Gold’s drop only an accident?

Gold reached a new record high at 1,900$/oz last week and then dropped by almost 200$ within three trading days. Many market commentators have identified the hike of margin requirements for gold futures as the cause for the abrupt u-turn of gold. However, we doubt that lifting margin requirements were the only reason triggering the plunge to 1,706$/oz.

From our point of view, the – at least temporary – recovery of stock markets also played a crucial role. The sentiment in stock markets changed as the Fed seminar in Jackson Hole, Wyoming, approached. Last year, Fed Chairman Bernanke presented the plan for QE2 and this year, there was speculation in the markets that he would now present the plan for QE3. Gold headed south as investors cautiously increased their risk appetite and stock markets traded higher. It is also striking that gold recovered on Thursday after the German DAX future plunged within a few minutes by 200 points or more than 4% without any obvious reason. This plunge dragged also US stock indices lower, which was supportive for gold.

In our quantitative models, the VIX volatility index has normally not a significant impact on gold. Only if the VIX is above a certain level, the impact of stock market moves on gold is increasing and gold is sought as a safe haven. While the VIX had been above this crucial level several times this month, the index ended last Friday far below the threshold level. Nevertheless, the VIX also serves at this lower level as a good indication for the risk aversion of investors. A further decline of the VIX would signal the investors reduce their risk aversion, which could have a negative impact on gold.

It is ridiculous to postulate that financial markets are rational as academic theory does. Expectations in financial markets concerning the Fed seminar in Jackson Hole provide the proof that sometimes expectations are irrational. From our point of view, it came as no surprise that Fed chairman Bernanke did not announce QE3. The recent FOMC meeting took place on August 9 when stock markets were already in turmoil on fears of a global recession. The Fed clearly underlined in the statement that the slow GDP growth is not only the result of temporary factors like the rise of energy prices following the unrest in the MENA region and the earthquake in Japan. The decision to keep the Fed Funds target rate at the current level for another two years found stronger opposition among the voting members. This already indicated it would be rather unlikely that Ben Bernanke would announce QE3 in a seminar speech.

However, the financial markets have overlooked another phrase in the statement. The Fed is monitoring the development closely and is ready to act when needed. This implies that QE3 is still an arrow in the quiver of the Fed. The speech given by Ben Bernanke was along the lines of the recent FOMC statement. The US stock market traded higher on the option that QE3 is still possible. The US Treasury market also traded higher, despite the 10yr T-Note future pared gains, as QE3 is less likely to be implemented at the next FOMC meeting. Gold rallied later in the US trading session also on expectations the Fed might ease monetary policy further. However, as traders headed home earlier due to the hurricane warnings in New York, a less liquid market might have contributed to the late rally on Friday.

All in all, we expect that a recovery of stock markets would reduce the appeal to invest in gold. This would indicate that gold might be in for a consolidation. However, the debt crisis in the eurozone is far from being solved. The decisions taken by the head of states at the July 21 summit have to be approved by national parliaments. German Chancellor Merkel is facing growing opposition in her own coalition parties and it is not a done deal that the German parliament will pass the bill. Also the question of Greece collateral for financial aid demanded by Finland could lead to a set-back. Therefore, even in the case that gold might consolidate, it appears to remain well supported.

Fools never die

This title of a novel written by Mario Puzzo also fits to two statements, which were quoted in markets reports as a trigger ending the stabilization and sending stock markets south again. The first was the report in the Wall Street Journal. An unnamed executive of a European bank stated that the New York Fed would be concerned that the US units of several European banks would obtain sufficient funding for their operations in the US. As the responsible bank supervisor, it is quite normal that the NY Fed investigates the current situation. However, this unnamed banker must be rather stupid talking to the WSJ. He did not do his company a favor because European banks operating in the US came under general suspicion of having funding problems. It was not only European bank shares, which got sold off heavily, but also US banks and other companies. The New York Fed has not commented the report in the WSJ, which lets open another possibility. It might be today’s version of “blue horseshoe loves anacot steel” from the famous movie Wall Street. It is also possible that the story was launched by a short seller to make a quick profit.

Sweden’s central bank, the Riksbank, is becoming a risk-bank. In an environment, where participants in financial markets are already rather jittery, the chief economist of the Riksbank warned about a collapse of the interbank money market. If money market traders of a bank hear such a warning from the chief economist of the central bank, their reaction is easy to predict. They get even more cautious and reduce lending to other banks in the money market. Thus, the statement of this Riksbank official could just become a self-fulfilling prophecy.  

In a situation, where silence is golden and some comments were better not made, statements like those above trigger a further flight into the save haven of precious metals. Gold reached another record high last week at 1,874$/oz. Also silver posted a strong gain. Unlike in the first week of August, also the PGMs profited from safe haven buying despite fears of a global recession dominated stock markets.

Germany is no longer the growth engine in the eurozone thanks to the u-turn of the Merkel government in the energy policy. While the consensus forecast of economists was looking for a decline of GDP growth from 1.5% q/q in Q1 to 0.5%, the German economy expanded by only 0.1% in the past quarter. The index of energy production dropped from a monthly average of 91.9 in Q1 to 84.7 – a fall of 7.8%. This plunge of energy production is not only the result of a warmer than usual spring season, but is due to a larger extend by the order of the Merkel government to switch off seven older nuclear power plants. The Munich based ifo-institute estimates that the u-turn in energy policy has reduced the Q2 GDP growth by 0.2 percentage points.

In the US, there is a divergence between economic activity data and survey data. The July ISM manufacturing PMI declined sharply and also the production sub-index dropped. However, according to the data released by the Fed last week, industrial production rose far stronger than the consensus had predicted. Industrial output increased by 0.9% while the consensus was looking for +0.5%. Also the preceding month was revised up to +0.4%. However, the survey reports of business activities of two regional Federal Reserve Banks disappointed by unexpected strong declines. The Empire State survey for New York declined from -3.8 to -7.7 and the Philly Fed manufacturing index plunged from 3.2 to -30.7 while economists expected an increase for both indices.

As the chart shows, there is a good correlation between the ISM manufacturing PMI and the Philly Fed manufacturing index. Based on a regression analysis, our model predicts that the August ISM manufacturing PMI could come in at 49.5 and thus would signal contracting economic activity.

We have pointed out last week that recessions in the US were typically preceded by an inverted yield curve. This is not the case so far and given the Fed’s commitment to keep the Fed Funds target rate at the current exceptionally low level until mid-2013, it is rather unlikely that the spread between 10yr and 3mth US Treasury paper will get negative during this time span. Thus, the monetary conditions remain expansionary. Nevertheless, as long as the financial markets fear a recession, gold and silver will remain in demand and base metals might remain in a trading range with a risk to the downside. 

“We have nothing to fear but fear by itself”

Some stock markets have suffered their longest and steepest loosing streak since the mid-70^th. The sell-off continued last week after Standard & Poor’s downgraded the rating of US Treasury notes and bonds by one notch to AA+. One factors contributing to the plunge of stock markets is the fear among traders and investors that the US economy might head towards a recession. Thus, it should not come as a surprise that also industrial metals dropped last week. However, is this fear justified or overdone?

As pointed out earlier, the downward revision of US GDP numbers for the last few years including the first quarter of this year came as a negative surprise. However, the market participants focused on the downward revision and ignored that growth picked up in the second quarter. Thus, to fall back into a recession, the US economy would have to shrink in the second half of 2011. We doubt that this is the most likely scenario.

The FOMC reckoned in its statement that GDP growth is lower than the Fed had expected and that it is not only attributable to the rise of food and energy prices. Nevertheless, it has been the rise of these prices, which had been a drag on consumer spending for other goods and services. The rise of crude oil caused by the riots in the MENA region was one factor for the rise of gasoline prices in the US. Another factor was the weather impact on the transportation of gasoline from the refineries to the gas stations. The flood of the Mississippi and its tributaries prevented that sufficient gasoline could be shipped. As a result, gasoline prices soared. The RBOB future at NYMEX reached almost 3.5$/gallon and retail prices came close to the 4$-mark. However, since May, the gasoline price came down again. The RBOB future traded last week shortly below 2.6$/gallon. Thus, the decline of gasoline prices will increase the financial means of private households disposable for spending on other items.

The US economy is not creating enough jobs to reduce unemployment significantly. However, the recent release of the US labor market report also shows that it is dangerous to draw conclusions about a recession from one report. One reason for the expectation of slipping back into recession has been the June non-farm payroll figure, initially reported at 18K. However, this number has been revised up and the preliminary July figure also surprised to the upside. Therefore, the lower number of new jobs created in May and June might be the result of supply disruptions following the earthquake and nuclear catastrophe in Japan in March.

The ISM indices have dropped in July. The manufacturing PMI came in at 50.9 and the service sector PMI at 52.7, which also contributed to the sell off in stock markets. Nevertheless, both indices are still above the 50 mark, which is regarded as the threshold between a positive and negative economic outlook. However, empirical analysis shows that the critical level for entering a recession is below the 50 mark at 46.

Paul Antony Samuelson, a Noble laureate in economics, once said that the US stock market predicted nine out of five recessions. It seems that the current situation is comparable to one of those predictions, which did not end in a recession but was a false alarm by market pundits. Unless a recession is caused by an external shock, as for example after the first oil price shock in the mid-70^th, there is a typical pattern, which leads to a recession. As the economy expands the utilization of the production capacity increases. Less idle capacities imply normally increasing marginal costs of production. These higher marginal costs could be passed easily to the buyers. Prices rise not only for a small number of goods in one sector but over many segments. Not only headline but also core inflation picks up and accelerates. Central banks react by increasing the interest rates. As a result, money market rates rise stronger than long-term government bond yields. The yield curve, often measured as the difference between 10yr T-Notes and 3mth T-Bills, inverts. An inverted yield curve is the best indicator that the economy will head into a recession about 12 to 24 months later.

As the chart above shows, an inverted yield curve also preceded the top of the S&P 500 index in 2000 and 2007. The last few weeks, the US yield curve has flattened significantly due to the flight into the safe haven of US government bonds, despite the last minute compromise to lift the debt ceiling and the downgrade by S&P. However, the Treasury curve is still normally shaped and far from an inversion. The FOMC decided this week that the target Fed Funds rate will be held at the range between 0 and 0.25% until mid-2013. Thus, also the 3mth T-Bill rate will be closely anchored at this rate. It appears rather unlikely that the 10yr T-Note yield will fall below the 3mth T-Bill rate. This was also not the case in Japan despite the traditionally low yield environment. Also the fear that the downgrade by S&P would lead to a significant increase of funding costs for companies seems not justified as the Fed keeps interest rates low for the next two years and the decline of US Treasury yields as the benchmark. Many commentators make the mistake to look just at spreads between the US Treasury yield and yields on corporate bonds. However, what matters for business fixed investments is not the spread but the absolute level of corporate bond yields and funding costs.

Of course, one should not overlook the risk that the panic in stock markets has a negative impact on the economy. The plunge of stock markets and the comments by the famous permanent bears like Dr. Roubini could induce companies to postpone investments and new orders. Thus, the fear of a recession could eventually lead to a recession as a self-fulfilling prophecy.

Based on the past patterns, the steepness of the US Treasury yield curve does not support the view that the US economy would enter a recession. The more likely scenario appears to be that US GDP growth remains below the long-term output potential but positive. Thus, also the drop of prices for industrial metals seems to be overdone. It might offer a good opportunity for commercial users to hedge some of the exposure and for investors to buy again.  

Only gold profits from panic in stock and bond markets

It was a last minute compromise that saved the US from failing to meet its obligations. Normally, such an event leads to a relief rally in stock markets. This was also the case on Monday August 1, but it did not last very long. While Asian stock markets closed with gains, European markets opened with an upside gap, but pared gains. A negative harbinger for what followed at stock markets during the rest of the week.

Many stock market indices lost more than 10% over the week. Three factors contributed to the massive sell-off in major stock markets. Gold was the only metal, which could profit from this turmoil and ended the week higher. Silver and the PGMs posted losses. Also the base metals plunged with the LME metals index dropping by 9% over the week. Whether gold will profit further and other metals will remain under pressure depends on the developments of the three factors contributing to the plunge of stock markets and on the reaction of investors and traders.

The first factor was the uncertainty among investors about the reaction of the rating agencies on the last minute compromise. Moody’s and Fitch confirmed the triple A rating of US government paper by the middle of the week. However, Standard & Poor’s was the most critical about the political process. Last Friday, four hours after the US markets closed, S&P reduced the rating of US Treasury notes and bonds by one notch to AA+ with outlook negative. Two reasons were given by the agency, the political wrestling for a solution, which was in danger by the fundamental opposition of the Tea Party fraction within the Republicans, and that the savings agreed remained below the demand of S&P. From our point of view, S&P is only partly right. It is part of the political negotiations that compromises in difficult situations are made in the 11^th hour. Financial markets sometimes lack this understanding as traders and investors could make decisions rather quickly and implement them immediately. And with different majorities in the House and Senate, compromises have to be found between the two parties. If some members insist on their positions and are not willing to find a solution, the political business in the Congress is more complicated. However, the second argument creates the impression of blackmailing the members of the Congress. Investors should also keep in mind, that it was S&P who was the most aggressive in rating bonds backed by junk sub-prime mortgages as triple A. This agency acts like an arsonist who attacks now the fire brigade for extinguishing the fire.

The crucial question is now, how will the financial markets react on what has already been discounted. Already on Friday, rumors were spread around that S&P would downgrade US Treasuries. If financial markets react according the rule of buying the rumor and selling the fact, then stock markets would rebound from the plunge last week. This does not necessarily imply that all losses would be pared quickly, but equity markets would recover considerably in this case. A recovery of stock markets would also lift the metals with an industrial use and gold might give back some of the gains. However, if markets remain in panic mode, then the downgrade by S&P could lead to further falling stock markets and industrial metals.

Except some of the usual doomsday prophets like Dr. Rubini, many economists expect that the US economy would continue to grow in the second half of 2011 and in 2012. Also many equity strategists are still optimistic for stock markets. Nevertheless, among many traders, the economic sentiment is bearish. They were shocked by the downward revision of US GDP history since 2007. This revision also had an impact on Q1 GDP growth. Furthermore, the ISM manufacturing PMI came in far lower than expected. But the service sector PMI was stronger than expected and this sector is more important for US GDP growth than the manufacturing sector. In addition, the labor market report for July surprised to the upside. The number of new jobs created came in at 117K, far above consensus. Also the non-farm payroll figure for the two preceding months was revised up. The pessimists pointed to the number of persons leaving the work force. However, for GDP growth, the number of new jobs created is more important. History shows that people leaving the work force because jobs are hard to get return to the labor market once jobs are again easier to get. How quickly economic sentiment improves among traders and investors will depend on further economic data. However, also the Fed could contribute by considering some further monetary stimulus.

The third factor is the European debt crisis, which develops into a never ending saga of political failures to calm the markets. As the markets fear a contagion of Spain and Italy, the CDS and yields on bonds of these two countries rose further. The market is fully aware that the decisions made at the recent EU summit are not sufficient to shield Italy. Mr, Barroso was right in pointing out that the volume of the EFSF would have to be increased further to convince the markets. Making this letter public is the first mistake of politicians. But even worse is the reaction from the German finance ministry rejecting this proposal. This was an invitation for speculators to attack Italy further. However, the more Italy and Spain are in the line of fire from speculators, the more the European stock markets came under pressure. The German magazine “Der Spiegel” reported today that the economic advisors of Mrs. Merkel oppose any help for Italy. Fools never die. The more Germany is refusing a quick and convincing solution, the higher will be the costs for the tax payer.

The ECB also missed a good opportunity to teach the markets a lesson not to attack the eurozone. During the ECB press conference, the ECB started to buy again bonds of peripheral member countries after pausing for several months. Initially, this had a positive impact also in Spanish and Italian government bonds. However, as soon as the market got aware that the ECB did only buy bonds of countries already obtaining funds from the EFSF, the market reversed direction. The bund future rose to a new high and spreads of Spanish and Italian bonds widened again. This would have been a good opportunity the buy those bonds too in a second round of market intervention. Speculators and traders would have been caught wrong twice and normally get less aggressive in selling peripheral bonds short.

On Friday, after markets in Europe were closed, Reuters quoted an ECB official saying that the ECB would be ready to buy Italian bonds. The Italian government announced also on Friday evening that it would balance the budget already in 2013 instead of 2014 as scheduled in the package pushed through in early July. The ECB will hold a council meeting by telephone conference later this Sunday. If the ECB decides to buy also Spanish and Italian government bonds to prevent a contagion and shows strong bids for bonds of these two countries when the markets open on Monday, they might be successful in calming strained nerves of jittery investors. This would also contribute to stabilizing stock markets.  

At the start of the new week, there is no major economic data release scheduled. The FOMC meeting will take place on Tuesday. If the FOMC finds the right words in the statement, it could also contribute in stabilizing the markets. Despite the downgrade by S&P of US Treasury paper, there is still a chance that stock markets stabilize and rebound. This would also be positive for industrial metals. Gold might be less attractive as a safe haven in this case. However, a stronger euro versus the US dollar in the case the ECB decides to buy also Spanish and Italian government bonds could provide support to gold.