PGMs perform again best amongst precious metals

Gold and silver ended the week lower with a loss of around 1.5% for gold and 2.2% for silver. Both metals gave back the gain of the preceding week and gold even closed lower than 2 weeks ago. On the other hand, platinum gained 1.5% on the week while palladium rose by 2.9%.

After a positive start, gold and silver plunged on the last two trading days of the week. On both days, the three major fundamental factors for the price development of gold and silver according to our fair value models had been positive. Normally, flows into the risky assets and commodities had been favorable for gold and silver last year. However, this is not the case in this year so far. Gold and silver get under selling pressure when investors also move out of the safe haven government bonds, the US Treasury notes and the German Bunds.

On Thursday, the Bund future initially rallied on disappointing flash estimates of the Markit PMI for France, which came in far weaker than expected. Also a surprisingly strong flash estimate for the German PMI did not change the direction. Gold and silver could not profit from this move, but came under stronger selling pressure inline with Bunds and US Treasuries after the release of US economic data. The initial jobless claims number surprised for the second week with a further decline to 330,000. This points to a better labor market report released next Friday, on February 1. In addition, the flash estimate of the Markit PMI for the US manufacturing sector jumped from 54.0 to 56.1, which indicates that the US economy is probably expanding at a faster pace again. The leading indicator compiled by the Conference Board also posted a stronger than expected increase of 0.5%.

On Friday, traders cited the new home sales report as a reason for the continued sell off in gold and silver. While the number of new home sales remained below the consensus estimate, the previous month’ number had been revised considerably higher. In Germany, the ifo business climate index also surprised with a stronger than expected increase, which pulled the Bund and the US T-Note futures lower.

Many market participants believe that the economic recovery might be stronger and that the Fed might stop QE earlier than assumed. They also believe that QE would be a necessary condition for higher gold and silver prices. However, this is not the case as we have pointed out several times. Nevertheless, QE is certainly a supportive factor. But even without QE, gold and silver prices could move higher as stronger GDP growth and a fall of the unemployment rate are necessary conditions for terminating QE. In this case, however, also the output gap narrows and the risk of inflation picking-up is increasing. This would be positive for both metals for two reasons. First, both metals are bought as a hedge against inflation. Thus, it would not be rational to lift the hedge just when the need for the hedge is most urgent. Second, with a stronger economy, at least two of the major fundamental factors will improve further. Stock markets are likely to rise further and also the price of crude oil is probably rising with stronger economic activity, unless new technologies lead to supply increasing stronger than demand.

Even if believes are wrong or not rational, they could nevertheless move the markets. Holdings at the major US gold and silver ETF held quite well, or even increased during the last couple of months, whereas large speculative accounts reduced their net long position in the Comex gold and silver future. But now also the ETF holdings declined. The holding in the SDPR Gold Trust ETF declined by 6 to 1,329.9 tons while the iShare Silver Trust holdings decreased by 266.2 to 10,468.76 tons. This decline reflects a shift in sentiment among the more medium- to long-term oriented investors.

Whether gold and silver remain within the recent sideways trading range will depend on two events in the coming week. First, on the statement of the FOMC, which will be released after the meeting on Wednesday, January 30.  Second on the US labor market report released on Friday, February 1. If any of these two events will increase the fear of an earlier termination of quantitative easing by the Fed, then the selling pressure on gold and silver could increase. In this case, the PGMs will probably continue to perform better than the other two metals in the precious metals segment.

PGMs outperform gold

Despite profit-taking on Friday, which set in with the opening of stock market trading in Europe and the rebound of safe haven government bond futures, platinum and palladium closed the week strongly higher. While gold managed to post a gain of 1.25%, the PGMs ended the week almost 3% up. Only the price of silver rose stronger by gaining 4.6%. Platinum traded briefly above gold for the first time since summer 2011. Now, the crucial question is, will the PGMs also perform better than gold for the rest of the year? From our point of view, this is the most likely scenario.

The prices of PGMs are expected to increase on balance in 2013 due to favorable supply and demand factors. We pointed already out that Johnson Matthey predicted in its interim report the platinum and palladium would be in a supply deficit in 2013. Also Norilsk Nickel expects that the Russian supply of palladium is going to decline as Russian inventories fell. Earlier this week, Anglo American Platinum, which is the world’s biggest producer of the white metal, surprised the market with the announcement to mothball four shafts and to sell one of its mines in South Africa. The company also plans to cut 14,000 jobs in South Africa. The decision of Amplats reflects the struggle of South African mining companies, which are faced with input costs rising three times faster than inflation, instable power supply. Also safety stoppages as well as violent labor conflicts weigh on mine operators.

While supply is likely to decline more than Johnson Matthey predicted in November, demand is expected to increase stronger. The automotive sector in Europe is in dire situation as figures showed again this week. However, more important is the global car production, which is still increasing, especially in China. The Chinese GDP grew again stronger in the final quarter of last year. This indicates that demand for cars will also increase further. Also the US economy is expanding and private consumption is one the rise. Therefore, we expect demand for the PGMs to increase and thus, the supply deficit is likely to increase due to declining production and higher demand.

One indicator to gauge the performance of platinum compared to gold is the platinum/gold ratio. A rising ratio indicates that platinum performs better than gold. However, gold shows the better performance when the ratio declines. We have developed a forecast model for the platinum/gold ratio, which is based on the same fundamental factors as in the fair value models for precious metals. A rise of the S&P 500 index as a proxy for global economic perspectives as well as higher crude oil prices have a stronger positive impact on platinum and thus lead to an increase of the ratio. Also an increase of the yield on 10yr US Treasury notes is positive for platinum/gold ratio. An increase of the US dollar index, i.e. a stronger US dollar, is negative for the price of all precious metals. However, a firmer US dollar weighs more on gold than on platinum, thus, also an increase of the US dollar index is a positive factor for the platinum/gold ratio. All the four factors are significant even at the 1% level.

In the forecasts submitted to the polls of ThomsonReuters and the London Bullion Market Association (LBMA), we predicted that the precious metals will have a positive performance in 2013. However, the PGMs are likely to perform better than gold and silver, which are more in the focus of investors and speculative traders.

Gold, the Fed and Chinese Inflation

After several weeks of consecutive losses, gold and silver managed to close the week slightly higher. The PGMs recovered stronger. While palladium closed 1.6% higher, platinum gained 4.6% on the week.  Also gold and silver were trading higher, but both metals declined last Friday by about 1% whereas the PGMs closed slightly higher. The reason for the fall of gold and silver given by a market report was the Chinese inflation rate in December.

The consensus of economists forecast predicted already an increase of the Chinese inflation rate from 2.0% in November to 2.3% in December. However, the inflation rate jumped to 2.5%, which led to the fear that the People’s Bank of China would provide less monetary stimulus to foster the GDP growth. China has been hit by a severe cold, which has a negative impact on cabbage, a main aliment during the winter season. Thus, the rise of cabbage prices was the major culprit for the jump in the inflation rate. That this increase of the Chinese inflation rate is the reason for the fall of gold and silver on Friday is not a convincing argument for several reasons.

China plays an import role for the demand of physical gold. If inflation were really a concern, then Chinese investors would be expected to buy more gold as a hedge against inflation. Selling the protection against inflation does not make sense in this case. And indeed, gold and silver did not come under stronger pressure during the Asian trading hours.

As it has been the case so often during the last couple of weeks when gold dropped, the plunge set in with the start of trading in the US. This was also the case last Friday that gold plummeted after the start of trading at the Comex. In the early US morning hours, also the stock market and US Treasury notes headed lower. US traders and investors having sold gold on the fear of rising cabbage prices in China would slow global economic growth did not act rationally. The PBoC follows the headline inflation but even central banks focusing on the headline CPI inflation usually take seasonal impacts into account. Therefore, as long as the PBoC does not expect that the seasonal distortion will have a lasting impact on the inflation rate, there is no reason to provide no further monetary stimulus.  Furthermore, even after the increase in December, the Chinese inflation rate is still well within the target zone.

Gold and silver trade more in line with risky assets and this was probably also the main reason that both metals came under pressure at the start of US trading. The wrong conclusion many investors and traders drew from the Chinese CPI figure was only one factor. The earnings season started in the US and on Friday, Wells Fargo reported its earnings for the final quarter in 2012. Despite a record gain beating earnings estimates, analysts found a fly in the ointment. The net interest rate margin declined. However, in an environment of falling yields and money market rates close to zero, this should not come as a surprise. Nevertheless, it was another reason for the negative start of the US stock market.

Another widespread misperception is that quantitative easing is a necessary condition for rising gold and silver prices. Flows into an asset could come from three different sources. The first is from reallocating funds from one asset into another one. Selling US Treasury notes and investing in gold is one possibility. However, it is not necessary that the buyer of the notes is the Fed. Only a few primary dealers have this access. Other investors would have to sell Treasury paper to primary dealers or other investors. Certainly, QE made it easier and provided many sellers with a better price compared with a situation without QE. Nevertheless, QE is not necessary for this process. The second source is by net savings, which is also not directly dependent on QE. The third source is from borrowing with current assets serving as collateral. Again the possible leverage does not depend directly on QE, but the purchases of central banks had a positive impact on asset prices.

The minutes of the latest FOMC meeting as well as comments from various council members during this week had a negative impact on the price of gold. Thus, the correlation between the price of gold and US Treasury notes has increased again lately. For an exit of the Fed from QE there are two possible reasons. The first is of course the economic development and the potential risk of future inflation getting out of control. The second is balance sheet considerations, which some members of the FOMC brought forward.

If the Fed will end QE for the first reason, it should not be negative for gold and silver but positive. In this case, the US economy will grow stronger and the output gap will narrow again. Risky as well as tangible assets will perform better. Also yields on US Treasury bonds and notes should increase and for some maturities should become positive again in real terms. However, also a slight positive real return for medium-term maturities should not be a reason to sell gold as along the Fed does not abandon the current Fed Funds target rate. The FOMC indicated that this would not be the case before mid-2015.

While operation twist was neutral for the balance sheet of the Fed, outright buying of mortgage backed bonds and US Treasuries will extend the balance sheet by $85bn every month. Despite the looming hit of the debt ceiling, the US Treasury is unlikely to default. As outlined last week, minting a super platinum coin could avoid this scenario. Thus, the Fed does not need to be worried about a default risk of the Treasury paper held. However, rising yields could pose a risk for the balance sheet in the case of marking-to-market valuation. Last Friday, Philly Fed president Charles Plosser pointed out the risk of rising bond yields on the exit from QE. Certainly, bond markets will anticipate an end of bond purchases by the Fed, which will lead to rising yields. And yields are also likely to increase after the Fed terminates QE as the shortfall of a total of $85bn of bond demand would have to be compensated. However, the US Treasury market misinterpreted the comments from Mr. Plosser, who is a long-time critic of QE. The risks of an exit do not imply that the FOMC will continue QE infinitely  But the US Treasury market rebounded after this comment, ignoring the inflation warnings of Mr. Plosser. This also supported gold and silver and prevented another weekly loss.

The current sentiment among large speculators is negative for gold, as the latest CFTC report on the commitment of traders underlines again. Thus, gold and silver are likely to be caught in a trading range, with the risk to downsides overweighing the chances for a breakout to the upside. But as we expect that the economic situation in the US will improve and that Asian economies will grow also stronger again, the outlook for the major fundamental drivers of gold remains positive. Thus, the current sideways market might offer good opportunities to buy gold and silver for a medium-term investment horizon.       

Will platinum be the new gold standard?

Former republican lawmaker Ron Paul advocated for a long-time that the US should return back to the gold standard. This appeal was also supported by Paul Ryan, who ran for vice-president last year. In Idaho, republican lawmakers even brought in a bill to make gold coins a legal tender. However, according to a plan currently being discussed, platinum might be the metal setting a new standard.

In a last minute compromise, as we expected and pointed out several times in this blog, the US Congress avoided a fall of the US economy over the fiscal cliff. However, there was a deep split with the Republican Party. The tea party wing lost the battle in the House as a sufficient number of moderate Republicans voted with Democrats to pass the bill. But this compromise postponed the decision on spending cuts by two months and it should be part of a compromise for lifting the debt ceiling.

The debt ceiling is a legal construct, which is only applied in the US because it is an inconsistency of a fiscal system. The right to determine the budget is the primary right of every democratic parliament. However, in the US, the parliament passes a budget law authorizing the administration to spend money. But with the debt ceiling the lawmakers could prevent the president to borrow the money for fulfilling the legal obligations. There is a dispute among lawyers whether the debt ceiling would not be overruled by constitutional obligations. However, since the start of this year, also an economic plan to circumvent the debt ceiling is hotly debated.

This plan emerged already in the middle of last year. Last week, it has been discussed on Bloomberg Blog and TV and was the topic of a comment by Paul Krugman in the New York Times. It is also widely discussed on Twitter under #MintTheCoin. This plan exploits a legal loophole provided by 31 USC § 5112. Normally, the US Treasury can not issue coins without the approval of the US Congress, but this law makes one exception. The US Treasury can mint platinum coins with whatever specification the secretary regards as appropriate, including the denomination. The intention of this law was to allow the production of commemorative coins for collectors.

The plan proposed is to mint a super platinum coin with the denomination of 1 trillion US dollars. According to this plan, the coin could then be deposited at the accounts held with the Fed to finance the payment of the government’s bills. As this coin would be legal tender, the Fed would have to buy this coin at the denominated value and would have to credit the amount on the accounts of the US Treasury. The difference between the costs of minting the coin, which is to a large extend only the cost of the metal and one ounce of platinum might suffice, and the denominated value is called the seigniorage. The seigniorage is a kind of windfall profit for the government and is normally treated as ordinary revenue, like tax revenues. In many countries, it is not treated as government debt. Otherwise, this plan would not work.

In terms of national accounts, the Fed is part of the state sector. Thus, debt issued by the US Treasury and bought by the Fed in the secondary market cancels out each other. However, it is still counted as outstanding debt of the US Treasury and is relevant for the debt ceiling. Depending on how debt bought back by the US Treasury is treated, one possibility would be that the US Treasury mints the super coin, deposits it at the Fed. With the proceeds, the Treasury buys back notes and bonds from the Fed. This would have the advantage that the balance sheet of the Fed would not be inflated. At the end there would be only an asset swap – the Fed would hold the super coin instead of US Treasury paper. For the Fed such an operation would have another advantage. It would reduce the risk on the balance sheet of holding Treasury paper in the case of rising yields on US Treasuries. Unlike for notes and bonds, there is no depreciation risk of the super coin. It will always be worth its denomination. This would also mitigate the fears of several FOMC members, which voiced concern of continuing QE at the current pace, according to the FOMC minutes released this week. In the case that such an operation would reduce the amount of outstanding debt with respect to the debt ceiling, then, the US Treasury would have again sufficient leeway to fund its expenditures by borrowing in financial markets.

Some commentators compared this plan with the hyper-inflation in Germany during the time of the Weimar Republic or with Zimbabwe. This is absurd and economic non-sense. It only demonstrates that the critics lack basic economic 101 understandings. Such a super coin could not be a coin in circulation. Not even Warren Buffet, Bill Gates or Carlos Slim could buy this coin as they are just billionaires. However, in the Weimar Republic or in Zimbabwe, everybody had bills denominated in millions or even billions. Even in the case that the super coin would lead to a rise in the size of the Fed balance sheet, it is not going to lead to hyper-inflation as the critics pretend. The US Treasury can not just spend all the money for purchasing goods and services. The restrictions of the budget still apply. In addition, the Fed still has its weapons to contain negative impacts on the money supply. Furthermore, inflation rises if aggregate demand exceeds aggregate supply. Even with avoiding the fall over the fiscal cliff, the US economy is still far from a situation that aggregate demand will exceed output potential and would trigger accelerating inflation rates.

Some commentators pointed out that such a plan was already made by the Simpsons a long time ago. The author of this blog was never a follower of the Simpsons and thus had to rely on links provided by those commentators. However, there was only a one trillion dollar bill – no mentioning of coins. Those commentators referring to the Simpsons have also not understood the plan. A bill would not solve the problem of the US Treasury with hitting the debt ceiling soon. A US dollar bill is issued by the Fed. Coins are minted by the Treasury and sold. Selling or depositing the coin is the crucial condition for the US Treasury to stay afloat after hitting the debt ceiling.

Minting a platinum coin is a smart plan and excellent arrow in the quiver of US President Obama for the negotiations with Republicans on spending cuts and lifting the debt ceiling. Whether it will be realized depends on the Tea Party wing of the Republicans. If they continue their fundamental opposition and remain unwilling to compromise, then the odds for minting a super platinum coin could increase. Thus, platinum might set a new standard. However, it would not be comparable to the gold standard as this coin would not come into circulation.