Gold flies high as Helicopter Ben is ready for take-off

The Fed was the major factor for the development in metals markets last week. Not only gold and other precious metals rose, but also the base metals advanced. A market report from Reuters stated that the comment about inflation would have triggered demand for inflation sensitive assets. In another report, an analyst is quoted saying that “the association with deflation is panic, then that flight to quality and liquidity is worth something”. Thus, what is the real reason for the firm metals markets after the FOMC meeting and what will be the future perspectives?

Two paragraphs of the FOMC statement are important to assess the monetary policy of the Fed:

1)       Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability. With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate.

2)       The Committee will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate.

(For the complete FOMC statement see Federal Reserve).

Unlike other central banks, the Fed is not looking at a broad measure of consumer prices. The FOMC members are smarter than the members of the ECB council and know that they can not fight the impact of weather conditions on consumer prices. Thus, the Fed is focusing on core inflation excluding the rather volatile segments of food and energy. The favorite index is not the urban CPI, which gets more attention in financial markets and in public, but the core personal consumption expenditure deflator. The core PCE has risen in the second quarter by 1.5% yoy after 1.8% yoy in the first quarter of 2010 (for the core PCE). The recent CPI data, the still rather low capacity utilization as well as the moderation of GDP growth indicate that the core PCE is at risk of declining further. All price indices have some measurement weaknesses. Thus, price stability is usually associated with a rise by close to 2% yoy and not just remaining unchanged. In this respect, there is no difference between the Fed and the ECB, the target for the Bank of England had been set by the Chancellor of the Exchequer (finance minister) at 2.5%. Thus, the first paragraph quoted clearly expresses the concerns of the Fed that aggregate demand might be too weak to prevent a dip into deflation.

The second quote underlines that the Fed would be ready to act to prevent deflation. It does not provide the slightest hint that the Fed would embark on an inflationary policy. In the likely case that the Fed would implement a new round of quantitative easing, there would be no rational reason to buy metals as a hedge against inflation. The Bank of Japan is applying quantitative easing since almost one decade and is still in an uphill fight with deflation. Thus, quantitative easing is by no mean a guarantee for an accelerated rise of inflation indicators.

 In the case of outright deflation, which Japan is currently experiencing, there is no reason to buy gold or other metals as a store of value. In addition, contrary to the above quoted comment from an analyst, gold does not provide any additional liquidity advantage. Physical possession of gold is associated with storage costs. Even at the very low interest rates offered on short-term Japanese Government paper, holding government paper provides superior real return perspectives. Even paper currency beats gold and other metals as a store of value in a deflation.

However, there is one major difference between Japan and the US, which plays a crucial role for the demand for metals. The Japanese yen is an important currency, but the status of the US dollar as global reserve currency is unrivaled. As the most important metals are priced in US dollars, the external value of the US currency plays a crucial role for the price trends in metals markets. A new round of quantitative easing by the Fed will have an impact on short-term interest rates and government bonds along the whole yield curve. Falling interest rates increase the incentive to use the US dollar as funding currency in carry trades and to invest in higher yielding assets in other currencies. The US dollar is likely to depreciate with quantitative easing, except a new financial crisis would trigger again a flight into the safe haven and to unwinding of carry trades. For the Fed, a weaker US dollar would have the positive impact that it would help to achieve the target to prevent deflation by higher import prices. For commodity investors, it would be supportive as commodity prices often rise stronger and more than compensate the impact of a weaker US dollar. And it is exactly this perspective, which was the main driver for precious and base metals following the release of the FOMC statement.

We are skeptical that the Fed would be successful with implementing further quantitative easing. Increasing the Fed balance sheet could be even counter-productive for three reasons.

First, as several academic studies demonstrated, the yield curve is one of the best indicators for future economic activity. A steepening of the yield curve signals that the outlook gets brighter and economic activity usually picks up with a time lag of around 6 – 12 month. Two measures of yield curve steepness are often watched to assess the outlook for GDP growth, the spread between the yield on 10yr US T-Notes and the 3m T-Bill rate or the difference to the 2yr US Treasury yield. In any case, the scope for quantitative easing to lead to a steeper yield curve is rather limited. The 3m T-Bill rate is at 0.19% and the yield on 2yr US Treasury paper is at 0.44% currently. Thus, quantitative easing might probably lead a flattening of the US yield curve, which would send the wrong signal to businessmen that GDP growth would moderate even further.

The second reason is related to the first one; however, it does not refer to spreads along the US Treasury curve but to spreads compared to other segments of the US bond market. Buying treasury paper by the Fed is likely to lead to wider spreads of other instruments over the government paper. A widening of spreads of mortgage bonds could send the wrong signal to financial markets as they might regard the spread widening as another sign of renewed pressure on the housing market. This could also lead to a deterioration of consumer confidence and lower consumption spending. For business fixed investment, the level of capital costs should be the more important factor. However, increasing spreads of corporate bonds over treasury notes could signal to corporate treasurers that the market would view investment plans as more risky. The board might decide to postpone investments, which would then be another dampener for aggregate demand.

The third argument refers to the relationship between yields and savings. Contrary to conventional textbook theory, lower yields would not necessarily lower savings, but could lead to a higher savings ratio. It affects the corporate as well as private household sector. Many companies sponsor pension schemes. As yields decline, those pension schemes get underfunded. While the value of current bond holdings rises as yields drop, the capital gains are not always sufficient to compensate for the lower income earned from new investments. If the duration of the portfolio is lower than that of the pension obligation, underfunding emerges. Quantitative easing is expected to drive yields lower and thus, to increase the underfunding of pension schemes. Companies would have to invest more funds in their pension schemes to meet future obligations. In Japan, the low interest rate level had severe implications for private consumption and the US might face the same problem. People already in retirement rely to some extend on their savings for their consumption. If the yield on these savings declines, they have to reduce consumption. Similar to the problem of companies, the active work force might have to increase the saving ratio in order to reach a certain level of wealth for future spending once they retire. Thus, the falling bond yields, which are probably pushed further down by quantitative easing could have the adverse and undesired effect that companies and private households increase their saving and spend less.

All in all, quantitative easing bears some considerable risk of even depressing aggregate demand and thus, increase the deflationary pressure. And it is doubtful whether a depreciation of the US dollar as a result of quantitative easing would be sufficient to compensate the negative factors mentioned above. The Fed might then increase the balance sheet expansion to fight deflation. The demand for the industrial use of metals might decline, but a weaker US dollar could still be enough to push metal prices up.    

Nothing’s going to stop gold, but for how long?

Last week, we wrote that the stronger than expected growth of Chinese industrial production would be positive for industrial metals, but probably negative for US Treasury yields and thus, also for gold. While industrial metals gained indeed, gold did not correct. Quite the opposite, it reached a new historical high.

At the beginning of the week, US Treasury paper climbed higher and yields declined as there were talks the Fed would buy more Treasury notes and bonds than holdings were maturing. Thus, the market priced in more quantitative easing by the Fed. The rise of the 10yr US T-Note future explains well the increasing price of gold at the beginning of the week.

However, as also US economic data came in better than expected during the week and US Treasuries pared their gains made earlier, gold did decouple and reached new record highs on Thursday and Friday. One explanation given by market commentators in the media was a weaker US dollar. However, this argument is not very convincing. Japan intervened in the foreign exchange market to weaken the yen against the US dollar. Thus US dollar index also moved sideways during the week, thus, it also does not explain the further rise of gold after US Treasury paper declined again.

The holdings of the biggest gold ETF, the SPDR Gold Trust, do not provide a clear picture. On balance, the holdings rose by 8 tones to 1,300 tones. However, after a rise on Tuesday, holdings declined again significantly on Wednesday. Only on Friday, the holdings at SPDR Gold Trust rose again. While gold closed higher on four days, the stocks at the biggest ETF increased only on two days and declined also on two days. This is not a strong indication.

Large speculators increased again their net long position in COMEX gold futures in the week ending September 14. According to the latest CFTC “commitment of traders” report, they have added on balance 4,564 contracts. Thus, their net long position at 244,261 contracts is again close to the high recorded at the end of June. As gold continued its advance, hedge funds and CFTs have probably added to their net long positions during the remainder of last week. Also the small speculators have increased their net long position slightly.

After reaching a new record high, analysts have revised their forecasts for gold higher. Many market pundits are now expecting a rise to 1,300 or even 1,400$/oz by the end of this year. These bullish forecasts might have triggered further gold buying. However, the market reaction was not very strong. If a market is really in a bullish mode, breaking out above a previous high should lead to a significant push higher. But gold made a strong daily advance to reach a new record high on Tuesday. In this case, it is not uncommon that a market digests the rise first before continuing the rally. And gold made new daily highs, which is also a positive sign. The technical indicators are also bullish. Thus, the chances are still good for a continuation of the rally and more days with new record highs.

Nevertheless, there is still one warning signal. Spot gold closed above the upper Bollinger band line, which is bullish as long as the closing price remains above this line. However, a close again inside the band is a negative signal, pointing at least to a consolidation or even the start of a correction. On Friday, spot gold closed inside the Bollinger band again. In addition, gold had formed a reversal chart pattern.

All in all, we are still convinced that the economic fundamentals do not argue for being long in gold. We fully agree with George Soros that gold is the next big bubble. However, the market is in a bullish trend since the end of July. This trend could continue. The technical warning signals are just a warning but not a sell signal yet. Thus, as long as no sell signal is triggered, going short gold is probably a dangerous game.

Believe in the Chinese Boom and not in Dr. Doom

In the 1960ties, the British mass tabloids reported in the summer months about the emergence of the monster of Loch Ness. This year, the monster had been replaced by the talk of a double dip recession in the US and in China. Even expert economists like “Dr. Doom” Nouriel Roubini explain that the double dip monster is looming around the corner. But like in the case of the monster of Loch Ness, lot has been written about the douple dip recession, about it has never been seen when monetary policy was expansionary. All those experts predicting a double dip recession in China had been proved wrong over this weekend.

Chinese statistics for industrial production and consumer price inflation were initially scheduled for release later this week, however, last Friday, the statistics office announced that the data would already been published on Saturday local time. Many experts and market participants expected that the re-scheduling was due to disappointing figures. But it turned out that all those experts were completely wrong. While the consensus of economists had been looking for a rise of industrial production in August by 13.0% yoy – not a weak number by any standards – the actual rise was almost a full percentage point higher at 13.9% yoy.

Chinese consumer price inflation came in as expected at 3.5% yoy, however, the rise of the inflation rate was driven by food prices, which is not a surprise given the rally of agricultural commodities in August due to the drought and harvest short-falls of wheat in the Black Sea region. A sound monetary policy would look through food price inflation as fighting higher agricultural prices after a poor harvest season would cause more harm then benefits. And the lower than expected rise of producer prices by 4.3% after 4.8% yoy in the preceding month would also argue for keeping monetary policy unchanged. However, Chinese monetary aggregates expanded too strongly. New loans rose to 545bn yuan from 533bn in the previous month while the consensus was looking for a drop to 500bn yuan. Also the growth rate of money stock M2 jumped from 17.6% yoy to 19.2%. Thus, a further tightening of Chinese monetary and credit policy has to be expected.

Economists have the reputation of not coming to a clear conclusion and arguing by on the one hand and on the other hand. However, the mixed economic data out of China on Saturday makes it difficult to draw a conclusion how base metal markets will react at the start of the new trading week. The rise of industrial production and the slower increase of the PPI would clearly argue for a rally, in particular in the copper market. However, the thread remains that the Peoples Bank of China will tighten monetary policy further given the surge of monetary aggregates. Thus, we would put a slightly higher probability on the scenario that base metals recover from the fall at the end of last week and continue to climb higher. However, the risk scenario that the market prices in a tighter monetary policy and sells base metals has also a high likelihood. Thus, we would remain long but would also buy some downside protection.

The Chinese economic data is probably negative for gold. The stronger rise of industrial production should reduce the fear of a double dip recession. Investors’ risk appetite is likely to increase, which implies that funds will flow out of the safe havens into the stock markets. The US Treasury market saw a slight rebound at the beginning of last week, but ended the week lower. The upward trend, which had been in place since April, has ended by various indications like trend line violation or MACD falling below its signal line. Gold come close to the record high last week, but did not reach it. It also closed lower on the week. Thus, we expect that the close correlation between gold and the US T-Note future will hold. Both markets are likely to trade lower on the outlook that the global economy will not dip into a renewed recession. 

   

Improved Outlook for industrial metals

September has the reputation of being the worst month for stock markets. As equity markets are a leading indicator for economic activity, there was fear that only gold would shine and other metals would be falling. Already during the preceding month, the major burden for industrial metals was the fear that global economic growth would slow down and that the US economy would drift into a double dip recession. Even Fed chairman Bernanke admitted that the outlook for US GDP growth would be unusually uncertain. The Fed decided not to embark on its exit strategy but to keep a floor on its balance sheet, which increased the concern in the markets. The yield on the 10yr US Treasury T-Note plunged, which had been interpreted as another indication for the emergence of a double dip recession. However, September did not live up to its reputation so far. Quite the opposite, the first three trading days are promising for industrial metals.

The trigger for an improvement of sentiment had been the release of the manufacturing PMI indices. The official Chinese PMI remained above the 50 threshold in the previous month. However, the markets focus more on the Markit/HSBC PMI, which dipped below this level. This month, both indicators increased and the HSBC PMI rose from 49.4 to 51.9, which gave industrial metals a first push to the upside. In the eurozone, the PMI was revised up from its initial estimate to 55.1. In the US, the ISM manufacturing index was expected to decline by more than 2 points to 53.2 but it rose surprisingly to 56.3. We were never convinced by the arguments for a double dip recession. We argued that a reading of 60 or even above has not been sustainable in the past. The PMI indices then declined, but remained at levels, which point to further growth in the manufacturing sector.

Also the US non-farm payroll figures were a positive surprise. While I was working for Dresdner Kleinwort investment bank, one of my colleagues was the best US economist, Kevin Logan. One valuable lesson I learnt while working with him was that economists get more cautious if their forecasts were too optimistic for two consecutive times. Then their forecasts get a too pessimistic bias. This was also the case with the current US labor market report. The reports for June and July disappointed due to the lay-offs of temporary workers hired for the US census and by States due to budget constraints. However, as the Obama administration pushed through that the federal government provides funds to the states, it was likely that the forecasts for the non-farm payrolls got to pessimistic. Instead of the expected loss of 101,000 jobs, only 54,000 jobs were lost. In addition, the two preceding months had been revised up significantly.

The economic data released during the first 3 days of September demonstrate that the fears of a double dip US recession as well as a sharp slow down of Chinese GDP growth were overdone. Dr Doom got it wrong this time. We expect that figures will show that GDP growth in the US will moderate from the fast pace of the recovery, but will remain positive. In China, the authorities prevented an overheating of the economy, which might be now on a non-inflationary expansion path. Thus, the fears that demand for industrial metals would collapse are also not justified. Therefore, we expect that industrial metals are likely to rise on balance during the final four months of 2010.

The improved economic data had a negative impact on the yield of 10yr US Treasury Notes, which rose again. The recently close correlation between gold and the 10yr US T-Note future would argue that investors also take profits in gold as the risk of a new round of quantitative easing is getting less likely. However, some gold bugs might play now the inflation card despite an acceleration of inflation is far away given the low levels of capacity utilization rates. Nevertheless, we would not rule out, that gold decouples from the US T-Note futures and might advance further. But one should keep in mind, that gold is already overbought. The net long position of large speculators rose further in the week ending August 31 and is close to the peak in June. Therefore, we regard a correction still as the more likely scenario for gold.