US Politics and Precious Metals

The recent comments concerning the precious metals markets still focus on tapering by the Fed. In this context, one would expect that the forthcoming US labor market report, which is scheduled to be released on Friday October 4, 2013, might be the most important factor for the precious metals this week. A strong US labor market report is probably negative for gold as it would increase the likelihood for reducing the volume of bond purchases at the next FOMC meeting.

However, the crucial question is: What makes the US labor market report a strong one? The non-farm payroll figure is predicted by the consensus of Wall Street economists to increase by 10K to 179,000 new jobs created in September. Thus, a significantly higher non-farm payroll number might be already regarded by some traders as a strong report. But one has to keep in mind that also the figures for the two preceding months are subject for revisions. Even if the non-farm payrolls comes in higher than forecasted the labor market report could still be perceived as a weak one in the case that the household survey disappoints.

The recent decline of the unemployment rate was the result of a low labor market participation. It has been pointed out in this blog that during the summer vacation months, there is little incentive for unemployed persons to look for a new job and to return back to the labor force. However, chances might increase after the US Labor Day holiday and thus, some persons might decide to join the labor force again and look for a new occupation. In this case, the unemployment rate might edge up again slightly. An increase in the unemployment rate would most likely convince the majority of the FOMC voting members that the decision made in September was the right one and it would be still too early to taper.

Thus, it is hard to predict, which influence the US labor market report might have on the price development of precious metals. If the majority of market participants comes to the conclusion that the labor market report would lead to a further delay of tapering, then precious metals might trade higher. But the upside might be capped as many economists and commentators could argue that tapering would be only postponed by one FOMC meeting.

However, another political development in Washington could lead to the result that the BLS (Bureau of Labor Statistics) might not be able to release the labor market report on October 4, 2013. The US administration might be forced to close all non-essential departments if not a last minute compromise on the budget for the next fiscal year starting on October 1st is reached. Furthermore, the US Treasury is approaching the debt ceiling and it is estimated that by mid-October the US Treasury runs out of sufficient funds to honor all obligations in time.

Currently, it seems that financial and commodity markets are relatively relaxed. The situation is not uncommon and had been solved just right in time several times since the summer of 2011. Kenneth Rogoff and Carmen Reinhart titled their famous book “This time it is different” as a warning. Whenever somebody used this argument to promote an investment, times were not different and the investment ended in losses. This might also explain that markets are currently relatively calm. However, is the current situation really the same as it had been before?

In the past, there had been already some movements towards a compromise, albeit slowly. This time, there appears to be not any compromise in sight. The situation resembles like two trains collide at full speed and none of the drivers stepping at the brakes. The Tea Party fraction of the House Republicans sticks to its demands and is not showing any willingness to move even one inch towards a compromise. At the time of writing, a last minute compromise appears light-years away.

A failure to reach an agreement on the budget for the next fiscal year would have serious negative consequences for the US economy. The Fed would have to postpone tapering for quite some time into the future. The normal reaction among investors in periods of economic weakness would be to buy the government bonds and notes. However, with the looming debt ceiling and the risk that the US Treasury might default on its obligations, the US Treasury market is not the safe haven it used to be. But gold will not default and therefore, if a rush into safe havens sets in, gold might rally like in the summer of 2011. Only in this respect, times might not be different.

Swarm intelligence and the Fed: Yes, the majority can be wrong!

Two thirds of the Wall Street economists polled either by Bloomberg or ThomsonReuters were wrong. The FOMC did not start tapering at its September meeting. Now many of those economists, but also strategists and even some traders and fund managers talking to the media behave like bad traders, which blame others for their losses. In this case, they blame the Fed for misguiding them. However, this criticism of the FOMC is unfounded and unfair. Those, who have bet on tapering in September, should better carefully analyze which mistakes they made in misinterpreting the FOMC statements.

When Fed chairman Bernanke made the famous statement at the Congress testimony in May, he used the simple conditional form. However, it can be observed times again and again that some persons, among which are also journalists, have difficulties to make the right distinction between the simple conditional and the simple future form. Many analysts, economists and journalists interpreted the sentence that the FOMC might decide at one of the next few meetings to reduce the volume of bond purchases as that the FOMC will make the decision. Furthermore, the expression next few meetings was reduced to the next three meetings and thus, many just concluded that the FOMC will taper in September.

However, the intention of Mr. Bernanke was just to prepare the market for an event which was a possible outcome of the discussions within the FOMC. But the decision was still open. Reading carefully the FOMC statements and the comments made by Fed chairman Bernanke and some other voting members of the FOMC, it was clear, there was no pre-commitment to decide to taper at the September FOMC meeting. Former ECB president Trichet used to emphasize at each ECB press conferences that the ECB was not pre-committed. But even if Mr. Bernanke had pointed out again and again that the FOMC was not pre-committed to taper in September, there would have been still some traders, fund managers or economists who did not get the message and then complaint about being misguided by the Fed.

The FOMC always emphasized that the decision concerning tapering the volume of bond purchases would be data dependent. However, the FOMC never stated that a certain level of the unemployment rate would automatically lead to a reduction of bond buying. Furthermore, the data set relevant for the FOMC decisions also includes the Fed projections for GDP growth and inflation, which a central bank should take into account due to the impact lags of monetary policy. Again, some commentators now complain that the FOMC has revised its projection for GDP growth lower for this year by 0.3 percentage points and that this downward revision is a further argument for not tapering.

Some commentators also criticized that data dependency includes the change in financial market conditions, which occurred after Fed chairman Bernanke pointed out the possibility of tapering at the testimony on May 22, 2013. However, the FOMC cannot ignore the rise on yields on US Treasury notes and bonds as well as on mortgage bonds. If financial markets overshoot on the announcement of a possible action, then these markets should not be surprised that the possibility does not became reality. However, it is not the Fed to blame. Economists and traders just ignored that the market reaction could have a feed-back impact on the FOMC decision. Those, economists and traders who got the FOMC wrong have to do just a better job.

Data dependency also includes to consider future risks. One of these future risks is the US fiscal policy and that politicians tend to make the same mistake not only twice but several times. The Tea Party fraction of the House Republicans is again following an all or nothing policy and is unwilling to make a compromise. They risk again that the US might default on the Treasury debt. Such an event would have huge negative impacts on the US economic activities. Thus, prudent monetary policy just takes a wait and see attitude before reducing the monetary stimulus.  

We pointed out several times that the publicly available data for the labor market and price development were sufficient reasons for not tapering in September. The further arguments provided by the FOMC does not make the Fed policy unpredictable. As Lord Keynes once stated: “If the facts change, I change my mind. And what do you do, Sir?” The FOMC always made it quite clear that they would act like Lord Keynes by emphasizing again and again that the decision to taper is data dependent. Those, who got the FOMC wrong have obviously ignored to take changing facts into their analysis.

For the yield on 10yr US Treasuries, we stated that they would be very attractive at a level around 3% as the Fed Funds rate would remain at the extremely low level for some time, even after the Fed starts to reduce the volume of bond purchases. We came close to this level. After the recent FOMC decision, yields came down to 2.75%. Also at this level we regard 10yr T-notes still as a buy. It appears that the FOMC would prefer yields to be more in the vicinity of 2.5% before tapering.

Gold and other precious metals rallied after the FOMC announcement, but pared gains on Friday and even closed down in the week over week comparison. The market speculates now that the FOMC would taper at the next meeting. While it is also not yet a done deal that the FOMC will lower the volume of bond purchases in October (observe the risk stemming from the fiscal policy for the US economy) the commodity markets react like the decision has already been made. But the FOMC is not pre-committed. Nevertheless, the market reaction strengthens our assessment that precious metals remain trading sideways and that the upside potential is capped for the time being.     

Risk for precious metals more biased to the down-side

Just when some gold bulls revised their forecast higher, the market turned around. Initially, it was regarded as a consolidation only. But this week was negative for precious metals. Gold lost 60$/oz or 4.3% and ended at 1330$/oz, the worst weekly loss since the sell-off in June. As usual, the price swing was even stronger in percentage terms for silver, which lost 6.8% or 1.62$/oz to close at 22.2$/oz. Only palladium managed to remain on balance almost unchanged, but it suffered a stronger loss the week before.

The drop of gold could be attributed to technical trading, but this is only one factor and does not describe the whole picture. After gold did not manage to stay above the 1,400$/oz mark, which was regarded first as an important resistance that should also provide strong support then, some traders not only took profits but also reversed positions. This is reflected in the renewed decline of gold holdings by the SPDR Gold Trust ETF too, which fell again to 911 tons. Furthermore, large speculators reduced their net long position in COMEX gold futures by almost 10,000 contracts to 68,724 contracts in the week ending September 10, 2013 according to the recent CFTC report on the commitment of traders.

The development in the precious metals market over the last couple of weeks also demonstrates that Gold is not the safe haven as many gold bugs pretend it to be. A safe haven should provide a wealth protection also when the storm calms down, which the precious metals did not. The UN inspectors are providing evidence that poison gas had been used on August 21 this year near Damascus. However, the military strike, which in particular US Secretary of State, Mr. Kerry, but also the French president and the British prime minister demanded, became unlikely due to political developments during the course of this week. But even with the Syrian regime handing over chemical weapons to the UN for destruction over the next few months, the civil war in this Middle-East country is far from being over.

That gold and silver reacted so strongly on these political developments took some commentators by surprise. However, they completely overlooked that it is not only the safe haven risk premium, which had been priced out, but also a fundamental factor played a crucial role in this context: the price of crude oil. Syria is not a major oil producer, however, it is an import transit country for transporting crude oil through pipelines to the Mediterranean Sea. Furthermore, a military strike by Western forces bears the risk that the conflict escalates by involving directly or indirectly other states like Russia or Iran. This could have serious implications for the supply of crude oil. Thus, the price of crude oil initially rose, but also declined as a military intervention got less and less likely. The oil price is a major factor for headline CPI inflation, which explains why it is also a major fundamental factor explaining the price development of gold and silver in many quantitative models. Thus, the recent developments concerning Syria had two negative impacts on precious metals, first by reducing the appeal as a safe haven and second by lowering the oil price.

In this blog, it had been pointed out, that the economic data does not indicate any urge for the Fed to taper at the FOMC meeting next week. The committee would be well advised to wait a bit longer and not to repeat the policy mistake made by the Bank of Japan some years ago when they reduced monetary stimulus too early. Nevertheless, the consensus of economists expect the FOMC to make the decision to reduce the volume of bond purchases on September 18. Thus, it cannot be ruled out that the FOMC will indeed vote for tapering in order to avoid disappointing the markets. While this possible decision should have been priced in already, the precious metals reacted again negatively on this outlook.

Another Fed related event also had a negative impact on gold and silver this week, the appointment of a successor for Fed chairman Bernanke. The announcement of President Obama’s decision is still pending. This week, the Japanese daily business newspaper Nikkei reported that former Treasury Secretary Summers would be appointed as next Fed chairman. While it is rather unlikely that not one of the leading US papers like the Washington Post or the New York Times receives such information first, markets reacted nevertheless. The US dollar appreciated against the euro and the yen on speculation that an FOMC led by Mr. Summers would reduce monetary stimulus faster. A firmer US dollar is another negative factor for gold.

Which decision US President Obama will take is hard to predict. However, Mrs. Yellen would be clearly preferred by the markets. But it could not be ruled out that Mr. Summers will be the favorite candidate of President Obama. Furthermore, without renewed geo-political tensions, it appears as less likely that the price of crude oil will rise again. A further easing seems to be currently the more likely scenario. Thus, the risk for the precious metals are expected to be more biased to the down- than to the up-side.     

Fed is in no urge to taper in September

At the beginning of each month, the focus of international financial and commodity markets is on two sets of economic data: the purchasing manager indices of various countries and the US labor market report. However, the reaction on strong PMIs could vary as the Fed prepared the markets it might start tapering. But the recent data does not point to an urge for reducing the monetary stimulus.

One of the major worries in the first half of this year was the slow-down of economic activities in China. However, the PMIs for the Chinese manufacturing sector point to accelerating economic activity in China. The official manufacturing PMI rose stronger than the consensus among economists predicted and increased to 51.0 from 50.3 in the preceding month. Financial markets focus more on the HSBC PMI, but also this index increased stronger and surpassed the 50 threshold. Thus, also this PMI points to economic expansion.

The Chinese PMI data pushed the prices of base metals higher. However, towards the middle of the week, base metals pared most of the gains. Thus, the impact of better than expected Chinese data had only a limited impact on base metals.

Also in the US, the ISM manufacturing PMI surprised the consensus of Wall Street economists. Instead of declining, the PMI rose further from 55.4 to 55.7. Even stronger was the surprise in the case of the service sector PMI, which rose to 58.6 from 56.0 in the month before, while the consensus expected a decline to 55.2. However, in the case of the US purchasing manager indices, a further increase is not necessarily welcome in financial and commodity markets, especially among the fixed income investor. But also the precious metals reacted negatively. The reason is of course the pending FOMC meeting and the fear of tapering the bond purchase program.

The improvement of the PMIs is a positive indication. But the US economy is far from overheating. Even despite the recent upward revision of GDP growth in Q2, the US economy expands only at a modest pace. Also the capacity utilization rate, which was in July lower than at the end of last year, does not indicate any inflationary pressure in the pipeline. Furthermore, the preferred inflation gauge of the Fed, the core PCE deflator is far below the target of 2% inflation rate. Thus, the rising PMIs don’t indicate that the Fed would have to hurry reducing the volume of monthly bond purchases.

The US labor market report is a mixed bag and also provides not an indication that the FOMC would have to act reducing the monetary stimulus at the next meeting on September 18, 2013. The unemployment rate edged down to 7.3% while the consensus expected an unchanged rate of 7.4%. But as the household survey shows, employment did not increase in August but declined. Also the number of unemployed persons declined on a seasonal adjusted basis. Nevertheless, the lower unemployment rate was mainly the result of a decline of the labor force. The number of persons not in the labor force increased. However, after the summer vacation season is over, some persons might look again for a job and join the work force. This could lead to a slight increase of the unemployment rate in coming months.

The non-farm payroll figures are also providing more support for no action at the forthcoming FOMC meeting. The number of new jobs created in August was 169,000 and thus, it was clearly below the consensus forecast. This figure is also only marginally above the number of new jobs originally reported for July. However, the biggest surprise was the downward revision of the July figure from 162K to only 104K. This indicates that the underlying trend of job creation might be much weaker during the holiday season that previously assumed. Furthermore, it provides a hint that also the August non-farm payroll figure could be subject for a stronger downward revision.  

The Fed always stated that a decision on tapering would be data dependent. Furthermore, the Fed criticized rightly the Bank of Japan for reducing the monetary stimulus too early and the economic problems in Japan now last for already one generation. Thus, the FOMC would be well advised to wait a bit longer with reducing the volume of bond purchases. Nevertheless, it could not be ruled out that the FOMC already starts to taper this month. But then, it is purely because the markets expect the Fed to take this decision at the next meeting as one FOMC member stated recently.

The yield on 10yr US Treasuries briefly rose above the 3% level before edging down again after the labor market report. Given the outlook that the Fed will keep the Fed Funds target rate at the exceptionally low level well into 2015, the Treasury curve (3mth vs. 10yrs) is at an attractive level. Thus, we regard the current yield level at the medium- to long-term end of the curve as a good buying opportunity. But for precious metals, the rise in bond yields imply also increased opportunity costs. Thus, precious metals might have some resistance to rise further. Especially in the case of gold, which did not manage to stay above the 1,400$/oz level.    

QE3 and Emerging Market Currency Weakness

A few years ago, when the Fed embarked on quantitative easing and decided to extend its balance sheet, the finance minister of Brazil, Guido Mantega, coined the term currency war. However, he was not alone in its criticism of unconventional monetary policy by the US central bank. Also finance ministers of other emerging market economies and even the German finance minister joint the chorus of complaints. Quantitative easing would be targeted to weaken the US dollar in order to gain an unfair competitive advantage for US exports.

In this blog, we pointed out that quantitative easing by the Fed would facilitate shifting funds into emerging market economies, but would not be a necessary condition. Furthermore, we argued, that expected returns would play the main role in international asset allocations and capital flows. Indeed, as the chart below shows, some currencies strengthened against the US dollar after the implementation of QE1, but did not firm beyond levels already reached in 2008.

After Fed chairman Bernanke announced at a Congress hearing in May that the FOMC might decide to taper the bond purchasing program at one of the next council meetings, Mr. Mantega and his colleagues criticize the measure again and demand that the FOMC should consider more the impact its measures will have on other economies. Normally, one would expect that those emerging market economies, which suffered under the capital inflows and a stronger currency against the US dollar should now be glad that the Fed considers to take away the punch bowl, which they blamed for the developments in 2010 and 2011. But the opposite is the case.

Since the statement by Mr. Bernanke at the May Congress hearing, the weakness of the Brazilian real, the Indian rupee and the Turkish lira accelerated. However, these currencies already weakened before the Fed prepared the markets that QE3 would not last forever. But these currencies depreciated already earlier.

Hedge funds following a global macro strategy can and often do destabilize emerging market economies. At the first stage, the look for earning perspectives. Brazil and India looked attractive as being part of the BIRC group. In the case of Brazil, also the commodity demand of China made investments in Brazil appealing.

But at this first stage, hedge funds and other financial investors ignore the impact of their investments on the current accounts of the emerging market economies. If the capital inflows are massive, they lead to a stronger currency and a worsening of the current account balance. However, eventually the current account deterioration leads to capital being withdrawn from emerging markets. Initially, Brazil profited from rising commodity prices due to the brisk recovery of the Chinese economy.

In a recent article, Barry Eichengreen, pointed out that the policy of the Peoples’ Bank of China to cool down Chinese GDP growth had a negative impact on those emerging economies, which currencies came under stronger pressure recently. We agree with this conclusion. However, we also underline that for the Chinese export driven economy, the austerity policy in the Eurozone, which lead to a double recession there, also contributed to the decline of the GDP growth rate from 12% down to 7%. This had a negative impact on other emerging market economies by a negative price and volume effect. Mr. Eichengreen is also right in highlighting that domestic policy failures also are an important factor that some emerging economies now suffer under stronger currency weakness while other don’t.

However, also the central banks, at least in India and Brazil also contributed to the reversal of capital flows. At the time the Fed started to implement QE1, both central banks increased their key interest rate as the chart above shows. But increasing interest rates have a negative impact on real economic activity sooner or later and thus, they reduce the incentive to invest in the economy. Hedge funds then not only liquidate investments in the stock markets but also start to speculate on a weaker economy and/or that the central bank policy would not be sustainable and short the domestic currency against the US dollar or other currencies.

A currency weakness should lead to an increase in competitiveness and an improvement of the current account. However, this effect could be expected only in the medium-term. In the short-run, the weaker currency implies higher import prices, which leads to a further widening of the current account deficit. This effect is well known in economic theory as the J-curve effect.

The worsening of the current account balance is for precious metals markets relevant in the case of India, which is a top consumer of gold, together with China. The Reserve Bank of India (RBoI), has reduced the key repurchase rate already in 2012 and took several more steps in this year. It is less likely that the RBoI will increase its key interest rate again. However, the RBoI also took measures to curb the import of gold, the main item contributing to the current account deficit. Thus, a further weakening of the Indian rupee could lead to more restrictive measures to reduce the import of gold into India. Gold investors should not be surprised is India’s physical gold demand would be weaker than expected this festival season.