Metal markets suffer from economic uncertainty

The metals markets have had to withstand considerable stress by economic data leased around the middle of last week. But these are likely to be distorted vigorously through the hard and long winter in the northern hemisphere. In the coming months, there should be a correction, which would positive for the metals markets. The example of Greece has shown in the previous week, how little the information-efficient markets are, contrary to the theory of rational expectations. It would take some considerable time before the crisis has endured. Hence the fear of a Greek state bankruptcy remains in the spotlight and contagion to other countries in the euro zone stays on the agenda. For the metals markets, this means that a weaker euro could further weigh on prices.

The metals markets have already turned into the red at the beginning of the trading week. But they came under huge pressure with the publication of two economic figures before they could recover towards the weekend. In Germany, the ifo index of business climate fell surprisingly from 95.8 to 95.2, while the consensus among economists was looking for a slight increase to 96.2. This decrease was caused by a marked deterioration in current business conditions from 91.2 to 89.8. The key here was the retail sector, which suffered strongly due to weather conditions. However, for the further development of business activities, the business expectations are more likely to be of importance. These have continued to improve and have increased from 100.6 to 100.9. With the start of the spring, thus, the situation should improve in the retail sector and should also improve further in other sectors of the economy. In addition, the weaker euro is helping the German export industry, which also does not argue for an economic downturn, even if the GDP growth in 1st Quarter could well again stagnate.

The second negative factor for the metals markets came just hours after the publication of the Ifo index with the release of U.S. consumer confidence. Although even the consensus had expected a slight decrease, but did not calculate with a massive drop from 56.5 to 46.0. Consumer confidence suffered from the development of the labor market in particular. But even here, the weather plays a role, as was also acknowledged by Fed Chairman Bernanke in testimony before the U.S. Congress. With the end of the winter season, the situation could improve again. In addition, it must be remembered that the plunge of consumer confidence needs not necessarily lead to a massive drop in consumer spending. Even for the significantly lower than expected sales figures of the housing market, the weather played a role. But it remains to be seen, whether the situation improves again. For the copper demand, however, building permits and housing starts should be the more significant factors.

These economic data have not only led to falling prices in the stock markets, but also to declining prices for crude oil and declining yields 10yr. U.S. Treasury Notes. These figures were negative for the metals markets. In the gold market, it is often argued that lower yields reduce the opportunity cost. However, they also reflect a worsening of economic assessment, and thus diminishing inflation risks. Therefore, this is negative for gold. Thus also the precious metals could not escape the influence of the worse-than-expected economic data.

Greece came under renewed pressure and the CDS rates and the yield spreads on government bonds have once again widened. This was triggered by the rating agencies. But have only affirmed old positions and thus repeated long familiar-looking statements. The markets are not information-efficient, but behave like somebody watching repeatedly a scary move and gets again shocked every time. The market initially waits for Greece to launch a 10yr. government bond. But even with a successful placement, Greece remains on the agenda. Only when the government shows highly visible successes, reducing the budget deficit to GDP ratio in line with promises made, the situation might ease. Until then, however, the euro versus the U.S. dollar stays vulnerable. Therefore, the euro could remain a burden on the metals markets.

Fed interest rate policy is not negative for metals markets

The increase in the discount rate by the U.S. Federal Reserve is not negative for metals markets. In the current environment, it has even to be seen as a positive sign. Although there are first voices to delete the phrase in the statement of the FOMC that the interest rates would remain low for an extended period of time, a shift in interest rate policy, not on the agenda. Thus, the U.S. interest rate policy remains positive for the metals markets.

The financial and commodity markets reacted in the previous week already nervous that the voices in the Fed increase, which argue to drop at least in the FOMC statement any hint about how long Fed interest rates would prevail on the extremely low levels. It is therefore understandable that the markets, especially in Asian trading, followed the increase in the U.S. discount rate by 0.25% points to 0.75% with a Pavlov reaction of falling prices.

But this move by the Fed is not a change in interest rate policy. After the bankruptcy of investment bank Lehman Brothers, the Fed has massively reduced its interest rates. The discount rate is not the main interest rate of the Fed policy. Over the "discount window", the U.S. banks get emergency liquidity from the Fed. Hence the discount rate was generally well above the Fed Fund rate. During the financial crisis, the Fed has massively reduced the spread between discount rate and the Fed Fund target rate.

In hearings, Fed Chairman Bernanke has made it always clear that the U.S. economy is recovering, but still faces significant headwinds. This assessment has been reflected in the statements of the FOMC after the meetings. To interpret the increase in the discount rate as a signal of an imminent reversal of monetary policy is therefore a mistake. Moreover, this measure reflects the contrary that the situation has sufficiently stabilized on the U.S. money market, and thus, the Fed can gradually return from an emergency to a normal situation.

This view has gained dominance in the stock markets in Europe at first. After a weak opening, equity markets stabilized and recovered further during the trading session. This has pulled the metals markets higher, too. In addition, the euro could recover against the U.S. dollar from the lows and turned into the plus. The normalization of the U.S. money market underscores the fact the Fed's optimism about the further development of the U.S. economy. The economic data released the previous week had been largely better than expected. The recovery in equity markets is likely to continue in this light. Rising stock markets are in the current environment also positive for the metals markets, which should also have more upside potential.

China's monetary policy - no drop in copper demand

The two hikes of the minimum reserve ratio by the Chinese central bank (the Peoples Bank of China) by 0.5%-points each in mid-January and in the past week, and the brakes on lending by commercial banks does not mean the demand for copper at the largest consumer is going to collapse. Overall, despite a tightening of credit policy, copper consumption in China should develop better than the International Copper Study Group estimated in its forecast from early October 2009. The supply surplus could be lower in our view. This does not mean, however, that the price of copper will not suffer under greater burdens in the year 2010. These possible pressures, however, are more likely to come from those factors that have driven the price of copper strongly higher in 2009, although the LME inventories had increased significantly.

The net-lending of Chinese banks in the first 20 days of 2010 was around 151 billion euro. Given the objective of China's central bank, to limit the volume of new loans to around 781 billion euro, it comes as no surprise that the PBoC has twice raised the minimum reserve requirement ratio by 0.5% points and the commercial banks put on hold the granting of new loans during the last third of January. Even as the target of the PBoC is to reduce volume of new loans in this year to the equivalent of 999 billion euro, this volume would still be well above the amount of new loans in 2008. Therefore, China is far away from pursuing a restrictive monetary and credit policy, but it will not be as expansionary as in the previous year. However this is not surprising, given the recent growth figures for GDP of 10.7% in the 4th Quarter of 2009. The development of inflation in China suggests that China's central bank takes his foot off the accelerator, too. Although the inflation rate for consumer prices in January, after a surprise fall to 1.6%, is at a moderate level, but it has accelerated considerably for producer prices, which rather sooner than later would spill over to consumer prices.

The fears in the markets, not only for copper, seem to be based on the fact that some analysts and traders confuse acceleration and speed. In the 1st Quarter of 2009, the growth of China's GDP was still at 6.1% yoy. It has steadily accelerated to 10.7% in the last quarter. While one could still argue that the basis for comparison in the 2nd and 3 Quarter was distorted by the prescribed production stoppage with respect to the Olympic Games in Beijing, but this applies no longer to the 4th Quarter. The accelerated GDP growth has been due to the expansionary monetary and credit policy. In China, as the central bank takes the foot off the accelerator, the monetary and credit policy as a whole is less expansionary, but is still far from acting restrictively. For the growth rates, this means that they will not rise much further. But the Chinese economy is likely to be far away from a drop in growth rates. In yoy-comparison China's GDP could still grow by a double-digit rate this year.

For the demand for copper, this implies it should grow strongly again. The International Copper Study Group estimates that much of the Chinese consumption would be satisfied by supplies from the strategic reserve, which was strongly increased in 2009. We do not share this assumption. On the one hand, a strategic reserve is not used to compensate for short-term fluctuations. Secondly, the copper stocks in the warehouses of the metal exchanges have increased and copper is not scarce. In order to provide copper to the market from China’s strategic reserve, probably a significant plunge of the copper stocks in LME, SFE and CME warehouses would be required.

Overall, we consider the impact of actions by the Chinese central bank on the recent development of the copper price is far overdone. This does not imply that the price of copper is unlikely to suffer under various burdens this year. Many analysts and traders expressed surprise that the price of copper has risen almost to $ 7,800 per tonne, although the stocks in warehouses have steadily risen. Our econometric model for the fair value of copper shows other factors, which also have a significant impact on copper prices, have more than offset the negative impact of rising stocks. But in the course of 2010 these factors are likely to lose more and more their positive influence and could even become a burden. The OECD leading indicator could still rise further, but the further increase is likely to lose momentum, which is negative for copper. Also in the equity markets, the gains over the previous year are expected to decline. The Fed is likely to begin in the second half to adopt a less expansionary monetary policy. This would then also lead to rising yields of 10yr. US Treasury bonds and thus also impact on the price of copper negatively. Also we do not expect oil prices - as an indicator of expected inflation risks – to drop significantly, which would then also draw copper prices down. But a robust rally as in 2009 is not expected as well. The US dollar is already having a negative impact on the price of copper. After the weakness of the US dollar in 2009, when it served as the funding currency for carry trades, the greenback has gained strength in the foreign exchange markets, as the fear of state bankruptcy of Greece and breakup of the euro dominated sentiment. This scenario is absurd, as ECB President Trichet has rightly observed, but the irrationality leads to a flight into the safe-haven of US dollar denominated assets. Not only the precious, but also the base metals suffer under the flight into the US dollar.

After the strong upward trend in the previous year, copper could trade this year in a wide sideways range. In this scenario, Copper is for buy-and-hold investors not interesting, but should offer still attractive trading opportunities for more flexible investors.

The tail wagging the dog and metal prices fall thereafter

The correction in precious metals prices might be approaching its end, because in the previous week panic has engulfed the financial markets and this is often a sign of a speedy turnaround. The trigger for this panic is the development of credit default swaps (CDS) with which investors can hedge against a possible insolvency of an issuer. The 5yr CDS rate for Greek government bonds climbed in the previous week, according to data from Markit to 425.18 bp, which is 20.84 bp higher than the level of the previous week and this, although, the EU imposed tight controlling measures on the budget of the Hellenic Republic, to reduce the deficit in relation to GDP and to push it back under the limit of 3% by 2012. Also the CDS rates on government bonds have increased significantly in Spain and Portugal, after Portugal at an auction, has not accepted the buyer demands and reduced the volume of emissions below the level intended originally.

Rising CDS rates on government bonds are supposed to be positive for precious metals as a safe haven, because they reflect that the financial markets priced in a higher probability of failure of a sovereign debtor. But things are not so simple, unfortunately. The yield spreads between government bonds of different countries in the euro zone and German Bunds as a benchmark are based on the development of CDS rates. If the CDS rates for Greece, Spain and Portugal desend, it also widens the corresponding yield spread over Bunds. This relationship is now providing for hedge funds and proprietary trading desks of investment banks, a very attractive playground. The market for CDS is in fact much narrower and less liquid than that for government bonds. Hedge funds can therefore already pushing CDS rates upwards with a low risk. At the same time they sell their bonds, so for example, from Greece, and buy in return German Bunds with approximately the same maturity. Rising CDS rates can therefore lead other investors to the assessment that the affected country really is heading for bankruptcy. These investors will be compelled either to sell their holdings in these bonds, or secure the holdings by buying CDS. They will, however, reinforce moves in the CDS induced by hedge funds, which in turn has an impact on the yield spread. The tail wags so successfully with the dog.



On the foreign exchange markets, the interest rate difference plays a major role. For the exchange rate of the euro against the U.S. Dollar, this is at the short end of the term curve, the difference between the 3M or 12M USD Libor and the Euribor. At the long end of the curve, the foreign exchange market has so far mostly focused on the yield spread between the 10yr U.S. Treasury and the 10yr German Bunds. With the outbreak of the crisis over the deficit in the Greek state budget late last year, this is pushed into the background and focus on the foreign exchange market is also directed to the CDS rates. Quite a few foreign exchange strategist and professor of Doom, Nouriel Roubini, predicted an end to the euro. With rising CDS rates for Greece, Spain and Portugal, the euro exchange rate against the U.S. dollar got more and more under pressure. Since the high of 1.514 at the beginning of December 2009, the euro has fallen by over 10% until 1.358 against the U.S. dollar.

Rising CDS rates for southern European countries in the euro area not only lead to an exodus of investors from the euro, but because of the stronger U.S. dollar also out of gold. But as pointed out above, a market panic indicates often that a movement is nearing an end. The technical picture of EUR/USD and gold indicates that the sell-off could be petering out. The recommendation might be, then, buyer beware, because unlike in the opera and theatre, there will not be a bell ringing for the entry.