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.