Fed scaling back bond purchases and the impact on precious metals

It was a volatile week for some precious metals. Silver plunged at the start of the week but ended the week even slightly higher. Gold came under pressure during the testimony of Fed chairman Bernanke to the Joint Economic Committee on the economic outlook and monetary policy. However, also gold pared the loss and closed the week with a gain of 2%. On the other hand, platinum managed to close at the same level as the Friday before while palladium posted a loss.

Initially gold traded higher when Fed chairman Bernanke started his testimony. He defended the quantitative easing and the bond purchase program. For the slower growth of the US economy, he made the fiscal policy responsible. This was interpreted as a continuation of QE. But during the Q & A session, the sentiment in financial and commodity markets changed. One reason was the release of the minutes of the recent FOMC meeting, which showed the committee had an intense and controversial discussion about scaling back the volume of bond purchases by the Fed. In addition, Mr. Bernanke pointed out at his testimony that the FOMC might take a step down in the pace of bond buying in one of the next few meetings.

Thus, the Fed chairman indicated that the balance among the voting members of the FOMC might tip in favor of scaling back the volume of purchases. Thus, the question arises whether a gradual reduction of QE would be negative for gold and silver. We have always argued that QE by the Fed is supportive for higher gold prices, but it is not a necessary condition. In addition, last week, we pointed out that QE per se is not leading to higher precious metal prices, but it is more important which central bank implements QE. The decision of the Bank of Japan to extend its balance sheet had already triggered a wave of Yen selling against the US dollar. The real yield on 10yr JGBs is still positive, while the yield on 10yr US Treasury notes just compensates for CPI inflation. However, to base a decision about capital flows on real yields implies that the purchasing power theory would have to apply in foreign exchange markets also in the short-run. But this is not the case and therefore, investors have an incentive to fund in Yen and to invest in US dollar denominated assets. Scaling back the volume of bond purchases by the Fed is increasing this incentive as the spread of US Treasury notes over 10yr JGBs probably will widen.

However, one also has to take into account the impact of QE on short-term interest rates and not only on bond yields. Especially in the case that scaling back bond purchases by the Fed could lead to yields on medium to long-term US Treasuries are likely to increase and lead to losses, which could quickly exceed the coupon income of one or two years. Given the outlook provided by the FOMC, the short-term interest rates remain unchanged well into 2015. Thus, short-term interest rate differentials are most likely not a strong incentive for flows into the US dollar. But all in all, taking the foot of the gas pedal has probably the effect of strengthening the US dollar, which would be negative for the precious metals.

Economists have the reputation to argue always “on the one hand and on the other hand”. But we can not avoid pointing out that there might be also an effect, which could work positive for gold and silver in the case the Fed reduces the volume of the monthly bond purchases. For many months last year, investors regarded also precious metals as risky assets. When risk appetite increased, stocks and precious metals together moved higher. The correlation was positive. But this has changed with the announcement of purchasing $45bn of US Treasury paper per month. In addition, the fiscal cliff had been avoided and the headwinds from fiscal policy blew less strong than feared. But now, the stance of investors towards commodities changed. The outlook for stock markets was far better as long as the Fed pumps billions of US dollars in the system each month. Investors shifted the asset allocation and preferred stock markets at the expense of commodity markets. Reducing the holdings in gold ETFs was one source of funding investments in stock markets.

As the reaction in the stock market during the Bernanke testimony shows, reducing the pace of bond buying could lead to a stronger correction in stock markets, which some market pundits already view as massively overbought and overvalued. Even if one disagrees with the view of stock markets being overpriced, as we do, one has to take possible herd behavior into account. Therefore, if investors no longer regard stock markets as the more attractive investment, it could be sufficient to stop outflows of gold ETFs for funding investments in equity markets. This could have a positive effect for gold and silver, which might at least partly compensate the expected negative impact from the foreign exchange market. 

The platinum week 2013

Two weeks ago, we gave a brief outlook at the platinum week in London 2013, which took place last week. One highlight was the release of the Platinum Report 2013 by Johnson Matthey. The assessment of the platinum market differs in some aspects considerably from the report of GFMS, which had been released already two weeks earlier.

While GFMS estimated that the platinum market was in a supply deficit of around 80,000 ounces in 2012, Johnson Matthey estimates that the deficit was far bigger at 375,000 ounces due to supply shortfall from South Africa. The primary supply of platinum fell to 5.64 million ounces, which is a decline of 13% compared to the previous year. In South Africa, at least 750,000 ounces of output were lost due to labor disputes and closing of some marginal mines. Supply from recycling platinum declined to only 2.03 million ounces, far less than projected in the 2012 interim report, where a fall to 1.83 million ounces was estimated.  

The total demand for platinum decreased in 2012 by 0.6% to 8.05 million ounces. The gross demand from the automotive sector rose to 3.24 million ounces, an increase of 1.7%. Thus, the weakness in the European car market was more than compensated by rising demand in other regions. The gross jewellery demand was 2.78 million ounces, an increase of 12%. The price discount to gold was certainly one supportive factor beside the expansion of the jewellery distribution network in China.  However, industrial demand fell by 21% to 1.57 million ounces.

However, more important than the diverging assessment of the platinum market in 2012, is the outlook for 2013. Two weeks ago, we wrote that we would be surprised if Johnson Matthey would predict a strong increase of supply for this year. And indeed, JM predicts only a slight increase of primary platinum supply “with broadly the same level of sales from South Africa as in 2012 and slightly higher shipments from other regions”.

On the demand side, Johnson Matthey writes that “gross demand for autocatalysts is unlikely to grow and jewellery demand may well decline slightly. Demand from industry, notably the glass sector, is expected to rebound from the low 2012 level”. Based on the estimate that supply from autocatalyst scrap recycling would grow this year, JM concludes that demand from automotive and industrial sector as well as jewellery should be matched by supply. However, as pointed out, we have some doubts whether supply from scrap recycling will increase sufficiently. If new car registrations remain lackluster in Europe, this implies that old vehicles will be driven longer and thus, less catalytic convertors will be available for recycling.

However, so far demand for investment has not been included in the calculation. Taking this into account and expecting the same pattern as last year, JM concludes that the platinum market is likely in a slight supply deficit this year. This is quite different from the GFMS estimate of a supply surplus. As we regard the estimates from Johnson Matthey as more plausible, we expect that the supply/demand balance remains in favor of platinum.

However, even a further year of supply deficit might not prevent that the price of platinum might be lower on average compared to last year. Our vector autoregressive (VAR) model for precious metals shows that the price of platinum is strongly influenced by the development of gold. And it is the weakness of gold, which also dragged platinum down last week and could weigh further on platinum. Nevertheless, we still expect that platinum will perform better than gold this year. 

Gold’s false break-out not necessarily a positive indication

Until last Friday, it looked like most precious metals would trade sideways for the second week in a row. But the wave of physical buying, which set in after the plunge in mid-April, appeared to peter out as reports of some bullion trading houses indicated. At the same time, large speculators continued to sell gold. On the one hand, they reduced gold futures holdings and increased short positions according to the recent CFTC report on the “Commitment of Traders”. The net long position declined further by 7,629 to 89,423 contracts. The SPDR Gold Trust ETF recorded on Thursday the first increase in gold holdings since March 19. However, it was only the one swallow, which does not make a summer. Therefore, the question appeared to be only when and not if precious metals would break out to the downside.

Last Friday, then the unavoidable appeared to happen. Gold and silver traded below the low of the preceding week. Normally, one would expect technical oriented selling to set in and thus, driving prices further down. In addition, on a break-out day one would expect the close to be near the lowest price of the day. However, at the time of the London PM fixing, the spot market turned around and gold as well as silver pared most of the losses. Both metals closed again inside the sideways trading range, which prevailed until Thursday. Thus, the break-out would be characterized as a false one by chart analysts.

In technical analysis, one of the rules is that a false break-out often leads to a strong move in the opposite direction. However, we have some doubts for several reasons that the trading pattern of last Friday sets the stage for another strong move upwards and that gold as well as silver would complete a flag formation. The first reason is that some quantitative technical indicators indicate the two precious metals are overbought. Especially the stochastics indicator returned back into the neutral zone, which is often a good indication for further weakness to follow. In addition, the difference between the MACD and its signal line narrows, which is also a harbinger that gold and silver might head further down.

The second reason is of course the fundamental factor which led to the break-out of gold and silver. Crude oil was on balance positive for the price development of gold and silver, but showed a similar trading pattern last Friday because it reacted on the same factor, which also pulled the precious metals lower. Also the stock market was positive for the precious metals, but gold and silver have decoupled from the co-movement with the S&P 500 index since November last year. We pointed out several times, that the reason for this decoupling is the change in Japanese policy following the election of a new government. Prime Minister Abe is determined to end the period of deflation and to reach a CPI inflation rate of 2% within a time frame of two years. Also the Bank of Japan has changed its course and got more expansionary. The BoJ embarked on another round of quantitative easing too.

This leads directly to the argument that quantitative easing would be positive for gold and other precious metals. If QE were a necessary condition for a rally in gold, then the program of the BoJ to extend its balance sheet would have to be also positive for gold. Especially, as the BoJ targets a higher CPI inflation rate. There should be no difference whether QE is followed by the Federal Reserve in the US, the Bank of England or the Bank of Japan or any other major central bank. Also the argument that the discussion within the FOMC about the timing of scaling down or even stopping the bond buying program would be the major reason for the decline of gold and silver prices since last November is not convincing. First, this discussion had been made public after gold already traded lower. Second, the Fed policy remains accommodative until 2015.

Therefore, QE is per se not a necessary condition for a bull market in gold and silver. However, this does not imply that QE would not matter at all. Quite the opposite! However, it is the impact of QE on foreign exchange rates, which matters for the precious metals.  This also explains why quantitative easing measures of the Fed have the opposite impact than bond buying by the BoJ. The expansionary monetary policy of the Fed is having a negative impact on the US dollar exchange rate (if not compensated by other factors like the eurozone debt crisis), while balance sheet expansion of the BoJ weakens the yen against the US dollar and other currencies. A stronger US dollar is usually a negative factor for precious metals or other commodity prices.

The trigger for the false break-out of gold and silver was the movement of USD/JPY. Ahead of the G7 finance minister meeting in London on Friday, USD/JPY surpassed the 100 mark on late Thursday afternoon (GMT) and the Yen weakened further in Asian and European trading on Friday to 102 against the US dollar. The QE measures of the BoJ are likely to contribute to further yen weakness. Therefore, we remain sceptical that the false break-out of gold and silver would set the stage for a strong upward move. 

Ahead of the Platinum week 2013

On Monday May 13, the London platinum week will start and one highlight of this day will be the release of the PGM Market Report by Johnson Matthey. The Platinum report will give an outlook for the supply and demand for platinum and palladium in 2013.  This report is one of the most followed in the PGM market. Another widely followed report is the one published by GFMS, which was presented last week in Johannesburg. GFMS gave some insights into the market outlook for 2013 in an interview published at ThomsonReuters.

Reuters reports that according to GFMS, the platinum market would swing to be over-supplied in 2013 due to falling demand from European car manufacturers. The labor unrest last year in South Africa, which accounts for more than 70% of global platinum mine production, drove the market into a gross deficit of 83,000 ounces last year. For this year, GFMS predicts that supply would increase by 2%.  However, the Reuters report did not state any figures and updated figures were not available at Reuters Eikon.

Johnson Matthey estimated in the November interim report that total platinum mine production would decline in 2012 to 5,840 thousand ounces, down from 6,480 ounces in the preceding year as a consequence of the labor unrest in South Africa. However, also supply from scrap recycling was expected to decline to 1,830 thousand ounces. Thus, Johnson Matthey predicted a supply deficit of 400 thousand ounces. Even if the figures were revised down, it appears as less likely that Johnson Matthey would come up with a supply deficit figure close to the one of GFMS mentioned in the press report

We agree with GFMS that the European automobile sector will be a drag on global demand for platinum used in catalytic converters. However, the plunge of new car registrations in Europe, caused by the recession in many countries following the austerity measures, will also have an impact on scrap supply. If private households and companies buy less new cars then old cars will be driven longer. As a consequence, fewer cars will be available for recycling and therefore, also the supply from scrap platinum should be expected to decrease.

Furthermore, Reuters reported that Anglo American Platinum (Amplat), the number one producer, is expected to reveal the outcome of restructuring talks with the government and unions before the start of the Platinum Week. Amplat plans to cut up to 14,000 jobs and to mothball two mines. Cutting stuff and closing mines will have a lasting impact on mine production. Therefore, we would be surprised if Johnson Matthey were forecasting an increase of supply from mine production and scrap recycling to the level in 2011, which was at 8,525 thousand ounces. We expect only a modest increase of total supply in 2013 compared with 2012.

Investment demand for platinum is likely to remain robust. Holdings of platinum by ETFs have declined in April from the high reached in March. However, according to the figures compiled by Reuters, ETF holdings are still far above the level prevailing at the end of last year.

According to the November Platinum interim report, Johnson Matthey expected that jewelry demand increased from 2,480 to 2,725 thousand ounces. For this year, there might be two opposite forces having an impact on demand. The economic recovery in Asia, despite GDP growth rates remaining below levels seeing some years ago, should be positive for platinum demand. However, platinum is trading again above the price of gold, after trading up to 200$/oz discount about a year ago. The shift from a discount to a premium makes gold more attractive and thus, jewelry demand for gold could increase at the expense of platinum demand.

We pointed out several times that there is a closer correlation between the price of platinum and the development of share prices of some major car companies like Daimler. Those companies are less exposed to the falling demand in southern European countries and still have upside potential. While the supply deficit of platinum might be less in 2013 than Johnson Matthey expected in its November interim report for 2012, we still expect platinum to remain in a deficit and not to swing into a surplus. Therefore, the PGMs will probably perform better than gold or silver in the final months of 2013.