Don’t fight the Fed – not this time?

There is an old market adage that one should not fight the Fed. However, this week, the markets did not follow this advice. As the result should have been widely expected, in particular after the TV interview of Fed chairman Bernanke a few days before the FOMC meeting, buying the rumors and selling the fact would also not describe correctly the reactions in financial and commodity markets.

The FOMC almost kept the statement unchanged from the one issued after the November 3 meeting. However, the US Treasuries sold off and the yield on the 10year note rose to 3.5%. But also gold pared its gains and corrected strongly following the release of the FOMC meeting. Only the downgrade of Ireland by 5 notches by Moody’s led to a recovery of gold at the end of the previous week. While we pointed out that a rise of US Treasury yields would be negative for gold as its opportunity costs increase, the arguments provided from market commentator for the moves in the markets are not convincing. In addition, the US dollar profited only marginally from higher US yields as the debt crisis weighed still on the euro.

 The bond market sold off because investors fear that inflation would increase. True, that is the target of QE2. However, the current core PCE inflation is too low and the target of the Fed seems to be close to 2%. And this is well knows since the Fed prepared the markets for the implementation of QE2. But some investors and traders expected the Fed would scale back the volume of QE2 after some recent developments.

While during the summer, economists, among them the famous Dr Doom Nouriel Rubini, predicted the US economy would slip into a double dip recession in H2 of this year, the recent economic activity data points to a slightly firmer economic growth. Despite the recent slight decline, the PMIs for the manufacturing and the service sector indicate a robust expansion. However, the growth of US GDP is still to slow to create enough new jobs that the unemployment would decline. In addition, the capacity utilization rate of the US economy at 75.2% is far below a normal utilization level. Therefore, there is no inflationary pressure in the pipeline and the US economy could expand at a higher rate without leading to inflation.

Another widespread misinterpretation is the compromise between US president Obama and the Republicans to extend the Bush tax cuts. This is not an additional fiscal stimulus, which would lead to an overheating of the US economy. It is just an extension of the status quo. Without prolonging the Bush tax cuts, the fiscal policy would have got less expansionary and would have been negative for US GDP growth. Thus, with the decision to exit from expansionary fiscal policy later the US administration just prevents that the still weak US GDP growth would be dampened further. The extension itself does not lead to additional aggregate demand but avoids a drop of aggregate demand. Thus, it has no inflationary implications at the current state of the US economy. It would only be negative if the US economy was overheating, but this is not the case.

As the US economy is far from achieving the Fed’s target of growing sufficiently to reduce unemployment and that core PCE inflation is in line with what the Fed considers as appropriate, the FOMC is far from looking forward to tight tighten monetary policy in 2011. The bond and money markets got too far ahead of the curve. US monetary policy would not be a supportive factor the US dollar as far as the eye could see. Thus, we still expect that the US dollar remains a supportive factor for the demand of precious and base metals also in 2011. However, this does not exclude temporary recoveries of the US dollar, especially in the case that the debt crisis in the eurozone would show no sign of improvement.

This was the last contribution to this blog in 2010. The next article will be published at the beginning of January 2011. We wish a Merry Christmas and a Happy New Year to all readers.

China and eurozone remain key factors for metals

After Asian markets were closed, China’s central bank announced that it hikes minimum reserve requirements again by 50bp, the sixth increase this year. The preceding hike was only a few weeks ago and lead to fears in commodity and financial markets that an increase of key interest rates would follow soon. Thus, the speculation on a further tightening of monetary policy by the PBoC could be a negative factor for metals during the final few trading days in 2010.

However, there was also positive news out of China for base metals, in particular for copper, which ended last week at the highest close this year. Last month, China’s customs office reported a decline of copper imports in October. The copper market feared that the Chinese economy would slow down and that copper demand would decline. However, many analysts just overlooked that there was a week of public holidays in October. Thus, the market was again surprised by the rise of Chinese copper imports in November, which jumped unexpectedly by 28.5% on the month. Analysts just watched the arbitrage relationships between the SHFE and the LME, but did neglect the working day effect. We always emphasized that the Chinese economy is likely to expand strongly, which implies that also demand for base metals will be growing.

The euro could not defend the gains made in the week before and pared some of the gains last week. This week, the euro might trade range bound, but the risk appears biased to the downside. The crucial factors will be the bail out of Ireland, where the parliament has to approve the credit package with the EU and the IMF while opposition is mounting, as well as the EU summit at the end of this week. The German chancellor Merkel insists on a solution that includes the participation of private investors (haircut) in the case a eurozone country has to restructure its national debt. She also opposes plans of joint bond issues by the eurozone countries as Luxembourg’s PM Juncker proposed. Given the conflicting views and more and more unfriendly comments from EU political leaders, the risk is quite high that the EU summit is going to disappoint the markets and the euro remains under pressure.

Also the increasing talk that some countries should leave the euro is not helpful to restore confidence among investors. In addition, all those commentators demanding that either Germany or some peripheral eurozone countries should leave the euro play with fire. First, a membership in the euro is compulsory for EU countries, which fulfill the Maastricht criteria, only two countries have a clause that membership would be voluntary. The Mastricht Treaty does not include a clause to leave the euro, thus, many legal experts conclude that leaving the euro would only be possible by also leaving the EU. Second, even if one country would leave the euro, the euro would not cease to exist. In the case that Germany would leave the euro, the banks would face the risk that their assets remain denominated in euros while the liabilities would be converted to the new D-Mark. The banks have made credit agreements in euros and the borrower could insist to redeem the loan in euro. A financial crisis could be the result as banks have to write down some part of their assets. In the case of a weaker country leaving the euro, the banking system of this country is likely to experience a drain of deposits which would lead also to a banking crisis. In any case, leaving the euro appears to be no serious option. However, the ongoing discussion could increase the aversion of investors to hold euro denominated assets.  The dollar would strengthen against the euro despite the possibility of QE3 as Fed chairman Bernanke indicated last weekend in a TV interview.

However, the US dollar could be a headwind for commodities for another reason. We had pointed out earlier, that yields on 10yr US T-Notes at around 2.5% or lower are not attractive for long-term investors given the implicit Fed inflation target for the core PCE at around 2%. The headline inflation might be even slightly above 2%. While monetary policy should be concerned with core inflation, the investor has to focus on headline inflation to maintain his real purchasing power. The extension of the Bush tax cuts, which got more likely after President Obama agreed to extend the tax cuts also for the very rich last week, implies that the budget deficit will be wider than the market expected. As a result, investors sold off US Treasury notes and bonds. The rising yields on 10yr US Treasuries is another factor supporting the US dollar. In addition, it increases the opportunity costs for investors to hold commodities as an investment. Thus, the trend reversal of the US Treasury market could have further negative implications especially for the precious metals. Thus, we still expect that the base metals, in particular copper, to perform better than the precious metals.

China - the Game-changer

The opportunity for consumers of industrial metals to hedge their exposure or for investors do buy precious and base metals at lower prices did not last long. While some metals pared gains made earlier last Friday, they closed the week with a gain compared to the preceding period. There were two factors at play, which supported the metals markets. The game-changer was probably China.

After the article for this blog was posted the previous Sunday, the EU agreed on the rescue of Ireland by providing 85bn euro credit (incl. credits from the IMF). However, the EU also announced the creation of a European Stabilization Mechanism, which includes the provision that private investors should contribute to a restructuring of a eurozone country’s national debt. While the German proposal had been watered down considerably, the vague rules did not reduce the uncertainty among private investors. As a result, the markets did not welcome the decision of the EU and fears of a contagion spreading to Portugal and Spain remained high. This weighed on the euro and was not a positive factor for metal markets.

However, the sentiment improved somewhat on Tuesday after a speech of ECB president Trichet. The market then was driven by a rumor that the ECB would decide at its monthly council meeting to increase the volume of purchasing government bonds from peripheral eurozone countries. At the press conference following the ECB council meeting, Mr. Trichet did not announce a certain volume of bond buying, which disappointed the markets somewhat. However, the ECB extended the period of providing full allotments at the repo tenders until the end of the first quarter next year. In addition, Mr. Trichet emphasized that the bond purchasing program remains fully in place. As the ECB had not set a limit for this program, it could not increase a limit and the actual volume of bond purchases depends on market conditions. Thus, the euro recovered from losses made at the beginning of the ECB press conference, which was a positive factor for metals.

But the strongest push for base metals came from China. After another hike of the minimum reserve requirements by 0.5%, the market feared that the People’s Bank of China would soon follow with a further increase of interest rates. The markets already priced in a lower demand for base metals from Chinese consumers. Thus, the consensus expected only a modest increase of the official Chinese purchasing manager index by 0.1 points. However, the index rose far stronger from 54.7 to 55.2. Also the HSBC PMI increased by 0.5 points to 55.3, which points to an acceleration of economic activity and not to a slow-down. We regard this development as a confirmation of our assessment that the Chinese authorities just want to prevent the economy from overheating but would not choke off GDP growth. Thus, a GDP growth close to 10% in 2011 appears to be achievable in China. This would imply that demand for base metals is likely to expand further and to support the price development.

 In the US, the monthly non-farm payroll figures disappointed and send the US dollar lower, which pushed precious and base metals higher. While the consensus expected that 143K new jobs were created, the Bureau of Labor Statistics reported only a plus of 39K new jobs. This was in a sharp contrast to the ADP private payroll estimate. Economists provided two explanations. First, that the seasonal adjustment factors underestimate the number of new jobs. Second, the so-called birth/death model of the BLS estimated that new founded businesses on balance reduced jobs. However, this is again in sharp contrast with the ADP figures, which indicated that new companies added to payrolls. Thus, we would put more emphasis on leading indicators of economic activity like the PMIs, which came in better than expected in the US for both, the manufacturing and the service sector.

As it seems that the euro has found a bottom, despite not being out of the woods yet, and economic activity indicators improve further, the outlook for GDP growth in China but also the US remains positive. This should be supportive for base and precious metals.  

Silence is golden, Mrs. Merkel

Sir Isaac Newton once said he would be able to calculate the orbit of planets, but not the movements of stock markets. While many investment banks employ physicists nowadays, some graduates of this science still have difficulties to understand how financial markets work. One of them is the German chancellor, Mrs. Merkel. And what is even worse, she is stubborn to learn from past mistakes and to draw the right conclusions. However, commodity consumers outside the eurozone profited from her comments last week, which sent commodity prices lower. Among the metals, precious metals held well, but base metals ended the week lower as measured by the LME metals index.

At the start of the new trading week, markets welcomed that Ireland asked the IMF and the European Financial Stability Facility (EFSF) for a bailout, in particular to increase the capital of its nationalized banks. However, this request came at a high price for the Irish prime minister. His junior coalition partner only approve calling the IMF for help if snap election will be held. But the initial market reaction was as we expected in the blog article published on November 21. Also many fixed income strategists of investment banks pointed out that Portugal and Spain might be next to be bailed out. Nevertheless, even the Credit Default Swaps of these countries came down on Monday. Thus, precious metal prices rose at the start of last week but base metals pared earlier gains as stock markets came under pressure as contagion fear send jitters especially among US investors.

Geopolitical risk factors also played a role on Tuesday, as North Korean troops fired at a South Korean island. But this had only a temporary impact as prices recovered after an initial drop in Asian trading. But then came Mrs. Merkel into the spotlight and send the euro sharply lower against the US dollar by stating that the current crisis could lead to the end of the Eurozone and the EU. The firmer US dollar had a negative impact on base metals, but gold profited from its safe haven status. The German chancellor should have known what the impact of this statement on financial markets would be. The next day, at a meeting of the German association of industry (BDI), she bashed banks and repeated the demand that in future, private investors would have to contribute to bailouts of sovereign debtors in the eurozone. Of course, this has been another knock for the euro, sending the single currency further down against the US dollar.

 Mrs. Merkel lacks the skills of political leadership. She is not able to convince law-makers of her own party, the political commentators in the media and the population by sound arguments. Only by populist arguments like bashing the banks and by painting a bleak outlook if her policy would not be approved, she can get the support of law-makers being members of the government parties in Berlin. The results in markets are a catastrophe. The EFSF was intended to calm investors by demonstrating that there would be support for eurozone member countries. EU leaders even expressed the view that there would be no need for a eurozone country to ask for a bailout. However, by her populist policy, the German chancellor triggered a flight out of Irish government bonds. She even ignored the warning from ECB president Trichet. The strongest economy of the eurozone is expected to play the role of a political leader. The biggest problem of the euro is currently that Germany lacks a political leadership and a sound knowledge of economics.

As long as the crisis in the eurozone prevails, the euro is at the peril of weakening further against the US dollar, despite QE2. As gold is regarded as a safe haven, it might perform best among the metals. Industrial metals are likely to suffer, especially silver and palladium might correct stronger as it has already been the case last Friday. Among the base metals, the biggest losers are expected to be those metals with rising inventories and the highest speculative interest. This might also be negative for copper. However, as the market had been already in a 360K tons supply deficit in the period from January to August according to the latest report by the ICSG, which also expects a high deficit in 2011, such a correction of the copper price would present a good opportunity for consumers to hedge their exposure.

Bailout of Ireland should be positive for commodities, but…

Pressured by other eurozone countries including Portugal, Spain and Greece, which feared that a continued sell-off would also lead to higher funding costs for their own debt, Ireland’s finance minister declared this weekend that the country would ask the European Financial Stability Fund (EFSF) and the IMF for a bailout. In a radio interview, he stated that the volume of a credit would be less than 100bn euro, but some several 10bn euro. Earlier last week, the euro was still under pressure against the US dollar, however, after the meeting of EU finance ministers the euro stabilized as signs emerged the country might as for help to bailout its banking system. Thus, the official confirmation that Ireland seeks to get a credit facility from the EFSF and the IMF should lead to a further recovery of the Euro against the US Dollar.

In addition, the US dollar gained last week as some politicians of the Republican Party as well as some economists close to this party wrote open letters demanding the Fed to abandon QE2. However, at a speech given last Friday in Frankfurt, Germany, on invitation by the ECB, Ben Bernanke left no doubt that the Fed is going to implement QE2 as announced after the recent FOMC meeting. This should also contribute to a weaker US dollar, which would be helpful for commodities.

 The latest CFTC report on the “Commitment of Traders” showed that the large speculators reduced net long positions in metal futures traded on US exchanges. In addition, the total open interest declined considerably. The rumor, which was spread around at the end of the second week in November, that the Chinese central bank would hike interest rates has lead to a flight of investors out of commodities. Also the open interest of base metals traded at the LME declined according to data from the exchange. The development of metal prices, only silver and palladium gained in a weekly comparison, indicates that investors remained cautious and have not increased their risk appetite again. The statement of the Irish finance minister could lead to a strengthening of the euro, which would be positive. However, whether investors increase their risk appetite and buy metals again is probably also dependent on the developments in China. On Friday afternoon GMT, China announced another increase of the reserve requirements for banks. This is probably negative for base metals in the short term. In the medium-term, we remain positive for base metals, as we don’t expect a hard landing of the Chinese economy. Furthermore, we expect in line with the ICSG a supply deficit of copper next year. The launch of ETFs on base metals, in particular copper and aluminum are also supportive factors in the medium-term horizon.

In the short run, easing tensions at the periphery of the eurozone are likely to be positive for the euro and could lead to a rebound against the US dollar. This would be positive for metals. However, fears of a further tightening of monetary and credit policy in China could be negative. But China’s monetary policy should have a stronger impact on base than on precious metals. Therefore, precious metals might perform better than base metals and the outperformer of last week could also be the outperformer of the coming trading week.

China and the Eurozone – repeating mistakes weigh on metals

New highs during the course of last week, but then all metals plunged heavily last Friday. Precious and base metals both posted gains while also the US dollar index rebounded. This combination is not common as a stronger US dollar normally leads to profit taking by financial investors. However, the G20 summit in South Korea might have induced them to hold positions. But after the end of the meeting, commodity markets in general came under pressure, while the reasons for the sell-off were not the results of the G20 summit. Again developments in China and the eurozone were the driving factors.

It is not a shame to make a mistake, but it is a shame to make the same mistake twice. While China is expected to repeat a mistake, the German government and in particular the Chancellor Angela Merkel and her staff already made the same stupid mistakes they did in spring during the Greek debt crisis. Mrs. Merkel insisted that private investors would also have to make some sacrifices in the case the government debt of a eurozone member country would have to be restructured. She won approval at the recent EU summit, which took place at the end of October. Investors holding Irish government bonds feared a haircut and dumped the holdings. The fear that Ireland might fail on its government debt did not only lead to rising spreads of Bunds and soaring CDS rates, but also sent the euro again lower versus the US dollar. However, this was not a burden for gold as investors bought the metal as a safe haven. The German government made the situation even worse by spreading rumors about getting prepared for Ireland seeking funds from the EU stabilization funds and the IMF. The warnings Mr. Trichet made at the EU summit came true. Last Friday, the EU declared at the end of the G20 summit, that private investors would not have to make any depreciation on Irish government bonds. The euro rebounded against the US dollar, but gold could not profit from this move as investors also left the safe haven. Thus, gold plunged despite a firmer euro.

China released a series of economic data in the second half of the week. Initially, metals markets reacted positive on the data. LME 3mth Copper hit a new record high at 8966$/t, thus exceeding slightly the high made on July 2, 2008. The markets were also not much concerned about the rise of headline CPI inflation from 3.6% to 4.4% in October. However, on Friday, the markets were concerned that the central bank, the People’s Bank of China, might hike interest rates again. The major driver of the accelerated inflation rate was again the food component. We argued already earlier that one can not fight the weather with interest rates. A better way to reduce the impact of rising international agricultural commodity prices would be to allow a stronger appreciation of the yuan against the US dollar. However, Chinese politicians will not walk this way as their rhetoric ahead of the G20 meeting showed. It has to be feared that the PBoC will hike rates again, which would slow the economic growth. Nevertheless, in the case of copper, we still expect that the market would be in a deficit next year, in particular as launch of copper ETFs is looming, which would reduce the amount of available copper for consumption. Thus, any correction of copper is likely to be a good opportunity to for consumers to hedge against a further rise of copper prices.

Metals rise to fresh highs after FOMC

It has been well announced in advance that the FOMC would embark on a new round of quantitative easing at the November meeting. Normally, markets follow the rule of buy the rumor and sell the fact. However, metals rallied after the FOMC announced to buy more US Treasury paper. Gold reached a new all-time high on Friday and also base metals traded at a new high of the year as measured by the LME index. The outlook for the final few weeks of 2010 remains positive.

It was surprising that metals started to rally in the Asian trading hours on Thursday. The immediate reaction in markets following the announcement of the FOMC was negative. The total volume of QE2 at $600mn is slightly higher than consensus figures reported in the media, but the whisper number was higher and the markets priced in up to $1trn. Also the monthly purchases of US Treasury paper by $75mn is lagging behind market expectations. That the Fed would reinvest proceeds from maturing mortgage bonds has already been announce two meetings ago. It would just keep the balance sheet of the Fed unchanged and thus, it could not count as QE2.

The rise of gold to a new all-time high is also surprising against the background of latest available data on investors’ positioning. The reference date of the commitment of traders report compiled by the CFTC was the Tuesday and therefore before the release of the FOMC statement. Nevertheless, as gold rose on balance since the preceding reporting date, one would expect that large speculators have increased their net long position. However, the non-commercials have reduced their net long position again by 8,858 to 230,228 contracts. Within one month, the large speculators have reduced their long exposure from the recent peak at October 5 by 29,392 contracts or by 11.3%. The rise of small speculators net long position over the last four weeks by around 6,500 contracts in total does not compensate the liquidation by the large specs. Also the gold holdings of the biggest ETF, the SPDR Gold Trust, declined last week by 2.3 tons. The holdings declined further after the release of the FOMC statement on QE2. As gold rose against this backdrop, the sentiment remains positive.

In a Washington Post article, Fed chairman Bernanke pointed out that investors already bought more risky assets since the Fed pointed to the possibility of further quantitative easing in August. The US stock market has gained despite many pundits feared a drop in September as this month had on average the worst performance in the past. A rising stock market is one of the leading indicators of future economic activity. The German finance minister called QE2 as clueless. However, as investors’ risk appetite has already increased, the clueless politicians seem to be located in Germany. The period from November to March is very often positive for stock investments as the indices post their strongest gains during these months. This would be another positive indication for metal markets. In addition, the last quarter of the year is characterized by seasonal weakness of the US dollar – which also prevailed during the many years without quantitative easing. Thus, the perspectives for metal markets remain positive.

While the outlook for the precious and base metals is positive, nevertheless, investors should keep two factors in mind. First, the FOMC stated that the volume of US Treasury purchases would be spread over the period until the end of the Q2 2011. But the FOMC also stated that it would constantly monitor conditions and to decide about further measures. In the markets, this was understood that QE2 might be extended beyond June 2011. Second, the FOMC statement could also imply that the Fed would terminate purchasing US Treasury paper before the end of June 2011. The key would be the development of non-farm payroll figures and the unemployment rate. The labor market report released last Friday surprised on the positive side as more jobs were created and previous months’ figures were revised to the upside. Some more months with consecutive strong new job growth and the Fed might end QE2 already in Q1 next year.

US Fed in the spotlight

The US mid-term elections taking place next Tuesday will be overshadowed by the FOMC meeting the next day. However, for the commodity markets, the result of the mid-term elections will have a significant longer-term impact. Especially, it will be crucial for fiscal policy and whether the Obama administration will have a chance to implement a stimulus package to foster GDP growth. In particular, how candidates of the Tea Party will fare, could have a significant impact on US policy. Nevertheless, for the short-term development, the FOMC meeting will be more important.

We have already pointed out in this blog that the only economic policy option to stimulate the US economy is by monetary policy given the changes in the political landscape. Thus, the question is not whether the FOMC will announce a new round of quantitative easing, but how it will be implemented. The focus is on how much money the Fed will pump in the financial system and how quickly they will do it.

As events of the past week show, the risk for commodity markets in general appears to be on the downside. After the Wall Street Journal reported that the volume of QE2 might be less than the market expected, the US Treasury market came under pressure and the US dollar strengthened. Especially copper, the metal which is regarded as most sensitive to economic developments, lost heavily after reaching 8,554$/t the day before the WSJ article was published. Copper lost 281$/t and closed the day near the low at LME Select.

However, the US dollar pared the gains and commodities recovered after the Fed send a questionnaire to the primary dealers in US Treasury paper. This leaves room for interpretation. Either the Fed has no clue what they are going to do or they want to please the Wall Street banks. Both were not suited to increase confidence in the Fed action. It would be understandable, that model results were treated with some caution by the FOMC members. But asking the primary dealers is like asking a bank robber how much money he wants. The answer is always as much as he can get. The primary dealer has only his trading book in mind and not the whole economy. But the more the FOMC fulfills the demands of Wall Street, the more the US dollar is likely to weaken. As a result, the more commodities could profit from US dollar depreciation.

That the Fed would have to act was also underlined by the first estimate of the US GDP growth in Q3. While the annualized growth rate of 2.0% was fully in line with expectations, the core PCE deflator declined further to a mere 0.8%, which underlines the risk of deflation. However, not all metals profited from the GDP data. The precious metals traded higher as the US dollar gave back gains made earlier last Friday. However, copper and other base metals got under further selling pressure. Some economists were disappointed about the contributions to growth of some components. If the overall figure is in-line with expectations, they then argue by the quality of growth. The private consumption rose by 2.6%, which is positive. But some highly overpaid economists were disappointed by housing investment. Given the overhang of unsold houses, it is advantageous that housing investment is not growing strongly, as this would only increase the overhang of unsold houses and increase the pressure on house prices. And increasing house prices are important for private consumption, which has a far bigger share of GDP than housing investments. But for copper prices, the disappointment about the housing sector was negative as it sent copper prices further down despite a weaker US dollar following the release of the GDP figures.

The Fed has to find the right volume for quantitative easing, which is not an easy task. Is the volume to low, the measures might be regarded as insufficient. Is the volume rather high, it could also be interpreted negatively as it could create the impression the Fed would be in a panic. From our point of view, it might be best to announce a starting volume that might be increased in case it would be needed. As we also already explained in this blog that yields on 10yr US Treasury notes of 2.5% are too low compared to the Fed’s inflation target, we agree with PIMCO’s Bill Gross that quantitative easing could be the end of the 30yr lasting bull market in Treasuries. Thus, while a weaker US dollar would be positive for metal prices, a trend reversal in the US Treasury market would be a negative factor. In the medium- to longer-term horizon, the bond market could become the dominating factor for metal prices.

China’s surprising rate hike is not cooling metal markets in medium-term

The People’s Bank of China, the central bank, surprised markets last Wednesday with the first rate hike since 2007. It lifted interest rates for deposits and credits by 25bp each. The one-year benchmark loan rate is now at 5.61%. While the metal markets came under stronger selling pressure on October 19, the industrial metals recovered again. Only gold and silver remained under pressure and reversed their upward trend. However, these two precious metals already showed signs that a consolidation might be looming before the announcement of the PBoC.

We expect that the medium-term impacts of the rate hike by the Chinese central bank on precious and industrial metals will be rather small. It is not sufficient to derail the strong growth of the Chinese economy and it will also not prevent the US dollar to weaken further against the major currencies.

The timing of the rate hike has surprised many traders, investors and analysts. This could be seen as another indication that markets are not information efficient as the academic theory pretends. Unlike the hard-drive of a computer, the human brain stores information, but it also automatically removes information to get fresh storage capacity for new information. The computer only sends a disk full message in this case. A glance at the calendar would have been sufficient to expect a measure announced by China to take off some pressure ahead of the G20 summit, which took place at Friday, October 22 in South Korea.

And the old trick worked again. China was praised for the rate hike and the US was blamed for its monetary policy. It is said the thinnest book is the one about German humor, but the country seems to have the most fools and the biggest one appears to be the Minister of economics, Mr. Bruederle (see also article below). The most foolish comments came out of Germany over the weekend.

In its statement on the rate hike, the PBoC does not cite any reason for the move. However, most commentators refer to the increase of the consumer price inflation. In September, the CPI rose 3.6% from the same month one year ago. At a first glance, this might justify a rate hike to keep inflationary pressures under control. However, at a closer inspection, the move by the PBoC was not the most appropriate measure. Inflation in China was driven by surging food prices. The rally in agricultural commodity prices was not caused by expansionary monetary policy, neither in China or other economies. Large speculators held even huge short positions in grains at the beginning of the summer season in the Northern Hemisphere. The drought in many regions, especially in Russia and the Black Sea area, caused a short-fall of grain harvests compared with forecasts. Russia even had to impose an export ban on wheat. Smart central bankers know that they can not fight the weather by interest rate policy. But most German commentators and central bankers prefer to curb domestic demand by tighter monetary policy if rising food prices are the cause of increasing headline inflation rates.

The imbalances of the Chinese economy are well-known. China’s private consumption is too low, its savings rate too high. The rather high contributions to GDP growth by the trade surplus and investments are reflecting the excessive savings rate. Increasing interest rates not only for credits but also for deposits is the wrong measure. It increases the incentives to save even more, which could lead to a further decline of the relationship of private consumption to GDP in China. Instead of reducing the imbalances, the problem could be even aggravated. Again, it is rather foolish to praise the rate hike as the right measure to reduce the imbalance of the Chinese economy.

China’s political leaders resist appreciating the yuan more strongly against the US Dollar. However, this would be an appropriate measure. A stronger yuan would reduce the impact of higher international food prices on the consumer price index in China. It would also help to reduce the imbalance between private consumption and export driven growth. And a 25bp rate hike is likely not sufficient to reduce GDP growth to the extent that falling prices of other goods compensate the impact of rising food prices on CPI inflation. Therefore, also the demand for base metals is likely to expand further in 2011, maybe at a slightly slower pace, but still sufficient strongly that a supply shortage of copper will prevail as the ICSG forecasts. Only a series of stronger rate hikes might have a negative impact on Chinese demand for industrial metals.

Fools never die - they live happily in the German Ministry of Economics

The German minister of economics criticized the US monetary policy unusually harsh after the G20 summit, where he substituted the finance minister, who was in hospital. The creation of more liquidity would be the wrong way, stated Mr. Bruederle. An excessive, permanent creation of money would be an indirect manipulation of a market price, which would not be acceptable. What else is a fixed exchange rate and a hike or cut of interest rates by the ECB, stupid?

All monetary policy intends to have an impact on asset prices and returns, which a central bank can not set directly. But those asset prices and returns on assets have an influence on macroeconomic aggregates, which are relevant for the final target of monetary policy. The transmission mechanism of monetary policy to the real sector of the economy is via changing relative asset prices and returns on assets. This is widely accepted in monetary theory.

There appears to be a widespread perception that a possible new round of quantitative easing would only target at manipulating the US dollar exchange rate. This is wrong and could be even counterproductive. The target of the Fed for QE2 would be to strengthen final demand in the US economy. The export sector is rather small compared to other major economies. On the import side, the demand for some goods is rather price inelastic in the short run, especially for crude oil imports. However, weakening the US dollar would have an impact on the price of crude oil. The correlation between the US dollar and crude oil prices is quite high and often the oil price rises more than the US dollar depreciates in percentage terms. Thus, if QE2 would target to weaken the US dollar only, it would be the wrong monetary policy measure. In additions, the CNY/USD exchange rate is immune against any QE by the Fed. The target of QE2 is clearly to strengthen domestic demand.

There seems to be another misunderstanding of QE2. Politicians like Germany’s minister of economics or Brazil’s finance minister Mantega appear to think that dollar weakness would only be created by newly printed dollars. This is a big fallacy. The Fed has not yet decided to implement QE2 and the US dollar already lost 14.2% since the US dollar index (USDX) reached its peak at 88.706 in early June 2010. And when Fed Chairman Bernanke provided the first hint about not exiting easy monetary policy, the USDX even gained slightly in early August. US dollars could be sold out of the stock of money and not only when the stock of money is increasing.

We pointed to the relative returns of assets playing a role for monetary policy above. These relative returns also play a role for investors diversifying portfolios. If financial assets in other countries offer better risk/return perspective, there is an incentive to change the asset allocation of a portfolio. In the case of the US dollar, investors have reduced the holding of dollar denominated assets and bought more assets denominated in foreign currencies. This alone is sufficient to lead to a weaker US dollar. However, this has the impact that some investors then increase the holdings of a particular asset class, which is denominated in US dollars, the commodities and especially industrial and precious metals.

 Without any political stimulus measures, US GDP growth appears to be too modest to prevent the risk of a deflation. But it would also be insufficient to attract investors. The current political landscape makes fiscal stimulus measures almost impossible. Only monetary policy has a chance to improve the US economy. Whether the Fed embarks on QE2 or not, a weaker US dollar appears to be unavoidable. Only in the case the Fed would manage to stimulate US GDP growth, the US dollar might rebound over the medium- to longer-term horizon. Therefore, the US dollar is likely to remain a supportive factor for precious and industrial metals also in 2011. 

Gold at the cross-roads

In the previous article, we have pointed out that there are some warning signals gold might head towards a correction. The decision taken by the Chinese central bank on October 19, to hike interest rates by 25bp had been the trigger that tipped the balance. Gold sold off massively that day as the US dollar strengthened against the other major currencies.


The technical indicators, which we follow, all turned negative. The ADX declined after reaching a peak at 67. This indicates that gold is entering a major correction. Most of the trend following indicators like the MACD as well as oscillators like the stochastics triggered fresh sell signals. However, gold managed to close above the moving average line of the Bollinger band. This line often serves as support. Thus, gold would have to stay above this line in order to remain in an upward trend. In the case gold trades below this line, it would open scope for a further decline to the 38.2% Fibonacci retracement at 1,300$/oz. However, more likely would be a test of the lower Bollinger band coming in at 1,280$/oz and then at the 61.8% Fibonacci level at 1,243$/oz. But gold bulls should get aware that for some time the trend might not be their friend.

Is Ben no longer the gold bull’s man?

The most surprising move in the gold market took place last Friday. Not only the gold market, but also the stock, bond and foreign exchange market awaited the speech of Fed chairman Ben Bernanke at the Boston Fed conference last Friday. While he said that nonconventional policy would have costs and limitations, the also made it clear that everything else equal, there would be a case for further action. This is another indication that the Fed is ready to implement a new round of quantitative easing. However, gold did not rally to a new high as it did the days before. Gold was dragged down by a rebound of the US dollar and rising US Treasury yields.

The core inflation data released earlier last week in the US support the point made by Fed chairman Bernanke and other FOMC members. Prices at the factory gates as well as for consumers rose by a mere 0.1% on the month. This indicates that the core PCE, the favorite inflation indicator of the Fed, is likely to edge down further. While the Fed has not an explicit inflation target, it appears that the FOMC would be comfortable with a rise of the core PCE by 2% yoy. Some gold bulls argued that quantitative easing would eventually lead to hyperinflation and the only protection would be gold. Therefore, it appears surprising that gold declined after the speech of Ben Bernanke.

Many traders act according to the old market rule of buying the rumor and selling the fact. However, the speech of Bernanke was at best a hint that quantitative easing is high on the agenda, but it was not yet the fact, which should trigger profit taking. However, there might have been some awakening among the bond bulls. In the case the Fed would succeed with quantitative easing to push the yoy-change of the core PCE back to around 2%, and then the real yield on 10year US Treasury notes would be just too low with nominal yields at 2.5%. This appears to be a major risk of quantitative easing. Yields have already fallen strongly this year and purchases by the Fed might drive them even lower. Then nominal yields would be too low compared with the implicit Fed inflation target. Bond investors could take profits and send yields higher again to maintain a sufficient real yield and risk premium. This would also have an impact on the US dollar and therefore, also on gold.

Another surprise came last Friday with the release of the weekly CFTC report on the “commitment of traders”. Large speculators have still added to long positions, which reached a new record high at 304,564 contracts. However, they opened far more new short positions, thus, the net long position declined by 3,746 to 255,874 contracts. Since gold started its rise of around $210 at the end of July, there were also some weeks with a decline of the net long position of the non-commercials. But these declines were smaller, which sends a warning signal that hedge funds might get less bullish on gold.

The gold holdings of the SPDR Gold Trust ETF, showed a similar pattern. After reaching a high at 1,305.7 tons on September 29, inventories declined to 1,285.2 tons on October 13. However, last Thursday, the gold holdings jumped again to 1,304.3 tons. Thus, it might be premature to conclude that large speculators abandon ship. Nevertheless, gold bulls should have an eye on the holdings at the ETFs and the non-commercial net long position.

The decline of gold despite bullish news is a warning signal that gold bulls might have to take a breather. As gold did not reach the high of the preceding day, Thursday’s high marks a pivot high at 1,387$/oz. This alone is not worrisome as long as gold holds above the recent pivot low at 1,325$/oz. While technical indicators are bullish, the ADX, which measures the strength of a trend, sends a warning signal. This indicator is at 67, which signals that the rise might have gone too far. The last time, this indicator showed a higher reading was in November last year. It was followed by a 12.4% decline. But as long as other indicators don’t point to a reversal, we would follow the old market adage that the trend is your friend.

Metals to profit from Currency War

“War, what is it good for? Nothing, absolutely!” Many would agree with this line from the lyrics of a song performed by Edwin Starr, at least for a war like the Gulf War II. However, as Brazil’s finance minister Guido Mantega talked of a currency war, there appears to be more disagreement. The IMF warned of the consequences of a currency war. We take a look at the impact of a currency war on metals.

We don’t think that gold would be the winner of a currency war for the very simple reason that gold is not a currency. Gold might be an instrument for profitable speculation, even for multi-year trends, as has been seen since the beginning of the new millennium. However, it is not even a perfect store of value as those investors, who bought gold in late 1979 and early 1980, have still suffered a loss in real terms. Besides serving as a store of value, a currency has also to be in circulation. Gold also does not fulfill this required function. Sir Thomas Gresham, the founder of the Royal Exchange in London, observed that bad money drives out good. This became known among economists as Gresham’s law. Thus, gold could be horded but the currency in circulation would be still paper money. Nevertheless, gold and other metals could profit from a currency war just as Halliburton was profiting most from Gulf War II.

Since Brazil’s finance minister coined the term currency war, this notion is associated with countries taking measures with the intent to weaken their currencies and to gain a competitive advantage in international trade. The underlying assumption is, like in the Great Depression of the 30^th in the preceding century, countries want to export out of economic difficulties by a beggar the neighbors’ policy. The main culprits in many discussions are the Fed and the Bank of Japan by implementing measures of quantitative easing, in the case of the BoJ also via direct interventions in the FX market. However, from our point of view, this focus is to narrow. It has to include the foreign exchange policy of China, which we regard as the root cause.

China had fixed the exchange rate of the yuan versus the US dollar. In combination with the most favored nation status granted under the Clinton administration, the undervaluation of the yuan has led to a rising export surplus of China and an accelerating accumulation of US dollars as foreign reserves. In July 2005, China introduced some flexibility of the exchange rate of the yuan versus the US dollar. Its central bank, the People’s Bank of China was allowed to set the daily exchange rate within a small percentage change in both directions from the previous day’s close. Thus, the yuan appreciated versus the US dollar, but as the range was too small, it could not eliminate the imbalances in the trade balance between the US and China. During the financial crisis in 2008, China fixed the exchange rate again. This year, China allowed again a bit more flexibility, but again it is insufficient to reduce the imbalances.

Even in systems of fixed exchange rates, markets would normally force a country to appreciate its currency by buying the undervalued currency and selling the overvalued one. This would require interventions with an impact on domestic macro-economic aggregates and financial market rates. However, this requires a free flow of capital and a full convertibility, both lacking the yuan. Thus, China is in a position to maintain its competitive advantage against the US.

China is only in a position to fix its exchange rate against the US dollar but not against all other major currencies, as this would create arbitrage opportunities. Thus, there would be a possible scenario that China gains or maintains a competitive advantage against the US by undervaluing the yuan, but could suffer a loss of competitiveness against other currencies. But China also played this card very well. Initially, they got a helping hand from foreign exchange analysts and strategists. They focused on the rising US current account deficit and were worried about the financing of this deficit. However, they overlooked that this deficit was almost self-financing. China did not only deliver the goods, which caused the widening trade deficit, but also the capital imports of the US to purchase the Chinese goods. China became the most important investor in US Treasury bonds and notes. However, the worries of analysts and strategists led to a pronounced weakness of the US dollar, especially against the euro.

During the financial crisis in 2008, the US dollar strengthened against major currencies. This was not in the interest of China as Europe, in particular German exporters, got more competitive. However, China countered this development by questioning the status of the US dollar as a global reserve currency. Investors sold again dollars for euros and thanks to the fixed CNY/USD exchange rate, Europe got less competitive again.

We regard the accusations against the monetary policy of the US as not justified. While we do not expect that the US economy would slip back into a recession, we admit that US GDP growth would probably be too anemic to create more jobs and to reduce unemployment considerably. As laid out in this blog two weeks ago, we have some doubts whether quantitative easing would have the desired results. But to judge a measure fully, one has to compare it with the alternatives. Doing nothing and praying that the supposed self-heeling forces of a free market economy would lead to full employment again appears to be the worst of all options.

Unfortunately, two of the major culprits of the sub-prime crisis are a major obstacle for a stimulus, which might be the most efficient under normal conditions. The rating agencies did not only rate junk as triple A and thus misguided investors in the market for mortgage backed assets. Now they attack the ambulance which came to the rescue of financial markets. The financial crisis, the measures to stabilize the financial systems and to stimulate the economies led to rising budget deficits of many states. Partly, some measures taken only have a one time effect on the budget deficit, but led to a jump in the debt/GDP ratio. The rating agencies have already downgraded some European sovereign debt. The member countries of the eurozone had to come to support Greece and to introduce a fund to assist other member countries in the case of a crisis. However, this support came at a cost of introducing austerity measures and to exit from expansionary fiscal policy. Especially the German chancellor Merkel appears to be obsessed of a pre-mature exit from fiscal stimuli. Bond investors followed again the advice of the rating agencies and sent yields on the weaker eurozone countries to new highs since the introduction of the single currency, which is counter-productive to solving the problems. Bund yields have declined and spreads of even other sound countries over bunds have risen considerably. Fiscal policy to stimulate domestic demand is currently regarded as not being an option by governments and bond investors in the eurozone.

The rating agencies have not yet downgraded other Western countries like the US and the UK, which also run a high budget deficit. But they threaded that the top rating would not be for granted. In the UK, the new government is following an austerity policy and is determined to bring down the budget deficit. In the US, the mid-term election makes it impossible to implement a new fiscal stimulus package. Thus, fiscal policy is at best neutral but in many countries it is contributing to a slower growth or extended recession. Therefore, it should not come as a surprise that the Fed and the Bank of England consider a new round of quantitative easing to stimulate domestic demand.

The Bank of Japan is in a very uncomfortable situation. The economy is already in a deflation and GDP growth fell back to almost zero. Weakness of the US dollar leads to a strengthening of the yen and there is no hope that carry trades would trigger a reversal of yen appreciation. While some central banks valued an appreciation of their currencies because it made their job easier to keep inflation close to the target, the BoJ could not be happy with a stronger yen. The falling USD/JPY exchange rate implies that the deflationary pressure is increasing. One instrument to apply is a quantitative easing by intervening in the foreign exchange market without sterilization. Of course these interventions also have a positive impact on exporters. However, outright deflation lead to a wait-and-see position not only by consumers, but also companies would delays purchases. Thus, taking measures against deflation is an absolute necessity from domestic economic policy reasons for Japan.

The thread of rating agencies to downgrade the rating of sovereign debt as well as the risk aversion of bond investors, which only buy the safe haven government bonds, are a major reason that monetary policy has to stay or even to become more expansionary in some countries. The key to avoid a currency war is primarily the stance of China towards a more flexible exchange rate policy and an appreciation of CNY/USD. As long as China is resisting making any concessions, which could have an impact on its export sector, quantitative easing by the Fed appears to be unavoidable and is likely to led to dollar weakness against the major currencies. This remains a positive factor for investors demand for precious as well as base metals. But a stronger CNY/USD does not need to be negative for metal markets if China were taking corresponding measures to reduce domestic saving and to increase domestic demand. Thus, we expect that base and precious metals will profit from tensions in foreign exchange markets.

Bernanke is not heading the central bank of Zimbabwe

All precious metals and most of the base metals, the only exception were lead and zinc, closed last week higher. While base metals also got some support from the Chinese manufacturing PMI, which rose stronger than expected from 51.7 to 53.8, the major driver was a weaker US dollar. Some of the economic data released in the US were also better than the consensus of Wall Street economists predicted, the markets are still convinced that the FOMC would implement a large scale quantitative easing after its November meeting. Even a report in the Wall Street Journal warning that the magnitude of a possible program to buy US Treasury paper would be smaller than the market discounts had no major impact. The outlook for quantitative easing drove the US dollar weaker against the major currencies and this stimulated demand for metals.

 After the announcement of the FOMC it might implement a new round of quantitative easing, the media spends again a lot of attention to so-called investment gurus like Jim Rogers or Mark Faber. Jim Rogers stated in an interview with a German business daily that somebody who prints fresh money would ruin his country. Mark Faber called quantitative easing as monetary policy according to the Zimbabwe school of economics and likened Ben Bernanke as head of the central bank of Zimbabwe. They argue that quantitative easing would lead to a collapse of the trust in paper money and to accelerating inflation. From our point of view, both gurus are totally wrong.

First, quantitative easing had been implemented by the Bank of Japan after hesitating far too long and the Japanese economy was already heading towards deflation. While the BoJ pursues quantitative easing for now around 10 years, the inflation rate in Japan was -1.0% in August. The BoJ would be happy to lift the inflation rate above the zero mark. According to Messrs Rogers and Faber this is not supposed to happen, Japanese inflation should already been sky-high. Also the demand for the yen is contrary to their theory. There are more zeros printed on a yen bill with the smallest denomination than on comparable US dollar bill, nevertheless, the yen is strengthening against the US dollar. Thus, people still trust in paper money despite quantitative easing in Japan.

Second, the first round of quantitative easing by the Federal Reserve, the ECB and the Bank of England were dictated by the turmoil in financial markets in 2008, especially after the collapse of Lehman Brothers. Most economic commentators fearing inflation as a result of the balance sheet extensions by these central banks overlook an important factor. Contrary to widespread economic theory that markets would always be functioning if the government does not intervene, the money markets in the US, the eurozone and the UK ceased to function properly. A vanishing confidence and rising distrust among banks led to a collapse of interbank lending. Banks with excess liquidity preferred to deposit those funds at the central bank. Commercial banks, which needed liquidity, were not able to borrow in the interbank market and had to rely on the lender of last resort. Central banks increased the liquidity facilities and widened access to the various facilities in order to prevent a collapse of the banking sector. The extensions of central banks’ balance sheets reflect to a major extend the replacement of interbank lending by borrowing from the central bank. The focus of many economists on the balance sheet of the central bank has lead to some false conclusions. A look at the aggregate balance sheet of the banking sector (incl. the central bank) would have provided a far better picture as the interbank relationships cancel each other out. Only the provision of liquidity to other sectors could lead to the risk of increasing inflation.

Third, even with increasing lending to the non-banking sector, higher inflation is not an inevitable result. There was much talk about a possible credit crunch. Corporate treasurers might increase borrowing from banks and depositing the funds on accounts with short term notice. The higher borrowing costs could be viewed as an insurance premium to have funds available once they are needed, for example to redeem maturing loans or outstanding corporate bonds. Furthermore, not only banks, but also the corporate and the private household sector had to deleverage their balance sheets. In such an environment, the risk that quantitative easing would lead to inflation is rather small.

In addition, it is not sufficient to look only at the provision of liquidity. The argument that increasing money supply would lead to inflation is based on Irving Fisher’s quantity of money theory and his famous identity equation. One of the assumptions fully in line with the neo-classical theory is that the economy is operating at full employment and capacity utilization. However, with the US unemployment rate at 9.6% and a capacity utilization of 74.7%, the US economy is far away from a situation that increasing demand for goods would lead to rising above the comfort level of 2%.

We would not deny that snake oil salesman like the two gurus (both have a commercial interest in their biased statements) could mislead some investors. “Animal spirits” of retail investors, as Akerlof and Shiller explain in their superb book, could be sufficiently strong to push demand for gold as a supposed store of value and trigger a price rally. However, are the smart money managers at hedge funds also fooled by the argument that quantitative easing would lead ultimately to accelerating Zimbabwean-style inflation rates in the US?

We have our doubts for two reasons. First, George Soros already called gold the next major bubble at the World Economic Forum earlier this year. Nevertheless, his fund (Mr. Soros is not in the active management) invested heavily in gold ETFs. However, this appears to be more exploiting opportunities in markets according to a statement a former CEO of Citigroup made during the financial crisis that as long as the music plays one had to dance.

The second reason relates to what the UN describes in the “World Economic and Social Survey 2010” on page 114 as externalities of the US monetary policy. The provision of liquidity by the Fed does not only lead to lending to the industrial and private household sector or the government, but also to non-bank financial institutions. Hedge funds are among those non-bank financial entities. Hedge Funds could borrow at low US interest rates and invest outside the US in instruments with higher return perspectives. The US dollar serves as a funding currency in carry trades. In addition, Russia and China questioned the status of the US dollar as a reserve currency. Both, carry trades and the fear China might sell US dollars to diversify its foreign reserve holdings, lead to a weaker US dollar. But the investment driven capital flow is not only directed into emerging markets. A depreciation of the US dollar also triggers fund buying of commodities. And it is the impact of Fed quantitative easing on the US dollar, which is relevant for the demand for metals.

Some time ago, there was a report in the media that a taxi driver in New York stopped his cab on the way from JFK airport to Manhattan and asked Mark Faber to leave. Mr. Faber urged the driver intensively to buy gold. The driver was fed up and replied that he has to pay his bills and taxes in US dollars and not in gold. This taxi driver had more economic wisdom than the investment guru. Retail investors buying gold for its supposed store of value should keep this in mind. And journalists better spend less time interviewing Mark Faber on the prospects of the US dollar as he could provide less added-value compared to his taxi driver.