Metals recovered, but is it a new bull trend?

The metals market recovered last week. All precious metals closed higher compared to the preceding Friday. While the LME base metal index also reversed and closed higher, the development within the base metal sector was mixed. Some metals posted even stronger losses.

The technical situation of the precious metals has improved considerably. The MACD has crossed above it signal line and thus triggered a buy signal for all four metals. However, these signals are not very reliable. For example, the recent sell signal for gold was triggered by the MACD at the low reached on May 5. But one should also keep in mind that these signals could be very profitable in the case that the market enters into a new trend, which the trader could ride for some time. Therefore, before following a technical trading signal, traders should still have a look at the driving forces.

Stock markets were a bit in a roller-coaster last week. Economic data released came in below the consensus in cases. Especially the flash estimate of the eurozone manufacturing and service sector PMI, US GDP revision for Q1 and the US pending home sales disappointed. Thus, there is still some fear of a global economic slow-down in the markets. This would not be a positive factor for metals.

Positive for the metals had been that the euro stopped its decline versus the US dollar after falling below 1.40 at the start of last week. However, the rebound appears to be more driven by short covering. The uncertainties about the development in Greece are still high. The statement of the head of EcoFin that the IMF might not approve the payment of the next credit tranche cause a new wave of safe haven buying in the bond markets. However, on Friday, the acting IMF managing director John Lipsky stated that the IMF is still in negotiations with Greece and no decision is made yet. This calmed nerves a bit and contributed to the recovery of the euro above the 1.43 mark. However, it appears to be a sure bet that some European politicians can not keep the mouth shut making the wrong statement at the wrong time and nervous traders sell the euro again.

Positive for the metals markets had also been the buy recommendation from Goldman Sachs commodity strategists. After GS issued a sell recommendation earlier on expectations that commodities would be too expensive, the recent correction pushed prices down to levels, which GS regarded as price targets. As a consequence, GS issued now a buy recommendation.

One condition for a new upward trend in precious metals is that investors increase their positions again. According to the latest CFTC report on the “Commitment of Traders”, the large speculators have increased the net long position in gold in the week to May 24 by 7,791 to 172,394 contracts. In silver, the non-commercials added just 148 contracts to their net long position in futures. In platinum, they reduced the net long position further. Thus, there are positive signs that investors return as buyers to the market. However, as one swallow does not make a summer, more evidence of buying by large speculators would be needed.

As long as the markets are still concerned with the outlook for global growth, the recent recovery might be on a shaky basis. Especially as the rebound of the euro appears to be driven more by short covering the risk is that this short covering rally might not last long.

Most metals still in consolidation

In the previous blog article, we wrote that the consolidation in commodity markets is likely to continue. We also argued that it is probably too early for bargain hunting. Our assessment has not changed during last week, despite copper and lead posted a stronger gain on the week.

The large speculators reduced further positions in metals. According to press reports, George Soros has sold almost his entire $800 million stake in gold during the first quarter of this year, which weighed on sentiment at the start of last week. According to the CFTC “Commitment of Traders” report, non-commercials reduced their net long position by 11,766 to 164,603 contracts. Thus, the large speculators cut their net long position by around 25% within one month. In silver, the large speculators reduced the net long position in the week ending May 17, by 6,061 to 17,435 contracts. Thus, they trimmed down the net long position by more than 25% within just one week. Over the last four weeks, the net long position was almost halved. However, in copper the liquidation of net long positions was even more pronounced. Within one month, large speculators diminished the net long position from 25,059 to a mere 7,745 contracts, a decline of almost 70%. As long as large speculators close long positions in commodities, the risk for commodity prices is biased to the down-side and it is too early to go on bargain hunting. The knife is probably still falling and investors should listen to the advice not to catch a falling knife.

Gold ended the week higher thanks to a jump on Friday afternoon (GMT). Two factors led to this price spike. First, investors feared that something unforeseen could happen again over the weekend like the arrest of the IMF governor the week before or the secret meeting of a few finance ministers of the eurozone two weeks ago. Second, Fitch cut the rating of Greece to B+ reacting on the statement from the head of Ecofin, Mr. Junker, and warning that even a maturity extension would be regarded as a default. However, position squaring ahead of a weekend is less likely to lead to a trend reversal as long as the underlying fundamentals do not change.

For the PGMs, the platinum week in London was the main event. The supply/demand forecasts by Johnson Matthey were the main driver. JM predicts an almost balanced market in platinum but a supply deficit for palladium. However, Norilsk voiced that the palladium market would also be balanced. But over the summer month, demand for metals is usually lower and thus, the recovery of the PGMs might also be short-lived.

Two major fundamental factors would have to change to see again a stronger demand from consumers and investors in commodity markets. The US dollar did not strengthen further. But this is not enough for rising commodity prices. The dollar would have to weaken again considerably. The end of QE2 is looming, however, this is not a reason for a stronger dollar. As long as investors expect higher returns in other currencies, the US dollar could weaken further. The ECB is likely to hike rates further towards 2% by the end of this year or early 2012. This would argue for a weaker US dollar, but fears of a Greek default and a possible contagion to other peripheral eurozone countries is currently weighing on the euro.

The second factor is the outlook for the global economy. Investors are currently cautious as some economic data came in weaker than the consensus among economists predicted. Especially surveys among purchasing managers in the service sector and among analysts and fund managers disappointed, while the manufacturing PMIs are still at a very high level and point to strong expansion.  Usually, economists are slow to adjust their forecasts to lower than expected economic data. Thus, it might take some time that economic figures point still to robust growth and also exceed the consensus forecasts. Therefore, bargain hunters might find better buying opportunities over the next couple of weeks.

Dead cat bounce or time for bargain hunting?

At the start of last week, metal markets recovered from the sell-off in commodity markets. It is not an unusual behavior that markets rebound after a preceding plunge. This phenomenon is called a dead cat bounce. Those moves are only for extremely short-term long trades because markets are quickly returning back to the low, from which the bounce started. Often markets even fall further to fresh lows. Thus, a dead cat bounce is rather an opportunity to set-up short trades then a buying opportunity for traders holding a position for more than one trading session.

On the other hand, if panic caused the plunge and the market overshoot to the downside then it often presents an opportunity for bargain hunting. Once investors and traders analyze the market fundamentals soberly, they come to the conclusion that valuations of the market are extremely cheap and offer a buying opportunity.

Therefore, deciding whether it is time for bargain hunting or to use rebounds for going short requires an analysis of what caused the sell-off at the beginning of this month. Some commentators called the recent plunge of commodity markets a flash crash. Indeed, at a first glance, one might come to this conclusion. We fully agree that markets overreacted on the ECB press conference. As pointed out last week, it was not very rational to expect another ECB rate hike already in June. Also comments from ECB council members made it clear that the market misunderstood the message. Further rate hikes are likely to follow. And a one month delay really does not make a big difference.

However, we do not regard the current situation as a good buying opportunity for commodities. We disagree with Goldman Sachs commodity analysts this time, while we agreed when they recommended taking profits. Beside a panic reaction on the not as hawkish as expected ECB press conference, also the fundamentals – or at least how they are perceived - have changed.

After the report on Spiegel-online, the web-site of a German weekly magazine, about a secret meeting of some eurozone finance ministers and Greece leaving the euro, the nervousness of investors about a Greek default has risen again. Even after the finance ministers made it clear that Greece can not leave the eurozone and also Greece denied any intention to abandon the euro for a “new drachma”, some German professors regard this as unavoidable. They also demand Greece to declare default rather sooner than later. No wonder that S&P downgraded Greece by two notches to B- with outlook negative after this report at Spiegel-online. Also opposition within German government coalition parties against financial aid for Portugal, the creation of the EFS and further help for Greece is increasing. As it seems currently, the coalition is no majority in the lower house to push through legislation on eurozone bail-outs. Thus, the risk-aversion for the euro has risen last week and this is reflected by euro weakness against the US dollar, which is a negative fundamental factor for metal markets.

Chinese commodity consumers behave according to the Baumol model of inventory holding. As the Chinese central bank hiked interest rates and increased minimum reserve requirements several times, the higher funding costs for inventory holding have risen. Therefore, Chinese metal consumers reduce the inventories and also import less. The decline of imports is widely regards as a sign of slower economic activity in China. The summer season is also a period of normally lower import volumes. This could lead to further fears of a global economic slow-down.

The stock markets have recovered from the plunge following the unrest in the MENA region and the earthquake in Japan with all its negative consequences. However, the rise of US equity markets since late August last year was driven by the announcement of QE2. Next month, the Fed will terminate QE2 as scheduled. This does not necessarily lead to a correction in stock markets. However, even if the US (and also the European) equity markets consolidate at a high plateau, the year-over-year percentage change is probably going to decline. The performance of the US stock market is also highly correlated with the ISM index. Thus, lower yoy-performance of the S&P 500 is likely to be accompanied by a declining ISM Index. This would be a negative for metal markets over the summer months.

All in all, we conclude that there is currently a mix of overreaction triggered by the ECB press conference as well as a cloudier fundamental outlook. Thus, we would recommend bargain hunters to keep the powder try.

Commodity markets in panic

This was a very negative week for commodity markets in general, not only for the metals. The fundamentals have not changed in such a way that plunging prices in most markets were justified. Academic research tried to convince that commodity prices follow purely the fundamentals and that speculation did not play any role for price movements. This research is based on tests of Granger causality. However, those tests are not appropriate to measure the influence of speculators on commodity prices. If speculators buy or sell commodities, it has an immediate impact on prices as soon as the buy or sell button is hit and the order is rooted to the exchanges. As prices change simultaneously with changes in the positions of large speculators, and not with a delay of one period, Granger tests conclude that speculation would not have an impact on prices. However, when the CFTC publishes its next CoT report on Friday, May 13, we would not be surprised to see considerable declines in the net-long positions of the non-commercials.

Silver already consolidated at the beginning of last week. It is not an unusual behavior that bulls would need to take a breather after reaching a long-term high following a strong rally. One argument was that small speculators liquidated long positions after the Comex increased margin requirements. It is quite normal that margin requirements increase if volatility rises or prices have risen strongly. This should not come as a surprise to speculators who have done their homework. It is also not a convincing argument that increasing the margin requirements would increase the costs of holding a position in a future as T-Bills could be deposited as margin.

The decline of precious metals and crude oil prices at the start of last week could also be explained by the death of Osama bin Laden. The market has regarded this as a reduction of geo-political and terror risks. However, this might be the wrong conclusion.

The economic data last week was dominated by the purchasing manager indices. While the manufacturing PMI in the US and eurozone came in higher than expected, the non-manufacturing PMI in the US dropped stronger than expected, but remained well above the crucial 50 mark. Looking at the various PMI charts, it should be obvious that readings above 60 are not sustainable for a longer period. They often come back to the mid-50 level, which still points to sustained economic expansion. Based on our models, we regard the manufacturing PMI as more important for the commodity demand and they are still at high levels.

The plunge in commodity markets set in on Thursday and might have been triggered by two factors. First, the weekly initial jobless claims rose to 475K, which was not expected and intensified fears of an economic slow-down. Second, at the same time, the ECB held its press conference. The market obviously speculated that the ECB would prepare the market for a rate hike in June. However, this was not a very rational expectation. At the start of a new tightening cycle, the ECB usually does not hike in a two month interval. Furthermore, at the June meeting, the ECB will present its own staff projections and the survey of professional forecasters. It was far more likely that the ECB would wait for new information at the June meeting and then prepare the markets for a rate hike in early July. Also the wording, inflation risks have to be monitored very closely, is an indication that another rate hike is in the pipeline. The outlook for the ECB refinancing rate has not changed. Many forecasters still expect that the refi rate would be at 2% in December or early January 2012. Therefore, nothing has really changed except that the next step might take place in July.

Nevertheless, as the ECB had not use the key words “strong vigilance” the markets panicked. At foreign exchange markets, the euro was sold off against the US dollar. A stronger US dollar then triggered also massive selling of commodities across the board. On Friday, markets initially stabilized and the higher than expected non-farm payrolls in the US were also helpful. However, then Spiegel-online, the web-site of a German weekly magazine reported that Greece would declare to leave the euro at a conference of EU finance ministers later in the evening, the euro dropped again and also some commodities came under renewed pressure. However, according to the treaties, Greece could not leave the euro without also leaving the EU. The Greece finance minister denied immediately that Greece would seek to leave the euro. Also eurozone finance ministers made it clear later that Greece can not leave the euro and that a debt restructuring is also not at the table. However, the damage was already done. Thus, still anybody believing that speculation has no impact on prices? 

Gold and silver reach new highs

At the beginning of last week, reached a new high but then corrected sharply. However, this was just some profit taking ahead of the two day FOMC meeting. Following the release of the FOMC statement, both metals rose further and reached new highs. But while gold reached a new record high on Friday, silver corrected again after hitting the high from early 1980 when the Hunt brothers tried to corner the market. This is not an unusual behavior in markets that they consolidate a few days after reaching a major resistance. While investors having ridden the bull market in silver might take some profits, it is far too early to conclude that silver has reached a reversal top. Thus, shorting silver is not advisable.

It is often argued that gold and silver rallied because investors bought the precious metals as they fear inflation would rise. Many commentators have pointed to the rising headline CPI inflation rates. We have explained that the change of relative prices should not be mistaken with inflation, which is a rise of goods and service prices on a broad basis and not just in the volatile food and energy segment. However, the movements in precious metals and in the US bond market are not rational in the case that investors fear inflation. Last Friday, gold traded sideways in Asian and European trading but jumped higher to a new record high when the 10yr US T-Note future pared earlier losses and turned into the plus. If investors really feared inflation then they should have sold US T-Note futures. That notes and bond prices increased in line with gold indicates that there has to be another reason driving gold to new highs.

The FOMC statement and also the explanations by Fed chairman Bernanke during his press conference made it clear that the majority of the FOMC is not concerned about inflation. They view the rise of commodity prices in the energy and agriculture sector as transitory. This might turn out to be a misjudgment. As “longer-term inflation expectations have remained stable and measures of underlying inflation are still subdued” the FOMC concentrates on the second target of full employment. Thus, the FOMC still emphasized that the exceptionally low level for Fed Funds rates might prevail for an extended period. Replying to a question at the press conference, Mr. Bernanke pointed out that an extended period would mean several FOMC meetings. Therefore, the financial markets have shifted expectations backwards and no longer price in a Fed rate hike in 2011.

Many commentators and analysts in commodity markets argued that the second round of quantitative easing QE2 was the reason for the rally in commodity markets since the second half of last year. Some commentators even expected that the Fed would announce another round of QE3. However, the FOMC will end QE2 as scheduled in June and the FOMC statement as well as the press conference was interpreted as there would not be a QE3. We were never convinced that QE2 was the reason for the rally in commodities in H2 2010. Weather conditions led to massive production shortfalls in global agricultural commodities. QE2 was also neither a sufficient nor a necessary condition for US dollar weakness. The relative lower returns on US dollar denominated assets compared to returns achievable in emerging markets was the main reason for investors selling the US dollar and buying other currencies. The “currency war” was not the result of the Fed policy last year but the unavoidable consequence of emerging markets coming out of the financial crisis very quickly and strongly.

This year, it is diverging monetary policy that matters for the US dollar. The People’s Bank of China has already hiked interest rates four times since October last year. As food prices push headline inflation higher, further tightening has to be expected as long as rising supply of agricultural commodities does not lead to lower prices. The Chinese stock market underperforms the US equity markets, which also reduces the attractiveness to invest in Chinese companies in the short-run. Brazil and other countries have taken measures to stem capital inflows. In Europe, the ECB has started to hike interest rates. Despite the statement by ECB president Trichet that the rate increase at the April meeting would not be the start of a series of rate rises, the markets don’t believe him. The market expects that the refinancing rate would be at 2% by year end of the January 2012 meeting. Thus, spreads of money market interest rates move in favor of other currencies. The US dollar is likely to weaken further. Our quantitative fair value models but also many academic research studies show that a weaker US dollar is a positive factor for commodity prices. Therefore, except a bumper harvest will depress agricultural commodity prices, the FOMC is probably wrong in the assessment that the rise of food and energy prices is only transitory. However, the Fed is not to blame for this misjudgment. While the FOMC is looking through the cause of recently higher headline inflation rates, other central banks have not learnt from their mistakes in 2008. Thus, the ECB is likely to make a transitory rise of food and energy prices to a permanent one by strengthening the euro and weakening the US dollar. Therefore, gold and silver have probably not yet seen the highs of the year.