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.