Precious Metals rally after FOMC Meeting

While precious metals traded sideways ahead of the FOMC meeting, the four metals rallied as the US dollar weakened against the major currencies after the meeting. Gold jumped above 1,300$/oz. and silver above 20$/oz. However, we regard the reaction in the precious metals and foreign exchange markets as overdone.

The FOMC kept the Fed Funds target rate unchanged at 0.25% or lower and reduced the total volume of bond purchases by another $10bn. This should not come as a surprise. The Fed did not provide any hint that the majority of FOMC voting members would accelerate the speed of tapering. Even with the committee recognizing “that growth in economic activity has rebounded in recent months”, the stronger growth compared with the first quarter is not a convincing argument to change track in monetary policy. Also the improvement in the labor market is not sufficiently strong enough to justify a faster termination of bond purchases. The FOMC still regards the unemployment rate as elevated. Furthermore, the committee states “inflation has been running below the Committee’s longer-run objective, but long-term inflation expectations have remained stable”. Thus, also the second target of the Fed does not provide a justification for reaching the end of bond purchases faster than previously indicated.

The FOMC also presented its economic projections. It lowered the projection for GDP growth in this year from 2.8 – 3.3% to 2.1 -2.3%. At a first glance, this might look like a major revision in expectations for the current quarter and the second half of 2014. However, for the GDP in the final quarter of 2014 to be 3% higher than in the same quarter of the previous year, GDP has to grow at an average quarterly rate of around 0.75%. But due to the negative weather, US GDP declined by 0.25% quarter-on-quarter, which translates into a drop of 1.0% annualized. Taking this decline into account, the revised projection still implies an average quarterly GDP growth of around 0.75% for the other 3 quarters in 2014. Thus the new projection neither reflects a more pessimistic nor more optimistic view of the FOMC members on the underlying expansion of US economic activity. Also the revisions for the unemployment and inflation rate are only minor.

There was criticism that the decision to taper further by $10bn was inconsistent with the revision of GDP projections. However, as shown, the FOMC has not changed the projection for average quarterly growth for the remaining 3 quarters. Furthermore, the revision of the GDP projection has led to accusations that the Fed would always overestimate GDP growth. The FOMC presents a range of GDP growth, nevertheless, there remains an imponderability in any forecast of a random time series. And in the case of the Q1 GDP growth, the weather had a stronger impact on economic activity than on average during the winter months. Even meteorologists did not predict such a long cold period before the start of the winter season. Therefore, the FOMC is not to blame for overestimating the GDP growth in Q1.

But also the expectation of faster end of bond purchases are not rational based on the expectation of a recovering US economy. The projections of the FOMC for the dual mandate variable are only modified slightly. Also the underlying expectation for average quarterly GDP growth remains almost unchanged. However, for terminating bond purchases faster the FOMC would have to expect stronger economic activity than previously assumed. Just forecasting a recovering after the decline of GDP in Q1 is not sufficient.

The dot charts are sometimes misinterpreted. But they give a good indication about the direction of monetary policy and the possible Fed Funds target rate at the end of the corresponding year. There is still no majority expecting a rate increase in 2014. Thus, the middle of 2015 remains currently the most likely date for the first rate hike. However, there appears to be no majority for increasing the Fed Funds target rate beyond 1.25% by the end of 2015. The dot chart from the March FOMC meeting showed that the majority did expect the Fed Funds rate to be only lifted to 1.0%. Thus, the FOMC got a bit more hawkish as far as the outlook for interest rates is concerned. But the Fed Funds December 2015 future just prices in a hike to 0.75%.

From our point of view, the risk is clearly that the FOMC might hike the key interest rate more than the market prices in during the second half of 2015. This should be supportive for the US dollar against the euro and the Japanese yen. However, the Bank of England might increase the base rate earlier. But overall, the indications provided by the FOMC do not support arguments for a weaker US dollar. Thus, the FOMC policy outlook is also not positive for the precious metals.

But there is not only a danger for precious metals of the Fed monetary policy outlook for 2015 via the influence of the US dollar on precious metals. At the current yield of 2.62% on 10yr US Treasury notes, there is hardly any downside potential left unless economic conditions weaken surprisingly and would derail the FOMC policy projections. A rise of the Fed Funds target rate to 1.25% within the next 18 months should also lift yields higher at the medium- to long-term maturity range. Given the outlook provided by the FOMC, 10yr US Treasury yields in the range between 2.75 – 3.0% appear more appropriate and 2.62% looks as expensive. A rise of US Treasury yields also increase the opportunity costs for holding precious metals. Thus, also the medium-term outlook for the US Treasury market is a negative factor for gold and silver. 

Therefore, we come to the conclusion that the outlook for precious metals is not as positive as the market believes after the FOMC meeting. As long as the US economy develops as the FOMC expects, the risk for precious metals remains more biased to the downside. Only negative surprises, which would lead to a change in the outlook for the Fed policy, could make gold more attractive in the medium-term. However, geo-political developments could lead to demand for gold and silver as safe havens. How the situation in Iraq develops is hard to predict.