prices came under further pressure as Saudi-Arabia has been reported to pump around 10 million bpd to bring crude oil prices below 100 dollar. Another negative factor for the price of crude oil had been the weekly EIA report on US oil inventories showing a strong build of 8.5 million barrels while the market consensus expected a draw of 0.2 million barrels. As a result, the front-month light crude oil future at the NYMEX lost more than 6% and fell by more than 6 dollar from 99 to 9s.89$/bbl.

In the eurozone, buying the German bunds as safe haven got also support from traders losing patience with Spain hesitating to apply for a full bail-out, which would pave the way for the ECB to buy Spanish government paper up to maturities of 3 years. We argued that the disadvantages of the ECB’s OMT program are the strings attached. The conditionality of applying for a bail-out by the EFSF/ESM will deter governments to seek for financial help, especially, if the conditions are not known in advance. Thus, the hesitation of the Spanish government is fully understandable. Nevertheless, it is also not very rational to sell now Spanish government bonds and notes as Spain could apply anytime for a bail-out. Fading hopes that Spain would apply for a bail-out did not only lead to a decline of yields on safe haven German bonds at the longer end of the curve, but also the euro pared some of the gains made in the week before. Thus, also a firmer US dollar was a negative factor for the precious metals.

Stock markets were not only affected by the renewed wave of buying safe haven government bonds, but also by some economic data. In China, the PMI compiled by Markit increased from revised 47.6 to 47.8 but the market was disappointed by the fact that this index remained below the 50 threshold level. However, turnarounds do not occur as spikes but are gradual improvements. A change in the direction is the more important indication for the economic outlook. In Germany, the ZEW index came in better that expected. Nevertheless, the stock market was disappointed as the assessment of the current situation did not improve. But usually the expectations increase first and later also the assessment of the current situation increases. The expectations are the leading indicator and should be emphasized more than current business conditions. In the Eurozone, the flash estimates of the PMIs were also weighing on stock markets. In Germany, the PMI for the service and the manufacturing sector increased both surprisingly. However, even a bigger surprise was the plunge of the two PMI indices in France. The overall estimate for the eurozone showed an increase in the manufacturing sector but a drop in the service sector. However, the development of the French indices dominated sentiment. While European stock markets ended mixed, all the major US stock indices ended the week negative, which was another burden for precious metals. Beside the PMIs, also the outlook for the European automobile market given by the CEO of the German car company Daimler weighed on the PGMs.

Positive were the flow of funds data. Large speculators increased their net long position further by 9,099 to 191,115 contracts, according to the weekly CFTC report on the ‘Commitment of Traders’. For silver, the net-long position of non-commercials rose by more than 1,000 to 32,555 contracts. The holdings of the biggest gold ETF - the SPDR Gold Trust - increased by more than 16 tons to 1,317.76 tons during the past week. The silver holdings in the iShare Silver ETF increased by almost 200 tons to 9,940.66 tons.

The decisions taken by the ECB and the Fed in September pave the way for an economic recovery in the eurozone and stronger GDP growth in the US. If eurozone politicians do not counteract by imposing more severe fiscal austerity measures, the situation in the eurozone could improve. This would also be positive for other parts of the world. Stronger global economic growth would be positive for precious metals, not by a strong pick-up of inflation, but by increasing the risk appetite of investors. 

Metals rally on growth outlook and not on increasing inflation expectations

In many areas like natural science, you can not be right for the wrong reason. However, financial and commodity markets are an exception. Within one week, two of the main central banks decided on important monetary policy measures. Metals markets rallied and some commentators argued rising metal prices were based on increasing inflation expectations. However, inflation is not looming, neither in the eurozone nor in the US.

The ECB’s decision to buy short-term government bonds in the secondary market if a country asks the EFSF or the ESM for help has been criticized, especially by inflation paranoid German politicians and newspaper commentators, as leading sooner or later towards rising inflation rates. Even repeating this argument in parliament does not provide any sound economic basis. The ECB stated that all purchases under the “outright monetary transaction (OTM)” program will be sterilized. Thus, OTM will not lead to an increase of the ECB balance sheet. Furthermore, the number of eurozone countries being in a recession is increasing. Also core countries like Germany are likely to slow down and get close to recession in 2013. Thus, the risk in the eurozone is more biased towards deflation than inflation. Yes, it is true that food and energy prices are increasing, but this is just a change of relative prices and not inflation.

The Fed has not disappointed the majority of Wall Street economists. A majority of 65% expected the FOMC to implement the third round of quantitative easing, called QE3. However, the FOMC surprised the bond markets by announcing to buy $40bn of mortgage backed securities (MBS) per month for an unlimited period until the target unemployment rate is reached. Treasury notes and bonds will not profit from QE3 but operation twist will be continued. Thus, the Fed will extend its balance sheet.

With QE3, one condition for increasing inflation rates according to the famous Fisher equation will be fulfilled. Thus, it is not surprising that inflation expectations, as measured by the spread of yields on conventional and inflation-linked US Treasury notes, have risen over the last few days and weeks. However, as the past 20 years have shown, increasing money supply does not necessarily lead to rising inflation. Monetarists have made some assumptions to reach their conclusion that extending money supply would lead to inflation. One assumption is the constant velocity of money. But the velocity of money in circulation has declined steadily. The more important assumption is the full employment of resources.

The decision of the FOMC to provide more liquidity by unconventional monetary policy measures is based on the violation of the assumption of full employment. The current unemployment rate of 8.1% is far above the natural level, which is estimated to be between 5 – 6%. Furthermore, the decline of the unemployment rate was to a large degree the result of unemployed persons leaving the work-force. While a certain fraction of leaving the work-force could be explained by retiring baby-boomers, the vast majority has left because they see currently no chance of finding a job. However, it is also well known that the work-force participation increases again in times of stronger economic growth.

But it is not only the work-force, which is not fully employed. Also the second production factor capital is not fully utilized. One day after the FOMC meeting, the Fed released the data for industrial production and capacity utilization in August. Industrial production declined by 1.2% compared to the previous month and capacity utilization fell from 79.2 to 78.2%, which is 2.6% below the long-term average of 80.3%. But even in the case that QE3 would lead to an increase of the capacity utilization above the long-term average, it is not immediately inflationary. Only if capacities were almost fully used, inflationary pressure would build.

The measures taken by the FOMC could lead to an improvement of US GDP growth. This is the main reason, why investors have increased their risk appetite again and buy risky assets and sell safe haven US Treasury notes and bonds. QE3 also has an impact on the US dollar as buying risky assets also includes buying assets denominated in foreign currencies. If markets were not convinced that the Fed policy would lead to stronger growth, base metals would still trade at lower levels. However, also base metals rallied and this surge in prices can not be explained only with fears of higher inflation rates by some gold bugs. It is improved global growth prospects, not inflation, which drive precious and base metals prices. 

Precious metals rally on central bank policy

It were the policy action of the ECB and the expectations of further Fed policy action which drove precious metal prices sharply higher last week. However, whether prices will advance further during the next trading week will depend on the German constitutional court ruling on the EMS and the FOMC decision on another round of quantitative easing.

The ECB presented the details of its new bond purchase program called ‘outright monetary transactions OTM’, which is not the optimal solution. However, it is far better than following the advice of the German Bundesbank to do nothing at all. The ECB has attached some conditions, which make the program less effective. First, the ECB will only purchase bonds in the secondary market after a government has requested a bailout from the EFSF/ESM. In addition, the IMF should be involved in determining the conditions of a bail-out program, even if the IMF will not provide own funds. However, it is just the IMF conditionality, which makes governments hesitant to ask for a help. The doctrine of the IMF is to implement severe austerity measures. Even staff members of the IMF showed in a recent working paper, that austerity measures aggravate a recession and are not a cure to reduce a budget deficit if a country is already in a recession. The two main candidates for ECB bond purchases are Spain and Italy, which are already in a recession. Thus, both governments might not be too eager to ask for help from the EFSF/ESM and from the ECB to bring down borrowing costs.

Second, the ECB is limiting any purchase to bonds with a remaining life to maturity of up to three years.  This limit has to be seen against the background of critics that the ECB would violate its mandate and would finance governments illegally. The limit of three years is regard as being in compliance with the ECB’s legal framework. From the perspective of market impact, of course, no limitation of the maturity range would have been preferable.

Third, there appears to be now concrete target for yields. Thus, markets are probably trying to test the ECB once a country applies for help. By stating a concrete target, the markets might have moved to the target level without any need of the ECB to purchase bonds. But it is positive that the ECB is willing to purchase unlimited amounts of bonds in the selected maturity range.

The ECB’s outright monetary transaction program will not be a measure of quantitative easing. The amount of bonds purchased will be sterilized by withdrawing liquidity by other means, for example at the weekly refinancing operations. Thus, the OTM is not going to extend the ECB balance sheet.

Despite the ECB’s OTM is not quantitative easing, it is positive for precious metals. Those buying gold on fears the ECB policy would lead to higher inflation make the right decision but for the wrong reason. Without having spent even one euro on buying bonds of Spain and Italy, yields on government paper of these two eurozone member states already came down. Yields declined significantly not only at the short end of the yield curve but also for longer maturities. After the ECB announcement of OTM, speculators have to fear that anytime soon, Spain and Italy might apply for a bail-out and the ECB starts buying bonds. Thus, they already began to cover their short-positions in government paper of these two countries. And it is this decline of yields, which mitigates the funding situation. At the same time, also the risk of countries leaving the euro declines considerably. The debt crisis in the eurozone is not yet solved, but the ECB’s OTM is major step towards ending the crisis. Thus, the euro recovered against the US dollar, which is positive for gold. Also investors bought more stocks and the rise of equity indices is another positive factor for gold as investors’ risk appetite is increasing and they also buy not only stocks but also commodities again.

The US labor market report for August had been mixed, but overall it disappointed. It has increased the odds that the FOMC might already decide in the coming week at the meeting on September 12/13 to implement QE3. However, as a fiscal cliff in the US is not yet avoided, we see a slightly higher probability that the FOMC might keep its powder dry. In the case that the FOMC does not embark on QE3 at the next meeting, precious metals might suffer a set-back.

A potential risk for precious metals is also the ruling of the German constitutional court on the ESM. The majority of the German population favors that the highest court in Germany stops the ESM. However, this would be an economic disaster. But one never knows how the judges at a court will decide. Thus, this is an event risk and the result is hard to predict. In the case that the constitutional court paves the way for the ratification of the treaty, precious metals are likely to advance further. However, any blocking would probably be negative for the euro and risky assets, including the precious metals.

No news from Bernanke has been interpreted as good news

Precious metals had consolidated ahead of the speech given by Fed chairman Bernanke at the Kansas City Fed seminar in Jackson Hole, Wyoming. After the release of the text of his speech, precious metals rallied in line with US Treasury notes and bonds. Stock markets were initially disappointed but later pared losses, which was a further support for precious metals. Only the PGMs did not rally strongly enough to end the week with a gain compared to the previous Friday.

The behavior of most markets last Friday contradicts academic theory that markets are information efficient, which means that not only public available but also inside information is already discounted in the prices. Many market commentators expected the Fed chairman to provide a clear signal that the FOMC would implement a third round of quantitative easing at the next meeting, which is scheduled to take place on September 12 and 13, 2012. However, Ben Bernanke only repeated information, which was already provided by statement and minutes of the recent FOMC meeting. Thus, Mr. Bernanke did not provide any news the market had hoped for. As markets had already priced in more details about the implementation of QE3, the normal reaction expected would be a drop of prices for US Treasury paper and precious metals. However, these markets switched to rally mode – a very strange behavior.

Also the part of Mr. Bernanke’s speech, in which he defended quantitative easing, has to be seen more against the criticism, especially from republican lawmakers. Presidential candidate Mitt Rommney even declared as US president, he would sack Fed chairman Bernanke. While we fully agree that QE1 and QE2 as well as “operation twist” have their merits and helped the US economy to recover pretty well after the financial crisis of 2008, we have doubts about the effectiveness of a third round.

After the rally of last Friday, the yields on 10yr US Treasury notes stay at 1.55%. This is very close to the record low of around 1.4% reached just a few weeks ago. If this already historically low yield level on 10yr US Treasuries does not induce corporates to invest more, which difference would QE3 make? Furthermore, the yield on 2yr US Treasury notes is at 0.22%, thus, the steepness of the yield curve, often measured by the spread between 2- and 10yr T-notes, is 133 basis points. In a historical comparison, this is a rather flat yield curve level to have a strong stimulating impact on the economy.

For business fixed investments, the yield level of corporate bonds is more relevant than funding costs of the US government. Therefore, QE3 would have a stronger impact if the Fed would buy corporate bond ETFs or mortgage backed securities instead of US Treasury paper. Furthermore, companies do not just invest because the yield level is low. As James Tobin has shown with his famous q-ratio, funding costs have to be low relative to the expected rate of return on real capital. If business leaders are unsecure about the economic outlook, they hesitate to invest and postpone investment decisions into the future.

In this context, the stock market comes into play as it is often regarded as a leading indicator of future economic growth. So far this year, the US stock market has performed quite well and just about two weeks ago, the S&P 500 reached the highest level since May 2008. However, the US stock market reacts negatively in the case that hopes for QE3 get dampened. But it is well known that economic policy is to a large extent also changing the psychology of market participants. In this respect, QE acts like a drug, once injected it gives traders and investors a high feeling, but the hang-over is not far away. And then a higher dose is requested. Considering QE3 is already an indication that the Fed would not be convinced that the US economy will improve. How could the Fed expect business leaders as well as stock market investors would view the economic outlook more optimistic?

We do not deny that the US economy also faces some head-winds. Growth in China is slowing, which also has an impact on the US economy. The political leaders in the Eurozone are unable to come up with a solution to fix the debt crisis. All they do is buying time. And some necessary measures to stabilize the euro are torpedoed by the German Bundesbank. However, against these headwinds, the Fed can do relatively little. QE3 could even be negative for stabilizing the situation in the eurozone as a rally in US Treasury notes also pushes German Bunds higher. But a rise of Bund prices leads normally to selling of Spanish and Italian government bonds. Nevertheless, QE3 could have an impact to increase the competitiveness of the US economy by weakening the US dollar. However, if this would be the real hidden purpose of QE3, then the FOMC should better declare openly that they aim to weaken the US dollar.

Ben Bernanke’s speech keeps the door open for QE3 at the September FOMC meeting but it is not a pre-commitment that measures will be taken in mid-September. A lot will still depend on further economic data released ahead of the FOMC meeting. The most important is certainly the US labor market report due next Friday. This report will also have a strong impact on precious metals markets. However, a positive surprise in the number of new jobs created or the unemployment rate would dampen QE3 hopes, but as pointed out two weeks ago, no further quantitative easing is not necessarily bad for precious metals as a stronger economy is also supportive for precious metal prices.