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.