2011 in Metal Markets – a brief outlook

First of all, we wish all readers of this blog a very Happy New Year and that 2011 will be a successful year.

Since following financial and commodity markets, no year was just a repetition of the preceding one. This made the job of a professional market analyst and strategist interesting as change was the only constant. Therefore, the year 2011 is most likely different than the year, which just ended two days ago. Nevertheless, some factors having a strong impact on metal markets last year are likely to play a crucial role at least in the first half of this year.  

At the November FOMC meeting, the Fed started to implement QE2, the second round of quantitative easing. The Fed intends to buy US Treasury paper until the end of June 2011. However, whether this program will be terminated ahead of schedule or even extended beyond the end of H2 2011 will depend on the economic development of the US economy, in particular the core PCE inflation and the unemployment rate. However, QE2 is not undisputed, not only outside the USA – some politicians even regarded it as a weapon in a currency war – but also within the Federal Reserve System. The rotation of the voting members leads to a situation that the number of opposing voting members increases this year. Nevertheless, Fed chairman Bernanke is likely to have a majority for his policy. But more no votes among the FOMC members could have a negative impact in markets. However, the long end of the US Treasury curve might be more affected and the curve could get steeper. This would also have a negative impact on commodity markets as the opportunity costs for investors or the funding costs for consumers could increase.

A second impact has to be expected on the US dollar. It is not only the spread of money market rates, they are a crucial factor for carry trades, but also yield spreads for 10yr government bonds, which have an influence on exchange rates. We do not expect the Fed to hike the Fed Funds target rate this year. This would still be an argument that carry trades could weigh on the US dollar. However, an underperformance of the medium to long end of the US Treasury curve relative to other major government bond markets could dampen US dollar weakness or even lead to a stronger US dollar. This case would be negative for metals markets.

The crisis of European government debt is also likely to play a major role still in 2011. After the rating agencies downgraded some countries of the eurozone periphery or put them on credit watch for a downgrade before Christmas, the rise of CDS rates is likely to keep the speculation alive that Portugal might have to get bailed out by the European Financial Stability Fund and that other countries could follow. Also the decision taken by the head of states at the recent EU summit have not convinced the markets. Thus, in the short run, the fear of a contagion of the eurozone debt crisis could weigh on the euro in early 2011.

All countries have adopted more restrictive budgets for 2011. Especially the countries of the eurozone periphery voted for severe austerity measures. Currently, financial markets are skeptical whether expenditure cuts and tax hikes would improve the fiscal situation of those countries. They fear that the impact of restrictive fiscal policy on GDP might be more harmful than the governments estimate. Only time will tell if the medicine prescribed by the EU and the IMF as well as by pressure in bond markets will lead to an improvement. In this case, the tensions in financial markets could ease and CDS rates decrease again. This would be a positive factor for the euro and most likely also for metal markets. However, in the case that GDP would shrink stronger than markets priced in, the euro might weaken against the US dollar. But this case does not necessarily imply that precious metals would suffer. Gold and silver might even advance further on safe haven buying. But the impact on base metals could be negative.

A rate hike in China was expected for quite some time, however, the People’s Bank of China surprised the markets by the timing of this move. Over Christmas, the PBoC increased interest rates to cool inflationary pressures. Given the still strong pace of economic growth in China, further rate hikes have to be expected during 2011. This might have a negative impact on Chinese gold demand as fighting inflation would reduce the appeal of gold as an inflation hedge. However, the crucial question for base metals, in particular copper, is how far a restrictive monetary policy in China would dampen GDP growth and thus the demand for base metals.  Our base case scenario is that China’s GDP growth would slow from above 10% to close but below 10%. However, the construction sector might slow down stronger. Therefore, we expect that China would make a positive contribution to increasing demand for base metals, but that price increases are likely to be lower than in 2010. Also the demand from other “BRIC” countries should support base metal prices.

However, Chinese policy might have a negative impact on two precious metals. Also over the Christmas weekend, Beijing announced to reduce car registrations by 50% due to the congestion in the city. So far, it is only a measure taken by the administration in Beijing. But given the traffic and environmental pollution in other metropolitan areas, one has to expect that other cities like Shanghai would follow soon. The Chinese market contributed strongly to the growth of the automotive industry in 2010. The outlook for a drop of car registrations in China is a negative factor not only for the stock prices of car manufactures, but also for the demand for catalytic convertors. Thus, platinum and palladium might underperform gold and silver this year.

Two other factors play an important role in our quantitative fair value models, the year-over-year percentage change of crude oil and the S & P 500 index. OPEC shows no signs to increase the output quota any time soon. The demand for crude oil is rising in emerging markets. Thus, WTI could surpass the 100$/bbl mark in 2011. This would be a positive factor for metal prices, especially for gold and silver, which serve as a hedge against inflation fears. Many US companies also profit from operations in emerging markets or exports to those countries. As the Fed is likely to keep interest rates stable in 2011, the S & P 500 index might trend further up in the first half of this year. This would imply, that yoy %-change would be positive and would also argue for rising metal prices.

 All in all, we expect still a positive performance of metals, in particular in the first half of 2011. However, whether metal prices will also rise in H2 depends on a pick-up in US GDP growth and that Chinese GDP growth would not slow down too strongly. Thus, market timing instead of buy and hold might be more important this year than it was in 2010.