Gold sought as safe haven but rose less than expected

The major factor for commodity markets is currently the unrest in Libya. Revolution leader Gaddafi has lost control of most parts of the country, but is defending his position in the capital Tripoli. This political tension has an impact on commodity prices, but not all commodities profited. Gold and silver were sought as safe haven, but the price increase was disappointing as gold rose by only 1.6% on the week and silver by 2.3%.

The unrest in Libya led to a loss of crude oil production by about 600K to 800K barrels per day. However, the oil market feared that riots might break out also in other oil producing countries in the Middle East and North Africa. Brent surged to as much as120$/bbl but came down again as Saudi Arabia announced to increase production by 700,000 barrels per day and thus nearly compensating the production shortfall in Libya. Nevertheless, Brent ended the week at 112.43$/bbl, which is 9.7% higher than one week ago. The spread of Brent over WTI increased again to 14.19$/bbl.

The surge of crude oil prices will have an impact on headline consumer price inflation in industrialized and emerging economies around the globe. Thus, one would expect that gold were rising stronger. The argument that central banks would have to hike interest rates now even more is not a convincing argument against buying gold. The Fed is clearly focusing on the core PCE inflation rate. The rise of crude oil prices is unlikely to derail QE2. The soaring energy prices are likely to have a dampening impact on GDP growth. In the case that central banks try to fight the impact of higher crude oil prices on headline CPI inflation, they are likely to reduce GDP growth even more and could drive their economies into a recession. Therefore, central banks might accept temporarily higher headline inflation as long as core inflation remains well behaved. The hypothesis that the global economy would enter a period of stagflation is already spread around. You guessed right, the “new normal” is dead and the PIMCO snake oil salesmen have a new medicine to promote. But if one is expecting stagflation, then the better alternative is buying gold and silver instead of PIMCO funds.

Platinum and palladium suffered under their industrial use and could not post a gain on the week. Platinum lost 1.7% and palladium plunged by 7.1%. Again, the price moves of car company equities was a good guideline for the PGMs. The market fears that higher costs for fuel would reduce expenditures for cars and that automotive manufacturer would buy less platinum and palladium for catalytic converters.

The fear that soaring oil prices would lead to a slow-down of global growth or even to a recession in some countries had also an impact on the demand for gold and silver. Despite being bought as a hedge against inflation and as a safe haven, our quantitative fair value models show that stock market movements also have an impact on precious metals. The plunge of stock markets last week has thus also exercised a dampening impact on gold and silver. However, this does not appear to be sufficient to explain the meager performance of gold and silver during a crisis, which should lead to a stronger rise. The key are again investors. While the latest CFTC report on the “Commitment of Traders” shows an increase of the net long position held by large speculators by 7,580 to 180,424 contracts, the holdings of the largest gold ETF, the SPDR Gold Trust, dropped by 11.5 to 1,211.6 tons. Two hedge funds had invested massively in this fund. It appears that at least one of them is continuing to liquidate gold holdings. For the time being, those liquidations are likely to remain a drag on gold, but do not necessarily prevent a new record high of gold in March.

Copper will eventually break through the 10,200$/t barrier

For the second time within this month, LME 3mth copper made a new record high and came close to the 10,200$/t mark. But copper again fell back and lost almost 500$/t to ended the week at 9,827.75$/t at the LME Select platform. Copper traded below the low made during the preceding correction. Technical analysts would argue that copper completed a double top formation and would head lower. However, as support at 9,700$/t has held, the downside for copper might be limited.

China is the major factor for the development of copper prices and there are two conflicting forces at work. On the one hand, the expansion of the Chinese economy is still strong. The HSBC PMI has risen further and is now at 54.5 while it had been below the 50 mark just some months ago. Industrial production expanded at 13.5% according to the latest available figures in December 2010. Therefore, the restrictive monetary and credit policy of the People’s Bank of China has not yet slowed the economic growth that it would have a significant impact on the demand for copper.

On the other hand, however, CPI inflation remains at a high level. In January, the inflation rate rose again from 4.6 to 4.9% but was far below the consensus forecast of 5.3%. Nevertheless, the PBoC has lifted interest rates again by 25bp to 6.06% and has increased the minimum reserve requirements by another 50bp last week. The copper market fears that monetary tightening would eventually lead to lower demand for copper, especially if the monetary policy hits the construction sector severely. The Chinese central bank is concerned about rising CPI inflation. Thus, the key for further interest rate movements is the development of the consumer price inflation rate.

Not only in China, but in many other countries, independent if they are belonging to the group of emerging markets or are industrialized, the major driver of the consumer price indices are two segments, food and energy. The severe cold winter season in the Northern hemisphere has driven energy prices higher. In the US, the crude oil sort WTI has traded up to 93$/bbl but came back to 84$/bbl a few days ago, a level it also traded at the end of November last year. However, in Europe, Brent traded higher and reached the 100$/bbl mark. Beside shortfalls in North Sea production, also the political tensions in the Middle East have pushed the price of Brent higher. Oil reserves in the USA are abundant and this should keep WTI in a trading range. But, the price for Brent will also depend on how the situation in the Middle East develops further. However, as long as higher energy costs don’t spill over to domestic price pressure, a central bank would be well advised to look through this development.

The rise of food prices was triggered by surging agricultural commodity prices since July last year. The reasons were supply shortfalls due to drought and wildfires in Russia and the Black Sea region. Also grain harvests in the US remained below expectations. Monsoon rains had an impact on sugar prices. Weather conditions also had an impact on cotton prices. The La Nina weather pattern has an impact on harvests in Australia and Latin-America. Food prices would have to increase further to keep year-over-year inflation rates at the current level. Otherwise, food price inflation would edge lower in the second half of 2011.  However, agricultural commodity prices saw already sharp corrections last week. Speculative net long positions in grain futures are close to record high levels. The probability of profit taking by speculators is increasing if agricultural commodity prices don’t rally further or even enter a correction. Then profit taking could lead to sharply falling food prices, which would have a positive impact on inflation rates.

The conclusion we draw is that food price inflation is likely to come down in H2 2011 at latest but sharp corrections in agricultural commodity prices could lead to easing inflation pressures already in Q2. With falling food price inflation, the pressure on central banks to increase interest rates would also ease. In the case that Chinese CPI inflation would decline as food prices come down in the yoy comparison, the copper market would no longer fear that the PBoC might overwind the screw. It would be supportive for copper.

The second factor is the supply and demand balance. Inventories at LME warehouses have increased from below 350,000 tons in mid-December to almost 408,000 tons. The World Bureau of Metal Statistics reported last week that the copper market was in a supply deficit of 20,000 tons last year. However, the International Copper Study Group estimated in its latest monthly report that the copper market was in a supply deficit of 404,000 tons during the first ten months of 2010. It is unlikely that this gap had been almost closed in the final two month of last year. For 2011, the ICSG estimates a supply deficit in the magnitude close to last year’s deficit. Relative to this excess demand, the current copper inventories in LME warehouses are still at a rather low level. Therefore, we expect that copper prices will be well supported and that the medium-term trend to higher prices will prevail.

Gold resumes upward trend

Despite closing lower last Friday, gold had posted the second consecutive weekly gain. This has improved the outlook for gold. The resignation of Egypt’s president Mubarak pushed gold lower as some investors left again the safe haven. However, the situation in the Middle-East is far from returning to a peaceful status. Protests in Egypt will continue, but as announced by the opposition only once a week. Furthermore, protests emerged in Algeria over the weekend, which indicates that tensions could escalate in an oil-producing country. Thus, gold might still remain in demand for its safe haven status.

Front-month WTI crude oil future fell last Friday by 1.6% to end the session at 85.58$/bbl. With the military taking over the government in Egypt, the risk of closing the Suez Canal has diminished strongly. Thus, crude oil to Mediterranean ports in Europe is expected to flow uninterruptedly. Nevertheless, as protests emerged in Algeria, the markets are probably pricing in the risk that Algerian oil shipments might be impaired by protests in the case that tensions escalate.

In the case that crude oil prices remain under pressure as the Suez Canal remains open, the impact on gold is not necessarily negative. Usually, rising crude oil prices had been positive for gold. But recently, this correlation was rather weak. Gold corrected in January despite oil prices were moving higher. The link from rising crude oil to falling gold prices is via the US Treasury market. As PIMCO’s Gross and El Erian fueled the fear of rising inflation in the US, yields on Treasury notes and bonds rose and gold suffered as opportunity costs increased. Thus, falling crude oil prices could lead to a recovery of the US Treasury market, which would be supportive for gold. Last week, the US Treasury market already showed some signs of stabilization after a successful auction of 10yr US T-Notes.

Gold got also some support from a weaker US dollar at the beginning of last week. The euro jumped on Wednesday above 1.37 versus the US dollar after it was leaked the Bundesbank head Weber would not apply for the succession of ECB president Trichet, whose term ends in October, and would also leave the Bundesbank before his contract expires. However, the euro pared the gains the following days. Nevertheless, it had no major negative impact on gold. Some German papers even commented that inflation would rise after Weber leaves the Bundesbank and the ECB council. Those comments are real “no brainers”. Headline inflation in the eurozone rose due to scarcities in the agricultural sector, which were caused by lower harvests based on extreme weather conditions around the globe.

More important for the outlook for gold is the positioning of investors. The latest CFTC report on the commitment of traders showed the first increase of large speculators net long position. The non-commercials added 14,534 new long contracts and reduced shorts by 1,365 contracts. Thus, their net long position increased by 15,899 to 167,093 contracts. Also the net long position of large speculators rose by 6,383 to 37,063 contracts. However, the holdings in the largest Gold ETF, the SPDR Gold Trust, declined further to 1,225.5 tons, but they are still above the holdings on January 28, when gold hit the lowest price this year. Therefore, the positioning data shows signs that large investors have stopped reducing their gold positions, which is a positive indication for the price of gold.

Gold down YTD and copper at record high

Despite the recovery last week, gold is down since the start of this year, while 3mth LME copper has surpassed the crucial psychological resistance mark at 10,000$/t and hit a new record high at 10,100$/t last Friday. Some correlations, which held last year, have broken down. We will examine some of the arguments provided.

1) The debt crisis in the eurozone

The debt crisis in the eurozone has certainly eased lately. However, at the start of the year, bond markets were extremely nervous and doubted that some peripheral countries would be able to attract sufficient interest of investors to place their new bonds. Switching from auctions to placement by syndicates, the tensions eased. Also the huge demand for the first issue by the EFSF reduced concerns. But gold already started to fall during the first week of January, while the situation in government bond markets was still critical. The decline of CDS rates and yield spreads over German bunds were certainly a factor contributing to the fall of gold, however, it was not the trigger.

2) Gold and the 10yr US T-Note future

Last year, there was a strong correlation between the price of gold and the movement of the 10yr US T-Note future (or a strong negative correlation between gold and the yield on 10yr Treasuries). There were two arguments for this correlation. The first one was based on opportunity costs. Falling US Treasury yields would reduce the opportunity costs to hold gold. Thus, the change of the relative prices to hold government bonds and gold would lead to an increased demand for gold and pushed prices higher. However, the 10yr US T-Note future dropped in November and December, while gold reached new all-time highs. And in January, the US government bond market was rather stable during the correction of gold.

 The second one was based on inflation expectations. Already before the announcement of QE2, some market pundits predicted that US monetary policy would ultimately lead to rising inflation. Marc Faber even compared the Fed with the central bank of Zimbabwe. While the Fed feared that their preferred inflation measure, the core PCE, would head towards deflation without an additional monetary stimulus, fears of future inflation was often cited as a reason for the rising price of gold and other precious metals. Those believing in a surge of core inflation rates behaved rationally and bought gold as long as inflation is still tame. While inflation rates in emerging market countries already headed higher, headline CPI inflation rates in Western countries surprised to the upside when they were released in January. However, for gold to serve as a hedge against rising inflation, it does not make any sense to take profits just as headline inflation rates exceed the level, which some central banks regard as compatible with price stability. A more reasonable behavior would be to accumulate more gold as long as central banks have not reversed monetary policy from an accommodative to a restrictive stance. Also the recent sell-off of US Treasury paper could hardly be justified by inflation as the core rates are still at very modest levels.

3) Gold and increased risk appetite

US stock indices rallied further in January after already performing strongly in December. The VIX index, which measures implied volatility of options on the S&P index, has declined to as low as 15.4% in December and traded sideways since early December. Thus, this index is indeed indicating that risk appetite of investors has increased. Therefore, switching out of gold and silver into assets, which offer better return perspectives, would be a reasonable explanation for the correction of gold in January.  However, low readings of the VIX are also a warning signal that a correction in the stock markets could be looming. Thus, remaining anchored in a safe haven would also be a smart strategy.

The divergence between copper and gold/silver prices

Increased risk appetite also provides the link to the record high of copper. The correction at the beginning of this year was triggered by fears that the People’s Bank of China might tighten monetary policy too much and would chock off economic growth. However, as the latest CPI inflation came in better as expected, these worries took a back seat. Increasing risk appetite, still strong economic growth in China and other emerging market economies as well as supply not keeping pace with demand pushed copper prices higher. Normally, rising yields on 10yr US Treasury notes is a negative factor for copper. However, as the US and the Chinese economies are not in synch and the US is only the second largest copper consumer, the rise of Treasury yields has been overshadowed by other factors. But rising copper prices will eventually have an impact on core inflation rates; thus, the correction of gold and silver appears to be a buying opportunity for medium-term oriented investors.