US Bonds – helpful for precious metals short-term but medium-term risk

The major fundamental factors in our fair value models for the weekly metal prices were mixed this week. The major role played the outlook for US interest rates and stock markets for the precious metals.

Base metals were mixed but digested well the Chinese trade data, which showed a slower than expected increased of Chinese exports of 7.2% yoy compared with a 10% rise predicted by the consensus. Thus, the export surplus came in lower than expected at $31.6bn. Analysts reported that the import of metal was already affected by the probe of Qindao warehouses as banks are now more cautious with providing letters of credit to metal importers.

As far as US interest rates are concerned, two reports had an impact on markets. The first was a forecast revision by the chief US economist at Goldman Sachs. It took Mr. Hatzius a long time to wake up and to understand the messages, which the FOMC sent out with the quarterly short-term projections and dot charts. The message of the Fed was for quite some time that the first rate hike will take place most likely in mid-2015. But Goldman Sachs predicted against all odds that the first hike would not occur before Q1 2016. Now, also Goldman Sachs forecasts the first increase of the Fed Funds target rate for 2015. As the Fed prepared the markets for quite some time, this forecast revision should not have had any impact on markets. However, traders and analysts argued that the US stock market traded lower after the longer weekend due to the Goldman Sachs forecast revision. Another hint that the Chicago school theory financial markets are not information efficient is not worth a cent, neither an economics noble laureate.

The second report had been the minutes of the recent FOMC meeting, which were released on Wednesday. The interesting news of the minutes is that the majority intends to terminate the bond purchasing program with the October FOMC meeting. This implies that the purchases of US Treasury paper will be reduced not at the current speed of $5bn in October but by $10bn. However, ending QE3 by the end of October 2014 has also implications for the timing of the first rate hike by the Fed. Chair Mrs. Yellen stated several times that the first hike might take place about 6 month after terminating the bond purchase program. Therefore, the FOMC might decide already at the April 28 -29, 2015 FOMC meeting instead at the on at the end of June next year to increase the Fed Funds rate.

If the FOMC decides in April 2015 to hike the Fed Funds rate, then there are five more meetings scheduled were the committee could lift the key interest rate to a more normal level. Thus, also the level for the Fed Funds indicated by the dot charts of 1.25% by the end of 2015 gets more likely. However, the Fed Funds futures only price in a rate of 0.75%. From our point of view, fixed income markets are currently too optimistic for the outlook of Fed Funds by the end of next year. But adjusting expectations for the short-end will usually also have an impact on the long end of the US Treasury curve. Thus, 10yr US Treasury notes appear to be expensive at the current yield of 2.52%.

It might still take some time until the fixed income markets realize that the implied rate for the Fed Funds by the futures traded at the CME are too low compared with the signals send out by the Fed. However, once the market starts to correct its expectations, the potential impact on metal prices will be negative. On the one hand, rising US interest rates and yields increase the opportunity costs of holding metals. On the other hand, this development could reduce the attractiveness of commodity financing trades in China and thus, reduce the Chinese demand for metals used in commodity financing, which is not only limited to aluminum and copper, but also includes precious metals.

But that precious metals rose further during the past week, is the result of the “shoot first and ask later” mentality among traders and investors. On Thursday, Espirito Santo Financial Group (ESFG), which holds a stake of 25% in Portugal’s largest bank Banco Espirito Santo (BES), decided to suspend trading in its shares and bonds due to “material difficulties” at its largest shareholder Espirito Santo International (ESI), which is controlled by the Espirito Santo family. After BES shares fell by 19%, Portugal’s stock market regulator halted also trading in BES shares. Rumors swirled through markets that BES were in financial difficulties. As a result, not only the shares of BES and ESFG plunged, but it dragged also the Portuguese stock market and also other markets in Europe and the US lower. Furthermore, contagion spread also to the market for government bonds of the Eurozone. Yields on peripheral bonds jumped and Greece was only able to sell have the amount intended at an auction. The plunge of stock markets and soaring yields on peripheral Eurozone government bonds triggered a flight into save havens, which included also precious metals beside US Treasuries and German Bunds. During Thursday night, BES declared that its exposure to ESI would not put the bank at risk of running short of capital to assure investors about its financial stability.

This declaration led to a stabilization. However, according to reports published on Thursday, it should have been clear, that the problems of ESI are institution specific and not a general problem of the Portuguese banking sector in total. The flight to safe havens might support these assets for some time as investors might prefer to get more evidence that the Portuguese banking sector is not in troubles. Thus, in the short-run, the precious metals might be well supported by the safe haven status and as a mean to diversify the risk of holding equities. But the outlook for the US bond market in the medium-term indicates that the all-time high is far out of sight for gold and silver.  

Against the Fundamentals, but not the Flows of Funds

Last week, precious metals closed higher than the Friday before. However, all fundamental drivers included in our fair value models were negative. But investors have rediscovered commodities and the rise of some base metals also supports the precious metals.

Among the economic data, the focus was on the purchasing manager indices for many countries. The Markit flash estimates prepared the markets already for weaker PMIs for many countries in the Eurozone. Thus, it was not a surprise for the market that the final index confirmed the trend, especially as also the EU data on business confidence come in lower. In the US, the ISM manufacturing PMI also edged lower while the consensus of Wall Street economists expected a small increase. However, the lower ISM did not harm the recovery of the US stock market as some components of the ISM manufacturing PMI pointed to better index readings next month.

But not each decrease of a purchasing manager index translates into weaker economic activity. The first misunderstanding is the threshold level of 50. The PMIs are so-called diffusion indices based on surveys. The percentage of negative responses is subtracted from the positive ones. If the number of positive and negative replies is the same, the raw index is zero and the value of 50 is added to obtain an index oscillating around a positive number. However, the responses are not weighted by the size of the company. Regression analysis between economic activity and manufacturing PMIs show that the critical value is in most cases below the 50 threshold.

Furthermore, the time series properties of the PMI are different from those of financial assets. The vast majority of assets in financial markets follow a random walk, which could be described by a geometric Brownian motion. However, oscillating indicators like the PMIs are mean-reverting and their behavior could be described by an Ornstein-Uhlenbeck process. Even with a slow speed of adjustment to the mean, declines during the phase of economic expansion occur and are not necessarily already a harbinger of a slowdown.

In China, the official manufacturing PMI remained above the 50 threshold. However, the more widely followed HSBC manufacturing PMI fell below the 50 threshold in January and now rose again above 50 in June. This surprise already provided support for copper after the release of the flash estimate and lifted copper further up this week.

The US labor market data came in far stronger than predicted by even many optimistic forecasters. The number of new jobs created rose to 288,000 and also the figure for the preceding month was revised higher by 7K to 224,000. The unemployment rate was expected to remain unchanged at 6.3% but dropped to 6.1%. And average hourly earnings increased again by 0.2% on the month. Thus, the labor market report points to an acceleration of the US recovery after the GDP drop due to the weather in the first quarter. This has lifted the US stock market to new highs for the S&P and Dow Jones indices. Also the US dollar appreciated against the major currencies and the US dollar index rose. Furthermore, the US bond market declined and yields on the 10yr US Treasury note rose by to 2.64%. All these factors are usually negative for precious metals.

Stronger economic data is normally supportive for the price of crude oil as it indicates a rising demand. However, demand is only one side of the equation. It was developments at the supply side, which lead to falling oil prices. In particular the news that the Libyan government reached an agreement with rebels, who handed over ports with oil terminals, send the price of crude oil lower.

In 2013 and also in some parts of this year, a stronger US stock market was negative for precious metals. The rise of the PGMs could be well explained with a stronger economy, translating into higher demand from car makers, and the supply loss due to the strike in South Africa. But why does gold and silver now rise when the major fundamental drivers are negative?

First, correlations are not causations and many factors can have an impact on the relationship between two variables. This explains well, why correlations fluctuate widely if correlation is measured over a shorter time period like 20 or 30 days. There were also periods when the stock markets and gold moved in the same direction before.

Second, the behavior of investors is not constant. Their assessment of future performance perspectives changes. Also the perception of risk is variable. In 2013, investors were convinced that stock markets offer a better return outlook and they shifted funds massively out of commodities into stock markets. The precious and base metal prices declined from the levels prevailing at the start of last year. However, now, two developments have changed the outlook. Many investors get more cautious towards equities. The valuations do not look as attractive compared to last year. Volatility has dropped. This is often regarded as a sign of complacency by investors. However, fund managers are now aware that low volatility spells danger.

Analysts at the end of last year were predicting that supply of many metals would rise and would shift the supply-demand balance towards lower prices on average in 2014. In this blog, we pointed out for copper that the development of warehouse inventories were not compatible with the narrative told by analysts but also official organizations. Indonesia impost export regulations, which had a strong impact on the supply of some metals. Nickel was the first base metal reacting with rising prices. But also lead and zinc prices recovered during the first half. Now also copper recovered and is trading again above the 7,000$/t level.

Therefore, we conclude that an increasing risk-awareness towards equities and the improved outlook for commodities has induced investors to allocate again more funds into commodity markets. Unfortunately, the LME has delayed further the publication of data comparable to the “Commitment of Traders” report compiled for US exchanges by the CFTC. Thus, there is only data for copper traded at the CME available for base metals. At the start of the year, speculative investors were net long 10,363 futures contracts and by the end of the first quarter, this turned into a net short position of 32,975 contracts. But during the second quarter, the net short position was reduced significantly to 1,764 contracts as of July 1^st. In gold, the non-commercials were net long just 766 Comex gold futures at the start of June. Within one month, the net long position rose to 40,299 contracts, the highest level since early December 2012. Also the gold holdings of the SPDR Gold Trust ETF rose by almost 20 tons after hitting a low of 776 tons in late May.

If our conclusion about the behavior of large investors is correct, it has two implications for precious metals. First, firmer equities are not a reason to sell gold as some investors also buy gold as a hedge against the case that equities might reverse direction. Second, the improved economic outlook for the US and China leads to more funds flowing back into commodities. This is the kind of tight that lifts all boats. But as piano player Sam sung in the famous movie Casablanca: “Those fundamental things apply, as time goes by”. Thus, the stronger US recovery should lead to the first Fed rate hike in the middle of 2015 and rising yields will support the US dollar and weaken US Treasury paper. Both should weigh on precious metals and other commodities in the medium-term.