Base metals gain despite weaker PMIs

All base metals closed the week higher than on the Friday before. Nevertheless, the market came under stronger pressure on Thursday after the release of various PMIs, with especially the HSBC manufacturing PMI for China weighing on the market.

The flash estimate of the HSBC PMI for China declined further from 49.5 in January to 48.3, while the consensus of economists predicted only a marginal decrease to 49.4. Thus, not only the market for base metals but also stock markets came under pressure. However, one should keep in mind that there is also an official manufacturing PMI for China. The HSBC index is a survey under medium-sized, privately owned companies whereas the official survey comprises for large companies, which are mostly owned by the state. This official manufacturing PMI will be released on Saturday, March 1. In January, the official manufacturing PMI was at 50.5, and thus, unlike the HSBC index pointed to a still expanding manufacturing sector. For the February index, the consensus is looking for a slight decline to 50.3. While the official index is expected to point still to an increase in economic activity, the HSBC index shows an accelerating contraction of the manufacturing sector. But only one manufacturing PMI could get it right. As the companies surveyed in the official PMI have a greater contribution to GDP than those in the HSBC index, we would put more emphasis on the official PMI. Nevertheless, the financial and commodity markets rely more on the HSBC index.

Also in the Eurozone, the flash estimates of the manufacturing PMIs disappointed expectations among economists. The flash estimate of the German manufacturing PMI showed a surprising decline from 56.5 to 54.7, which is still indicating an expansion of the manufacturing sector, albeit at a slower pace. More worrisome is the further fall of the French manufacturing PMI from 49.3 to 48.5 while the consensus expected a slight increase. For France, also the service-sector PMI posted a surprisingly strong drop. Thus, fears about the French GDP growth re-surfaced after France grew in the final quarter of 2013. For the Eurozone, the flash estimate showed a decline of the manufacturing PMI from 54.0 to 53.0, which would still point to a further recovery of the manufacturing sector in the Eurozone, but with regional divergences. As the automotive sector reported increasing new car sales even in those countries being hit especially hard after the financial crisis, this development indicates that the demand for base metals should increase in the Eurozone.

In the US, the ISM manufacturing PMI will be released only at the first working day of the following month. Nevertheless, there are several surveys conducted by the regional Federal Reserve Banks, which usually provide a good indication for the nationwide PMI. The Empire State manufacturing index, published by the NY Fed, fell in February to 4.5 down from 12.5 in January. The Philly Fed manufacturing index plunged from 9.4 in January to -6.3 in February. Both indices point to another fall of the nationwide ISM index. A relatively new index is the Markit manufacturing PMI. Data is only available from May 2012 onwards. This index moved against the direction of the other indices and rose by 3 points to 56.7 in February. However, financial and commodity markets focus solely on this index, which triggered a rebound of stock indices and metal prices.

But one should be careful with the Markit manufacturing PMI for the US. This is just the result of a flash estimate. Thus, this estimate might be biased by responses from companies located in regions, which were less impacted by the severe winter season in the US. During the short history of the Markit PMI, it showed partly considerable revisions. Thus, the Markit flash estimate is not necessarily a reliable indication that also the nationwide ISM manufacturing PMI will increase in February. A disappointing index reading might turn out to be negative for stocks and base metal prices. However, a negative reaction at the US stock market might be positive for precious metals. 

Not all rosy now for gold in 2014

Precious metals performed well during the last week. All metals posted strong gains, but while silver rose 7.4% within one week, the focus of many commentators was on gold. The widely followed metal increased 4.1%, but what was more important for gold was the break of the psychological resistance at 1,300$/oz. In order to assess whether gold is now in an upward trend, one has to analyze which factors drove precious metal prices higher.

During the final quarter of 2013 and also in January, gold and other precious metals performed well, when the major stock markets consolidated or traded lower. However, last week, stocks and precious metals moved both higher. In both markets, the statements of Fed chairwoman Yellen at the testimony at the House had been welcomed. The January labor market report and weaker than expected PMIs in the US led to speculation that the Fed might slow the pace of reducing the monthly bond purchases. However, Mrs. Yellen confirmed the FOMC statement made only two weeks before. In the stock market, traders and investors interpreted the statement as an indication the FOMC would still expect a strong US economy. With this respect, the rise of US equity prices is understandable.

However, if the FOMC continues tapering as indicated and the weaker economic data was only due to the severe winter weather in the US, then there would be no reason for the precious metal to be excited about the Fed. Quantitative easing would come to an end rather sooner than later. Even if the Fed keeps the Fed Funds target rate at the extremely low level during this year, the outlook for rate hikes in 2015 remains intact. Thus, it has to be expected that short-term interest rates and yields on US Treasuries would edge up, which implies that the opportunity costs of holding precious metals would increase too.

The outlook for higher interest rates should be supportive for the US dollar. Also the forward guidance of major other central banks points to a continuation of the expansionary monetary policy. However, this appears not as sufficient to strengthen the US dollar against the major currencies. In the case of the Bank of England, the market is skeptical and fears the MPC might raise the base rate sooner than currently indicated. The ECB has been expected to ease monetary policy further already at the February meeting. However, the governing council kept rates unchanged. After declining in January, the 3mth GBP Libor rate edged up again. In the Eurozone, the 3mth Euribor rate also increased slightly after the ECB meeting and is still far above the level prevailing in November. Thus, the development of money market rates contributed to weaker US dollar against the major currencies. Furthermore, the emerging market currencies, which had been under pressure in January, managed to recover slightly as the rate hikes by the central banks in India and Turkey showed some impact. From our point of view, it was the weaker US dollar, which contributed to the rise of precious metals.

However, for the medium-term outlook, it remains questionable whether the US dollar will remain a supportive factor for gold and other precious metals. The GDP growth in the final quarter of 2013 was a bit stronger in the Eurozone than the consensus of economists predicted. The ECB also underlined the outlook towards an economic recovery. Nevertheless, the inflation rate headed lower again and fell to 0.7%, which is far below the ECB’s target rate of close, but below 2%. Of course, the ECB cannot state that the council would expect the Eurozone economy were heading towards deflation. Such a statement could become a self-fulfilling prophecy, which would be counter-productive. But this does not rule out, that the council would have to take further measures to ease monetary policy. Especially, the rise of the money market rates since early December could not be welcomed. Therefore, we still attribute a higher probability to the scenario of further easing. This would be negative for the euro. But higher import prices could be favorable in the present inflation environment. Furthermore, it would be positive in particular for the current accounts of Southern Eurozone member states. Therefore, the positive impact of the US dollar on gold might be short-lived.

Another factor contributing to the recovery of gold and silver has been the behavior of institutional investors. As they reduced their exposure last year, it seems that the pictures is changing. According to the CFTC report on the “Commitment of Traders”, large speculators have changed their attitude towards gold since last Christmas. They have increased on balance their long positions by almost 24K contracts and reduced short positions by around 22K contracts in the Comex gold futures. Thus, the net-long position rose from 25,904 contracts on December 17, 2013 to 71,201 contracts in the week ending Tuesday, February 11. Furthermore, gold holdings at the biggest ETF, the SPDR Gold Trust fell for more than one year from 1,350.82 tons at year-end 2012 to 790.46 tons at the end of January this year. It is well known that institutional investors were massive sellers in this ETF. But know, it appears that also PIMCO is now done with reducing its gold holdings. The gold holdings at SPDR Gold Trust increased over the last two weeks to 801.25 tons. This might be just the one swallow, which does not make a summer. However, it is already sufficient for prices of precious metals to recover that large institutional investors are no longer selling gold.

  

In our forecast for the LBMA annual analyst survey, we penciled in a high of 1,475$/oz for gold in this year. Thus, gold could still increase further and the current upswing might have further potential. However, we would be surprised if the main driver would be a weaker US dollar. As the US economy is expected to be in an almost Goldilocks situation with robust GDP growth and no inflationary pressure in the pipeline, the normalization of Fed monetary policy will continue, which implies terminating bond purchases this year and lifting the Fed Funds target rate next year. In this situation, the US stock market should provide attractive return perspectives. Furthermore, the yield on 10yr US T-notes should have only limited potential for a decline. But a strong rise also appears currently not as the most likely scenario. Thus, government bonds also offer good performance opportunities. In this environment, institutional investors could also switch quickly out of precious metals again. Thus, we still expect more a trading than a trending market for precious metals in 2014.

Fed Quantitative Easing and Emerging Market Currency Weakness

Just a few weeks ago, when some emerging market currencies came under renewed strong pressure and the central bank of Argentina suspended to intervene in the foreign exchange market and the central banks of India and Turkey hiked their key interest rates, many commentators compared the situation with the Asian currency crisis in the late 1990^th. However, in-between, the situation has calmed down a bit and the US stock market posted the first week with a gain in this year. From our point of view, the situation is not comparable to the Asian crisis.

There are several indicators, which could lead to a currency crisis, especially when a country has a fixed exchange rate regime. The first factor is increasing indebtedness in foreign currencies. Often, the interest rate level in an emerging market country is higher than the one in a country, whose currency is regarded as a reserve currency. Thus, it is not surprising, that borrowers try to take advantage of the interest rate spread between two currencies. The amount of outstanding borrowing in foreign currencies increases. Sooner or later, foreign exchange analysts regard the level of foreign debt as unsustainable and write reports with the recommendation to sell this currency. As traders and investors follow those recommendations, the currency weakens and the cost of servicing the debt in a foreign currency increases. These costs are then regarded as unsustainable in foreign exchange markets and the pressure on the currency intensifies.

However, statistics about the debt in a foreign country only state the amount of debt but not whether this debt is hedged against currency fluctuations or fully exposed to the exchange rate risk. Private entities as well as governments could enter swap agreements that transfer the foreign currency loan into one denominated in the domestic currency. The disadvantage of those swaps is the reduction in the borrowing costs is given up to a large extend.

Some central governments from emerging market countries, like for example Turkey, are frequent borrowers in international bond markets. If not explicitly ruled out by law, those governments could reduce the foreign exchange rate risk without sacrificing a large part of the interest rate advantage of borrowing in a foreign currency. They could enter an agreement with the central bank to sell the proceeds from the bond to the central bank for obtaining the corresponding amount in local currency and at the same time agree to reverse this transaction when the bond is due. The central bank would have an increase in foreign reserves and could invest this increase in a bond which expires shortly before the bond of the central government is due. Thus, the central bank would have the necessary liquidity back when the reverse currency swap with the government would be due. In addition, the central bank could earn interest on the bond in foreign currency. As the profit of central banks is usually distributed to the central government, the foreign exchange rate risk would be widely reduced. By and large, only the spread between the interest rate paid by the government on its bond and the interest rate earned by the central bank would be exposed to the risk of exchange rate fluctuations.

Such a transaction would not only reduce the exchange rate risk for the central government, but would also sterilize the impact of government borrowing on the current account. The rise in capital imports is neutralized by the increase of foreign reserves. However, the central bank extends its balance sheet. But also this effect could be sterilized by withdrawing liquidity from the banking sector.

Another indicator often quoted is the rise of capital imports. An increase of capital imports is viewed as a growing dependence on foreign capital inflows. Furthermore, it is argued that those capital imports would increase the debt of the private and government sector in foreign currencies, and thus, would intensify the risk of an unsustainable debt level if the currency depreciates. This could indeed be the case. However, also in this case, a more in-depth analysis is required for avoiding the wrong conclusions. Capital imports are not necessarily the result that a country would have to obtain funds in a foreign currency to finance its imports. The rise of capital imports could also be the result of foreign investors, seeking higher returns, increase their investments in assets of an emerging market country. Investments in equity markets or bonds issued at the domestic primary market are normally denominated in the local currency. In this case, the investor would have to bear the foreign exchange rate risk. The higher capital imports in this scenario do not alter the level of indebtedness in other currencies, and thus, they do not change the risk that exchange rate fluctuations could lead to a default of private or public debtors.

The third indicator for the risk of a currency crisis is the development of the current account. A rising deficit in the current account is regarded as unsustainable if a certain ratio of current account deficit to GDP is exceeded. However, a closer analysis of the factors driving the higher deficit is also needed for this indicator. If, as it is often the case, the widening current account deficit is due to an increased demand for foreign goods and services by the emerging market economy, then this indicator could rightly point to an increased risk of a currency crisis. But if the original impulse comes from foreign investors purchasing more assets of an emerging market economy, then the situation is different. Even if the central bank tries to neutralize the impact of higher capital imports induced by the demand of foreign investors, it normally cannot fully sterilize the impact of foreign investors on the balance of payment. Thus, if capital transactions induced by foreign investors are the main reason that the capital account shows an increased net-import balance, then the current account has to be in a deficit. This is an underlying condition of balance of payment accounting.

The Economist published an interesting chart some weeks ago, which displayed the cumulative purchases of bonds and equities of emerging market economies by institutional investors. The striking point was, that the cumulative purchases started to increase already at the beginning of the new millennium, thus, about one decade before the Fed implemented quantitative easing. The glut of capital flows from two Asian countries with huge current account surpluses into Western capital markets depressed the return on government bonds, especially on US Treasury notes and German Bunds. However, also the spreads of other Eurozone member countries over the benchmark bunds fell considerably. Thus, institutional investors sought to achieve higher returns to meet expectations of funds sponsors by investing in emerging markets.

The financial crisis only shortly led to a decline of the cumulative investments in emerging market equities and bonds. For bonds, they almost fell back to zero. However, already in 2009, the cumulative investments reversed direction again and increased strongly due to the massive stimulus measures taken by China. The quantitative easing measures of the Fed supported this move, but were not the trigger. Therefore, the rise of capital imports by emerging market economies was induced by the decision of investors to allocate more funds for the purchase of emerging market stocks and bonds. By mid-2013 the level of cumulative investments in emerging market stocks as well as in bonds exceeded the pre-financial crisis amount by far. As lined out above, those investors also had to bear the risk of exchange rate fluctuations.

As former Fed chairman Bernanke announced in May at a Congress testimony that the FOMC might decide to taper at one of the next few meetings, institutional investors and fx-traders came to the conclusion that less money would flow into emerging market assets. In addition, rising yields on US Treasury paper had to be expected and the yield on the benchmark 10yr US T-Note indeed rose to 3%. Thus, also the relative advantage of domestic emerging market bonds changed. In this altered environment, institutional investors had to adjust their asset allocations. As a result, they reduced exposure to emerging markets, which already led to currency weakness in the summer of 2013. With the start of tapering in January, another wave of currency weakness set in.

However, as it were institutional investors, which increased their exposure to emerging markets, they were also the driving force behind the rise of capital imports and current account deficits by emerging market countries. They invested in assets denominated in local currencies of the various emerging market economies. The repatriation of funds could have a positive impact on the emerging market countries. With the devaluation of their currencies, their products gain in international competitiveness. The capital account should no longer be the driving force for the current account, which should improve. Thus, the situation is different than it was in the late 1990^th at the Asian currency crisis. That the situation has calmed down might be due that more investors recognized the differences.  

Fed Tapering, Emerging Market Currency Crisis and Precious Metals

During the past week, we received some questions from journalists about Fed tapering, the currency crisis in some emerging markets and their impact on precious metals. Therefore, this blog article will deal with those questions and the corresponding answers.

The decision of the Fed to reduce the volume of monthly bond purchases by another $10bn to a total of $65bn should not come as a surprise. It has been well communicated by the Fed and the US labor market report with a further drop of the unemployment rate to 6.7% indicated that the FOMC would stick to the exit strategy. Furthermore, several new voting members in 2014 also stated that they would even prefer a quicker reduction of the monetary stimulus.

Some analysts quoted in the media expressed the view that the FOMC might pause due to the currency crisis in some emerging markets. However, this was only wishful thinking and not based on a proper analysis of the Fed policy. The US central bank is responsible for the monetary policy in the USA and has to take the measures in order to achieve its two targets. It is not the task of the Fed to correct policy mistakes by other central banks or governments. The Fed implemented quantitative easing despite some criticism from other G20 members. Therefore, one had to assume that the FOMC would stick to the statement of the December meeting. Thus, the decision should have been already discounted in the precious metals market. But this does not rule out that precious metals might react on indirect effects.

One of those effects is the reaction in the US stock market. While the S&P 500 index rallied in December after the FOMC, the US stock market extended losses this time. Thus, unlike after the last FOMC meeting in 2013, precious metals advanced after the FOMC decision was announced. However, this did not prevent that all precious metals ended the week significantly lower compared with the close of the preceding Friday.

The currency crisis in some emerging markets should increase the appeal of gold and other precious metals as a safe haven. Thus, it is not a surprise that some emerging market gurus like Mr. Faber recommended to buy physical gold. However, the return of holding gold comes from two sources, the currency and the gold price, which is quoted internationally in US dollars. The return of investing in the US dollar in the case of a currency crisis is positive as long as the crisis prevails. But the correlation between the US dollar and the price of gold is often negative. Therefore, a potential buyer located in a country with a currency crisis would have to expect that the return of gold would be diminished by a decline in the price of gold. The expected return for such an investor is higher if she buys a short-term US Treasury note. Also the expected volatility of a short-term US Treasury note is lower than the one of holding gold. Thus, there are better alternatives as a safe haven than precious metals.

However, the considerations above do not take into account the possibility that the government might impose measures of capital controls. If an investor has to fear that those measures could be taken by the authorities then buying physical gold might be the better choice even if the risk and return is less favorable compared to short-term US government paper.

Among the countries suffering under a currency crisis currently, only India and Turkey are major gold consumers. However, in India the central bank already took measures to curb the import of gold in order to improve the current account deficit. There was some speculation that this measures might be lifted, but this was very likely only wishful thinking. The Reserve Bank of India would risk that the deficit widens again. Thus, India’s gold imports are unlikely to recovery considerably anytime soon. It could not be ruled out that Turkey might take similar steps to curb gold imports in order to improve the current account deficit quickly. Therefore, on balance the currency crisis could even have the impact that demand for physical gold declines instead of rising due to safe haven buying.

The currency crisis could also have a negative impact on precious metals prices via indirect effects. Despite the IMF revised its forecast for global GDP growth in 2014 up to 3.7% just a couple of days ago, equity investors fear that the currency crisis would lead to slower growth. The hike of interest rates during this past week by the central banks in India and in Turkey increased this fear. Thus, weakness of stock markets could be supportive for gold. That  gold declined this week on balance, despite weaker equity markets, is due to the biggest gold consumer. As China celebrates the lunar New Year, markets are closed there and seasonal effects point to slower demand after returning from the holiday week. But all in all, we continue to expect that stock markets will be the major factor for the further direction of precious metals and that the recent negative correlation prevails further.