ECB gets ready for easing, negative for precious metals

All precious metals ended the week lower than the Friday before. Among the major fundamental factors of our fair value model, the slight increase of the US dollar index and the marginally lower S&P 500 index were negative for the precious metals, while the modest increase of the crude oil price should have been supportive. However, the major fall of the precious metals occurred last Wednesday after the speech of Mrs. Yellen at her testimony before the Joint Economic Committee of the Congress had been released.

The initial reaction in the stock market was negative, but also the precious metals headed lower. But as Mrs. Yellen stated that the US economy would need further accommodative monetary policy, the stock market recovered. Also the statement by Russian president Putin that military forces had been ordered to return back to their home bases supported the stock market and weighed on precious metals.

From our point of view, the major risk for gold and silver is biased to the downside. And the recent events and economic data in the Eurozone strengthen our assessment. The EU Commission presented the spring forecasts. The inflation rate in the Eurozone is expected to be only 0.8% this year and 1.2% in 2015, which is a slight downward revision. GDP growth is predicted to be 1.2% in the Eurozone in 2014 and should accelerate to 1.7% next year. The German economy is expected to be the locomotive for the Eurozone with a GDP growth of 1.8% this year. Slovakia and the Baltic member states are expected to post stronger growth, but these countries have only a smaller share at Eurozone GDP.

However, also the growth engine in Germany sputters. The volume of new orders in March was expected to increase by 0.3%, however, it dropped by 2.8% on the month according to the preliminary figures. Industrial production figures also disappointed with a decline of 0.5% on the month, whereas the consensus among economists predicted an increase of 0.2%. One could rightly argue that the monthly data is volatile and that a 3mth moving average would provide a better picture. However, looking at the chart below, there is a worrying development. The German manufacturing production reached the highest level since the start of the financial crisis in 2007 in July 2011. Since then, the index of manufacturing production hovered sideways. The industrial production including the construction sector exceeded the high from 2011 marginally in February, but this was mainly due to construction activity, which was up as the winter season was unusually warm. The volume of total new orders (excluding construction orders) did not even come close to the pre-crisis level when it peaked in early 2011. 

But two others points are striking analyzing the chart. First, Germany pushed through that other Eurozone member states suffering under the fall-out of the financial crisis had to impose austerity measures when the debt crisis hit the Eurozone. But the austerity measures did not only lead to a fall of economic activity in the Southern European countries, they also fired back on Germany, which is depending heavily. Second, the flow of new orders and industrial production only recovered after ECB president Draghi gave the pledge that the ECB would do whatever is needed to keep the single currency intact in July 2012. Also the decision to introduce the OMT program was helpful to restore confidence. But it was again Germany, which opposed this policy of the ECB.

However, restoring investors’ confidence that the euro would not fall apart and mitigating the financial stress of Southern Europe came at a cost. The euro recovered against the US dollar and some other major currencies. While this was initially welcome and also attracted foreign investors buying government bonds of the crisis countries again, the euro has now reached a level, which is negative for two reasons.

First, the strong euro hurts the competitiveness of many countries, especially of those countries, which compete with Chinese exporters. Many German exporters will be hurt less by the current level of the euro as their goods are not easily substituted by products of Chinese manufacturers, like luxury cars for example. But in Southern Europe, the benefit of lower wages could easily be lost by the foreign exchange rate movements. 

The second reason is the impact of a stronger euro on the inflation rate. About 10 years ago, the ECB welcomed a stronger euro as it helped to keep the inflation rate close to the target rate. However, now, the situation is completely different. In many countries, the austerity policy and a negative output gap weigh on the development of consumer prices. In some Eurozone member states, the inflation rate is already negative. A stronger euro exercises further pressure on import prices, which will feed through to consumer prices. Thus, a further strengthening of the euro would increase the risk of outright deflation in the whole Eurozone and not only in some parts of the currency area.

The finance minister of France called for measures to weaken the euro. In a typical Pavlov reflex, a spokesperson of German chancellor Merkel already rebuffed this call. However, ECB president Draghi shared the concerns of the French finance minister. While the council did not take any measures at the rate setting meeting this month, Mr. Draghi prepared the market for some policy measures at the next meeting. Another reduction of the repo rate might not be enough to weaken the euro sufficiently. We are still convinced that only some measures of quantitative easing could lead to a desired depreciation of the euro.

But it is again Germany, which voices criticism about further rate cuts or QE. The main argument against further monetary measures is that it would lead to rising real estate prices and thus causing a bubble. However, the situation in Germany is currently not comparable with the US or Eurozone member countries at the start of this millennium. For a bubble in the real estate market, two developments have to coincide: the house prices have to rise and this rise must be accompanied by a surge in construction activity. As the chart shows, the index of house prices in Germany meandered along a slightly declining trend for the first ten years of this century. But with the debt crisis, the flight of many investors into tangible assets led to a rise of house prices. However, this price increase was concentrated on a few urban regions. Nevertheless, more important is that higher house prices did not lead to a strong rise of housing permits. The rise of house prices reflects the scarcity of housing units in the favored cities, which cannot be easily increased by construction activity. Furthermore, for a bubble, house prices would have to exceed the discounted net rent income. This is not everywhere the case even in suburbs of major cities. As long as the rise of house prices is mainly driven by demand from tenants wanting to become the owner of their home, there is hardly a bubble to build.

Therefore, we come to the conclusion that the ECB will act to prevent the euro form firmer further. Just a rate cut would not be sufficient to achieve this target. Thus, even if the council decides not to embark on QE at the June meeting, the foreign exchange market will force the council to take QE measures rather sooner than later. But with the ECB easing and the Fed on hold, the economic outlook remains positive for risky assets like equities. Funds are therefore expected to prefer stocks over precious metals. This outlook would not be positive for gold and silver. However, the best friends for gold investors might be politicians taking the wrong measures endangering the still fragile economic recovery in the Eurozone.