Continuing rally in gold and silver

Gold and silver reached new highs last week and the rally is probably not over yet. Gold surpassed the psychological resistance at 1,500$/oz. Silver rose above 46$/oz and is close to the record high reached when the Hunt brothers tried to corner the markets. However, the other precious metals, platinum and palladium, gained in the week over week comparison but remained clearly below recent highs.

One factor supporting the precious metals is the development of the US dollar. The rating agency Standard & Poor’s changed the outlook for US Treasury paper to negative and attributed the likelihood for a downgrade within the next two years at 3:1. This is reducing the attractiveness for foreigners to buy US Treasuries. Despite the negative surprise, the yield on 10yr US Treasuries declined and the spread over 10yr German Bunds narrowed. The spread convergence at the longer end of the yield curve is a factor weighing on the US dollar. However, once the Fed will have finished QE2, the yield movements in the 10yr segment might turn again positive for the US dollar. Nevertheless, it remains doubtful whether this would also lead to a stronger US Dollar.

The monetary policy of the Fed and the ECB are likely to diverge further after the ECB hiked rates earlier this month. As a member of the ECB council pointed out, markets are right in discounting further rate hikes. The open question is only when will the next move take place and at what level will the refinancing rate be at the end of the year. True, some members of the FOMC also sound hawkish and would favor an end of the ultra-low Fed Funds rate between 0.0 and 0.25%. But unlike in the ECB council, these members don’t have a voting right in the FOMC this year and the majority of the voting members still follow the guidance of Fed Chairman Bernanke. Therefore, it is likely that money market rates in the euorzone increase stronger than in the US, which is another negative factor for the US dollar.

The German politicians have not learned the lesson from last year and the various episodes of the debt crisis. But the Greek newspapers are not better. Both fueled by comments the speculation and fear in financial markets that a restructuring of Greece government debt would be inevitable within this quarter. Despite the denials of the Greek government and warnings by the central bank and the ECB, some German politicians and Greek journalist like to spread rumors and to spook investors. The yield on 2yr Greek government paper rose above 20% last week. Thus, a renewed wave of spread widening over Bunds and rising CDS on bonds from peripheral countries provides another reason for buying gold and silver as a safe haven. It could not be ruled out that the debt crisis will become the dominant factor for the EUR/USD exchange rate. Thus, despite a more restrictive ECB policy, the euro might weaken on debt concerns. Then, this could also be a negative factor for gold and silver.

Positive earnings surprises by US companies lead to an increased risk appetite of investors. Stock markets performed positive. Rising stock market indices are another positive factor in our quantitative models for gold and silver. However, the tightening of monetary policy in China prevented that the PGMs profited stronger from otherwise positive factors. Sell in May and go away is not necessarily the best advice for stock market investors. However, the yoy percentage gains of the S&P 500 index might be close to the peak in coming weeks and month. A turnaround would then also be a negative factor for the precious metals.

Also speculative money is flowing again into gold and silver. According to the latest CoT report, the net long position of large speculators rose in the week ending April 19 for gold and silver. In gold, the net longs have reached the highest level of this year and are close to the level at the end of last year. However in silver, the net long positions are considerably below the high of the year.

While the US dollar probably remains a supportive factor for some time, but the other factors in our quantitative models might get less supportive, especially as the typically weaker season is ahead. Thus, it could not be ruled out that investors take profits at some point, which could lead to a stronger correction. Therefore, we recommend to stay long in gold and silver as long as the current trend prevails, but also to tighten stops at the same time.

The Goldman Sachs blues – how long will it last?

The major factor driving commodity markets during the past week was the recommendation from Goldman Sachs to take profits. While the advice to cash-in profits referred to some specific market, it had an impact cross all commodities. Goldman Sachs has the reputation of being a long-time bull in commodity markets. At the same time, Glencore announced to go public, a move being expected already for a while. Some market commentators concluded that these two events would signal the end of the cyclical bull market in commodities.

Also in commodity markets, buy and hold is not necessarily the best strategy for a financial investor. Taking profits when a market is overheated and likely to enter a correction soon could lead to outperformance. If an expected correction takes place, the investor could go long again in commodities at a lower price. The recommendation to take profits is in particular justified in the case that a bullish move is based more on psychological factors then fundamental supply and demand developments. This appears to be to some extend the case in the oil market.

In the metals markets, there is a typical seasonal weakness during the summer month. Thus, the recommendation to take profit could also be justified against this background. However, for copper, also the fundamentals appear less bullish. The International Copper Study Group estimates that copper would be in a 400,000 tons supply deficit this year, an increase of the deficit by about one third compared to 2010. At the copper week in Chile, the CEO of a mining company even expected a widening of the supply deficit to 500,000 tons. However, if demand exceeds supply, the inventories should decline. But copper inventories in warehouses at the SHFE increased from 87,447 tons in early October to 177,365 in mid-March. Inventories in LME warehouses rose from 349,450 tons in mid-December to 450,425 tons last Friday, while inventories at the COMEX increased from 64,220 to 83,943 tons. Certainly, movements in and out of exchange registered warehouses to free warehouses could distort the picture. Nevertheless, a sustained increase of inventories in a market that should be in a rising demand surplus is a clear warning signal.

Inventories are not the only factor in our quantitative models for copper prices. The various leading indicators have reached levels, where another strong increase appears to be unlikely. Thus, they might rise marginally at best, but this would not be sufficient to push copper prices higher despite the rise of inventories. As China has just recently hiked interest rates, but another step seems rather probable. Therefore, the risk for leading indicators is more biased to the downside.

Another factor in our models is the external value of the US dollar. There are some hawkish comments from FOMC members, which have an impact on money and bond market rates. The markets priced in a rate hike already in the second half of this year. However, the majority of the voting members of the FOMC favors to stick to QE2 as scheduled and to keep the Fed Funds rate at the current low level for an extended period. The ECB on the other hand is likely to hike rates again in the second half of 2011. Therefore, the US dollar might weaken further, which would be a supportive factor for commodities. On the other hand, a strengthening of the US dollar would be another negative factor for copper.

Gold and silver have shrugged off the Goldman Sachs recommendation rather quickly. Both metals reached new highs. Stronger than expected headline inflation figures, as well as the US dollar, remain supportive for the precious metals.    

ECB fuels inflation, be long commodities

Some readers might think that the title of this article is foolish. However, the ECB has repeated the mistake it made in July 2008, which had pushed crude oil prices to almost 150$/bbl. We will explain the reasons, why it was wrong to hike interest rates. The result of the ECB monetary policy will be that commodity prices increase further and head line inflation is not going to decline in the near term.

We have pointed out in this blog several times that there is a difference between a change in relative prices and inflation. Inflation is normally defined as a general rise in the level of prices or as an adage describes it, the tight lift all boats. Weather conditions or geo-political events, which are all outside the control of monetary policy, could have an impact on the price of some goods, especially in the energy or agricultural sector. However, the headline indices of consumer or producer prices show an accelerated increase in both cases. A first step to analyze whether prices rise stronger over all groups of goods and services or only for some goods, which have a higher weight in the headline index, would be to look at core inflation indices. This is the way how the Fed proceeds. Its inflation gauge is the core PCE deflator. In the eurozone, the headline inflation rate accelerated in March according to the flash estimate from 2.4% in the previous month to 2.6%. However, the core HICP was only at 1.0% in February. Thus, a close look at both price indicators would have shown the ECB that headline inflation is only driven by rising energy and food prices.

In Keynesian macroeconomic models, inflation is the result of aggregate demand exceeding aggregate supply. One indicator to observe in this respect is the capacity utilization rate. Rising demand would push prices higher in the case that capacities are fully utilized and companies could not meet higher demand by increasing production. At 79.2% in the first quarter of this year, there are still ample spare capacities and a rate hike to restrain demand was not necessary. Also unit labor costs did not argue for a rate hike in the current environment.

But also the monetary indicators don’t support the arguments for the 25bp rate hike. The broad money stock M3 rose by just 1.5% yoy in January. Credit to the private sector was 2.0% higher than in the same month of 2010. Thus, the monetary expansion is still tame and does not indicate that domestic inflationary pressure would be in the pipeline.

As in July 2008, the ECB reacted on the inflation expectations of professional forecasters. They lifted their expectations for inflation to 2.6%, which triggered the change of the ECB council’s assessment of its policy stance at the March meeting and lead to the decision to raise the refinancing rate from 1.0 to 1.25%. The statement of ECB president Trichet during the press conference had been understand that more rate hikes would have to be expected as the wording used was in the past the indication that another rate hike would follow. However, Mr. Trichet also emphasized that this move was not the start of a series of rate hikes.

The rate hike was not only not necessary, it is also counterproductive. If the intention of the ECB was to reduce inflation expectations, it will fail miserably. The ECB overlooked again which impact its decision has on the foreign exchange and the commodity markets. As the euribor futures price in further rate hikes this year, the euro has strengthened in the foreign exchange market to almost 1.45 versus the US dollar despite Portugal became the third member country needing a bail-out. As our quantitative models show, a weaker US dollar is still a factor in the commodity markets that leads to rising prices. This had also been reflected in the energy and metal markets towards the end of last week. Normally, commodity prices rise in percentage terms more than the US dollar depreciates. Thus, the eurozone has to expect that prices of the inflation drivers will not come down but would increase further. The ECB would hike rates even more, behaving like a cat chasing the own tail.

Making a mistake is human and not a problem. However, making the same mistake several times is a shame. However, for investors in commodities, the ECB rate decision would very likely lead to further rising profits. Thus, thank you ECB for fuelling commodity price rallies as you did in 2008.

Precious metals still have upside potential in Q2

Gold ended the first quarter of 2011 close to our forecast of 1,440$/oz. Also platinum was only 2% below our forecast of 1,800$/oz. While palladium missed our forecast by 4% due to a stronger correction after the earthquake in Japan and the nuclear catastrophe caused by the tsunami, silver overshoot our forecast considerably. For the current quarter, we still expect that precious metals have some upside potential before the summer lull is leading to the typical seasonal correction.

Despite there are some good reasons to buy gold as a safe haven, i.e. geo-political tensions in the MENA region, the leak of radioactivity at the Fukushimi nuclear power station in Japan, it is currently more the risk aversion or risk appetite of investors, which has a strong impact on the price movements of gold. The decline of volatility indices as an indicator of investors risk aversion and the rebound of global stock markets in the second half of March pushed also the precious metals higher. Despite the production shortfall of Japanese car manufacturers, platinum and palladium recovered as did the stock prices of other major automobile companies. We pointed out that the stock prices of car manufacturers are normally positively correlated with platinum and palladium prices. The recovery of stock markets might still continue. However, the recent decline of the ISM manufacturing index in the US or the German ifo business climate index point out that these indices probably don’t advance much further. This would also be an indication that the upside potential for stock indices appears to be limited.

Furthermore, global central bank policy is another argument that stock markets are probably not trending higher through the rest of this year. In China, the PBoC has just recently increased the minimum reserve requirements further. Another rate hike, the fourth one since October last year, is expected in the near future. Fears that the PBoC might slow down GDP growth to strongly are a negative factor for stock markets and also for base metals. In Europe, the ECB is very likely lifting the repo rate by 25bp on Thursday this week. The MPC of the Bank of England is currently split about the further direction of monetary policy. However, the balance could tip easily. In the US, some Fed governors already demand to end QE2 ahead of schedule and to lift interest rates. The markets already priced in a Fed Funds hike in H2 this year. Even as the majority of the FOMC voting members still favor to proceed as scheduled, an extension of QE2 beyond June seems to be unlikely too. However, the FOMC might change the wording of the statement referring to the Fed Funds rate. Dropping the part “exceptionally low levels for the federal funds rate for an extended period“ would be interpreted as an exit from ultra-expansionary monetary policy. This could be a dampening factor for the stock markets, and thus also for the metals markets.

The euro strengthened versus the US dollar despite the crisis in some peripheral countries widened, especially in Ireland and Portugal after a series of rating downgrades by the agencies. One reason for the recovery of the euro is the monetary policy divergence in the eurozone and the US. Ending QE2 by the end of June and continued hawkish comments from some Fed officials could also trigger a rebound of the US dollar. A firmer US dollar would not only be welcomed by some emerging market countries, but would also be negative for the metals markets.

Some flow data also sends some warning signals that the upside potential for gold might be limited. The latest report of the CFTC on the CoT shows a rise of net long positions held by the large speculators. In the week to March 29, the net long position in Comex Gold futures rose by 18,284 to 193,121 contracts and is back to the level prevailing before the earthquake hit Japan. The net long position in silver fluctuated far less. At 37,139 contracts, it rose only by 364 contracts and is still clearly below the level of March 8. The holdings at the SPDR Gold Trust ETF declined further last week by 2.7 tons to 1,211.2 tons. Partly, this might be compensated by switching into other gold ETF, which have lower management fees. Retail investors are also switching from gold into silver, and this might explain the outperformance of silver in Q1 this year.  However, the conclusion from these developments is that investors get more cautious. But to push the precious metals strongly higher, investors would have to allocate more funds to precious metals.

All in all, therefore, we still expect that precious metals have some upside potential in the current quarter. However, the fundamentals might get less favorable during the next 3 month. We would still hold long positions, but would be very careful with entering new long positions. 

Questionable safe haven status of gold

While all the spot base metals posted gains on balance last week, gold ended almost unchanged and the other precious metals ended the week lower compared to the preceding Friday. This leads to the question whether gold is really a safe haven in times of increased risk.

The major concern during last week was the development in Japan after a major earthquake and a tsunami have hit the northern part of the Honshu Island. Both triggered a major incident at the Fukushima nuclear power station. The developments at this power station and the risk of a nuclear meltdown were the dominating factors in many markets and eclipsed the unrest in the MENA region.

Normally, this is a situation, where many expect that gold and the other precious metal would perform well and provide protection. However, gold was not the safe haven and was in a roller coaster. We have pointed out several times that gold is also a risky asset. A rise of volatility indices like the VIX is often accompanied by falling gold prices. The same applies for the other precious metals. Falling stock markets are often negative for the precious metals. This has been especially obvious last Tuesday, when stock markets tanked after a statement of the Japanese PM. And it was also the case after comments from EU commissioner Oettinger on the situation in Japan hit the wires. One possible reason for this link could be that stock investors might have to sell other assets to cover the losses suffered in stock markets. This could not be ruled out as some stock markets traded more than 10% below recent highs.

However, with plummeting equity markets, the risk inversion of investors increases and investors not only sell stocks but also other risky assets. And gold is one of those risky assets. This is underlined by the latest CFTC report on the “Commitment of Traders”. During the week ending March 15, the day gold hit the low of the week at 1385$/oz, large speculators reduced long positions by 12,773 to 240,661 contracts and increased short positions by 3,596 to 66,090 contracts. Thus, their net long positions dropped by 16,369 to 174,571 contracts. Also the gold holdings of the SPDR Gold Trust ETF declined further until Tuesday, but rebounded during the second half of the week.

 The stabilization of stock markets was very helpful also for gold. A further recovery of equity markets could lift gold further up. A rebound of automotive company share prices would also be positive for the PGMs as their price development is correlated with the price trend of car manufacturers. The latest news concerning the situation in Japan indicates that stock and precious metals markets might recover further. However, set-backs can not be ruled out.

Another geo-political risk factor is back in the spotlight. After the UN passed a resolution concerning a no-flight zone over Libya, France started military strikes against Libya and the UK and US forces joint them later. Last Friday, crude oil prices declined after Gaddafi announced a cease-fire. The military strikes against Gaddafi’s troops could lead to further decline of oil prices, which would be positive for stock markets. However, the impact on gold might be ambiguous as rising crude oil prices tend to increase the demand for gold as a hedge against inflation. However, in the current environment, the impact from rising stock markets might be the dominating force. 

The impact of the earthquake on metal markets

After a devastating earthquake and a tsunami hit Japan, the thoughts are first with the victims of these natural disasters. This will especially be the case for those readers who have friends and family or colleagues in Japan. The author of this blog was also several times on business trips in Tokyo and had many colleagues in the Tokyo branch of his former employer. The hopes are that they all are well.

Nevertheless, as financial and commodity markets only pause over the weekend, it is also legitimate to ask what the impact of the catastrophe will be, which hit Japan so strongly last Friday. Against the background that the situation in Fukushima nuclear power station is very dangerous and could result in another disaster, it is rather difficult to assess the damage caused by the earthquake.

According to press reports, the Bank of Japan is ready to provide as much liquidity as needed to the financial system, when markets open on Monday morning local time. This should prevent a run on banks. A situation comparable to the collapse of Lehman Brothers is most likely to be avoided, at least, as long as no panic sets in.

Japan’s GDP growth in the final quarter of 2010 was 2.2% yoy, with a trend towards slower growth. It could not be ruled out that GDP growth will come closer to zero or even that GDP will contract in the second quarter of this year. As the earthquake hit Japan towards the end of the current quarter, the impact of the current quarter GDP growth is probably smaller, in particular as industrial production and retail sales pointed upwards in Q1. However, it is currently not obvious, how strongly industrial plants in Northern Japan are affected by the earthquake and the catastrophe at the Fukushima nuclear power station.

Nevertheless, history shows that the impact of a natural disaster on economic activity is very often only temporarily. It is quite obvious that the earthquake and the following tsunami have caused damages on infrastructure and housing facilities. Reconstruction work will be positive for GDP growth going forward. Also cars have been destructed and need to be replaced. It is currently unclear, if the domestic automotive companies have the facilities to replace them quickly, but purchases of new cars are also likely to increase, which would be positive for the demand for PGMs (catalytic converters) and aluminum as well as copper.

Japan is a country with a big export surplus. Short-term production short-falls might not necessarily be negative for global GDP growth as long as they could be substituted by products from other countries. Furthermore, the reconstruction work in Japan might lead to increasing imports to Japan, which would also be positive for the global economy. However, given the opaque situation about potential losses of industrial production, there is the risk that some products might not be easily replaced by other suppliers and that this could have a negative impact on industrial production in other countries in the short run.

Japan is an importer of commodities. Production losses over the next couple of weeks will have an impact on the demand for commodities by the world’s third biggest economy. This might especially be the case on Japanese imports of crude oil. Already on Friday, crude oil prices edged lower. This would also reduce the inflation fear triggered by the recent rise of oil prices after unrest in North Africa broke out.

Fears, the Bank of Japan might sell US Treasury holdings and repatriate the proceeds, led to a stronger yen versus the US dollar last Friday. However, those fears appear not to be well founded. Even if the BoJ would sell US Treasuries, it is unlikely that the Japanese central bank would intervene in FX markets to strengthen the yen. More likely would be that Japan uses the proceeds to pay for imports. Thus, the US dollar might rebound against the yen. Declining Japanese demand for commodities and a stronger US dollar against the yen would be negative factors for metal prices short-term. But reconstruction works are likely to lead to higher demand for commodities in the medium-term. Thus, metal markets might correct further down on fears of a global economic slow-down. However, we would regard this as an opportunity for consumers to hedge against the risk of medium-term price increases.

Gold at new record high

Last week, we forecasted that gold would reach a new record high in March. Already on the first day of the month, gold rallied above 1,430$/oz and surpassed the former record high at 1,430.95$/oz recorded on December 7, last year. On Wednesday, gold reached the next new record high at 1,439.5$/oz. However, on Thursday, gold plunged by more than 20$, but ended the week at 1,420.8$/oz. Especially the trading pattern of the last two trading days of the preceding week show that gold is currently driven by two opposite forces.

On the one hand, gold still profits from geo-political tensions in the Middle East and North Africa, the MENA region. As there is a wide spread fear that the tensions might not remain contained to Libya but could spark off unrest in other oil producing countries, in particular in Saudi Arabia, the price of crude oil rose further. The energy complex has not only a high weighting in commodity price indices, but also in consumer price indices. Therefore, the surge of oil prices will have an impact on CPI inflation. As gold has the reputation to serve as a hedge against inflation, the fear of rising inflation rates is another factor supporting gold and other precious metals.

But on the other hand, many central banks are worried by the rise of headline inflation rates. After central banks in emerging economies already changed the stance of their monetary policy and lifted interest rates higher, central banks in Western industrialized countries were hesitant so far. The monetary policy committee of the Bank of England already discussed rate hikes, but the majority preferred to keep rates on hold fearing a dip back into recession as the fiscal austerity policy of the Cameron government is already a drag on the economy. While the consensus was looking for a strong increase, the GDP in the final quarter of last year already surprised by an unexpected fall. And this decline of GDP was not only due to snow falls in December. However, the biggest surprise came from the ECB last Thursday. At the monthly press conference following the council meeting, ECB president Trichet announced that the repo rate might be increased as early as next month. A rate hike in the eurozone could also tip the balance within the MPC of the BoE. Thus, interest rates in Europe are likely to increase rather sooner than later.

A rate hike by the two major central banks in Europe would be negative for gold for two reasons. First, the opportunity costs for holding gold would rise. This would be especially negative, if the ECB and the BoE embark on a series of rate hikes. Second, tightening monetary policy would have an impact on inflation expectations. If investors expect that inflation will remain well anchored close to the target rates, they might liquidate gold holdings.

However, there might also be another opposite effect. Fed chairman Bernanke is not concerned about the impact of rising oil prices on core PCE inflation. Thus, he provided no hint at the testimony last week that QE2 might be terminated earlier than scheduled. Many commentators, analysts and strategists expected the central banks to hike rates earlier than the Fed. Nevertheless, rate hikes in Europe are now probably implemented far earlier than expected. This is weighing on the US dollar and a weaker US dollar could be a supporting factor for gold.

Large speculators have increased their net long position in gold futures last week again, according to the latest CoT report of the CFTC. The non-commercials added to long positions in the week ending March 1^st and reduced short positions. Thus, the net long position rose by 16,829 to 197,253 contracts. Gold holdings at the SPDR Gold Trust ETF continued to decline, but at a slower pace as only 0.9 tons were sold.

All in all, gold could still rise to fresh record highs in coming weeks. However, the headwinds are probably getting stronger.