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.