A solution à la Cosa Nostra

One part of the business model of organizations belonging to the Cosa Nostra is to sell and to provide protection. However, what differentiates the mobsters from legal companies is that the mafia extorts protection money from unwilling customers by inflicting the damage, against which they are promised to get protected. Last Wednesday, Charles Dellara, the chief negotiator of the International Institute of Finance (IIF), a Washington DC based organization representing financial institutions, must have felt like a small shop owner in little Italy getting a visit from racketeers. Before the summit of EU head of states started on Wednesday, October 26, negotiations between the IIF and the EU on a higher voluntarily hair-cut for Greece debt reached a deadlock. At midnight, Mr. Dellara was asked to join the meeting of the eurozone head of states, where they faced him with the alternative either to accept a 50% hair-cut or Greece would default. Mr. Dellara accepted the lesser evil.

After the IIF agreed on a higher hair-cut, it took the eurozone head of states another four hours to reach a compromise on a package of measures. Banks will have to be recapitalized by a total amount of about 100bn euro. Also the EFSF, the European Financial Stability Facility, will be leveraged. Despite many details are still open, the financial markets welcomed the compromise.

However, it appears that the German finance minister Schaeuble is resistant against learning from past mistakes. Already after the EU summit in July, negative comments from Mr. Schaeuble increased the uncertainty among financial market participants and contributed to the rise of yields on peripheral government bonds and also a spill-over to the core countries. Now only two days after the summit ended, it is again Mr. Schaeuble warning against expecting too much from the summit. It would be a long way and many more summits would be required until the debt crisis in the eurozone is solved. Also outgoing ECB president Trichet sounded the same warnings in a newspaper interview.

Those warnings are counterproductive. Instead of giving the markets some hope that the crisis will be solved, those comments suggest that the worst might not yet be reached. Like Bill Clinton told former US president Bush senior in the presidential election campaign “It’s the economy, stupid” the German finance minister has to be told “It’s the market psychology, stupid”.

But the risk is not only that the financial markets might pare gains following the remarks from the German finance minister and the outgoing ECB president. The turmoil in financial markets during August and September had also an impact on business survey data. While real economic activity data remained resilient, the US GDP even grew stronger in Q3 than in Q2, expectations for future economic activity worsened, in particular in the eurozone. In the case that financial markets pare gains following the comments from the German finance minister, the already depressed business expectations could drop further. Then it would be only a question of time that falling business expectations also drag business activities down.

Gold posted the strongest daily gain last week on Tuesday after the press release that the summit of EU-27 finance ministers, originally scheduled to talk place a few hours before the summit of the EU head of states, was cancelled. Many market participants and commentators were confused by this headline. They did not realize that the decisive summit is the one of the head of states. Thus, even at Bloomberg TV, the commentator gave the initial impression that there would be another postponement of the EU summit and a failure to find a compromise for a solution. However, as it got clear that the summit would take place, gold defended the gains. Also stock markets pared losses. We interpret the recovery of stock markets on Wednesday and the rally on Thursday as the decisive factor that gold held the gains and even advanced further to close the week with a gain of more than 100$/oz compared to the preceding weekly close.

The outlook for gold and other precious metals will thus depend on the market reaction on the warnings from the German finance minister. If Mr. Schaeuble’s remarks lead again to turbulences in stock markets, precious metals are likely to be dragged lower. However, if the market will ignore him this time, then stock markets might recover further as economic data recently come in better than expected. This would also be supportive for the precious metals.  

Eurzone debt crisis still moves gold price

The situation in Greece gets more and more severe, despite the eurozone finance ministers decided to transfer the next tranche of the bailout funds. The Greek government pushes one austerity measure after the other through parliament while protests and strikes don’t come to an end. The fall of Greek GDP growth accelerates with each austerity measure passing legislation procedures. At the same time, gold and other precious metals trade far below their highs made this year. Therefore, some commentators ask the question whether gold still serves as a safe haven and whether the eurozone debt crisis still has an impact on the price of precious metals.

Of course, gold is still a safe haven. Otherwise, it would not have rallied to prices above 1,900$/oz in September. However, even prices of an asset serving as a safe haven could fluctuate. If there is a wave of save haven buying, as it was the case over the summer, demand has to increase permanently to absorb supply, which usually increases with rising prices. Once the rush to a safe haven subsides, also prices retrace. Or put it in other words, once the last seeker of a safe haven has bought, who is left to push prices still higher? If those investors who bought gold were no longer convinced that it is still a safe haven, they would sell gold and prices would be much lower.

Therefore, we can draw a first conclusion. Gold is still a safe haven but the eurozone debt crisis is no longer leading to sufficiently high safe haven buying to lift gold prices to new record highs. However, the question arises, how is this compatible with observations that negative news related to the eurozone debt crisis does not lead to short term price increases but to falling gold and other precious metal prices?

The answer is rather easy. Precious metal prices follow again more closely those fundamental drivers, which are highly significant in our quantitative fair value models. The three major fundamental factors are the stock markets, the price of crude oil and the US dollar, either versus the euro or versus the basket of the major currencies as measured by the US Dollar Index (USDX). And these factors are currently still heavily influenced by the development of the eurozone debt crisis. However, negative news with respect to a solution of the debt crisis has a negative impact on the fundamental factors, which finally also have a negative impact on the prices for precious metals.

We have now an approach to explain the price movements of the precious metals with respect to the debt crisis in the eurozone. However, this approach is not very helpful in predicting even the short-term direction of precious metal prices. The reason for this failure is the lack of reliability and credibility of European politicians. For example, last week at the G20 summit, the finance ministers of the eurozone promised to deliver a solution at the EU summit taking place today at October 23. But already the following Monday morning, the German finance minister paddled back and stated that a final solution to the debt crisis should not be expected at this summit. Thus, gold initially rose in line with stock markets and a firmer euro against the US dollar, but turned negative after the comments from Mr. Schaeuble. It is already hard to understand that investors buy bonds with a negative real return, but it is even harder to understand that they also buy bonds of a country, whose finance minister is no longer trustworthy.

It remains doubtful that the eurozone politicians will find a solution at the EU summits taking place on October 23 and 26. France and Germany are split in the crucial question how the EFSF could be leveraged. Many German commentators already get scary when they hear the word leverage. Furthermore, the German position is driving more by ideology and dogmas. Therefore, Germany favors a model of guarantying a part of the nominal value of government bonds against a default. The position of France is more pragmatic by favoring to provide the EFSF with a banking licence, which would open the EFSF the access to the repo facilities of the ECB, like for every other bank within the eurozone.

Thus, we can only come to the conclusion that gold would probably fall below the 1,600$/oz mark if the eurozone fails to deliver a convincing solution. However, if finally the eurozone delivers a package of measures that convince financial markets and therefore, also reduces the uncertainty within the real economy, then stock markets, the euro and also the precious metals are likely to rally. 

Recovery of the euro supports gold

One of the factors contributing to the fall of gold and other precious metals in late September was the weakness of the euro versus the US dollar. Beside the inability of politicians to solve the debt crisis in the eurozone and fears that the troika of IMF, EU and ECB would block the payment of the next tranche of bailout funds, the euro weakened also on speculation that the ECB would quickly reverse the direction of monetary policy. However, the ECB disappointed hopes to cut rates already at the October council meeting. The ECB repeated its stance in the monthly bulletin released last week. Inflation is expected to stay high during the final months of this year and is expected to decline next year. The risks for economic activity have increased due to the heightened uncertainty, especially in financial markets.

At least, the ECB forecast appears to be right for the trend of consumer price inflation. In the eurozone, the HICP inflation rate increased to 3.0% in September after 2.5% in August. Also the core inflation rate increased to 1.6% from 1.2% in August. Now also the underlying trend of inflation is getting closer to the crucial 2% mark. Thus, before cutting interest rates and embarking on a more expansionary monetary policy, the rate setting council might wait until the inflation data indicates that the peak has been reached. This would argue more for a rate cut at the end of this year or the beginning of 2012.

The fall of the manufacturing PMI for the eurozone to 49 in September and to 48.5 in October was probably a factor contributing to the warning of the ECB that downside risks for economic activity have increased. However, is seems that the turbulences in financial markets had an impact on the PMI, while actual economic activity is affected far less by the plunge of stock markets in August and September. The consensus of City economists expected that industrial production in the eurozone would decline by 0.8% in August. Instead industrial output increased by 1.2% on the month. While the fall of the PMI below the 50 threshold indicated a contraction in the manufacturing sector, industrial production expanded even faster than in July, which had been revised up to +1.1%. Despite increased risks, they have not yet materialized.

Thus, the ECB appears to be in a fix. Cutting rates early despite still robust economic activity data and inflation above the target by a full percentage point could prevent inflation to come down significantly next year. Waiting too long with a rate could bear the risk that economic activity eventually follows the PMI indicators down and that a possible downswing might be aggravated. This also indicates that the ECB would not be as quick in cutting interest rates as the market consensus had expected.

Keeping interest rates on hold will have an impact on gold and other precious metals via two channels. First, it has an impact on the exchange rate of the euro versus the US dollar. As long as money market rates remain higher in the eurozone compared to the US, there is an incentive to invest funds in the euro instead of the dollar. However, in this context also the eurozone debt crisis and the impact on the banking system play a crucial role. Plans to shield banks against the fallout of a possible default of Greece could reduce the risk of investing funds with European banks and thus could also contribute to a further appreciation of the euro versus the US dollar.

The second channel is via stock markets and risk appetite of investors. A delay of a rate cut due to firm economic data could reduce the fear that the global economy would head towards a recession. Value oriented investors already regard stock valuations as cheap after the drop in August and September. Thus, the risk appetite of investors could increase further and push stock market indices higher. A higher risk appetite would also be positive for gold and other precious metals.

Despite the better than expected economic data in the eurozone and also the US, the crucial factor remains the debt crisis in the eurozone. The G20 finance ministers urged the eurozone to present a solution to the debt crisis within one week at the next EU summit. Germany’s finance minister promised that the eurozone would deliver a solution. If it will be one convincing the markets, the euro might firm further and precious metals would probably be a beneficiary.

US economy is not heading towards recession

At least for now, the US economy is not heading towards a recession despite forecasts from some Wall Street economists. The most bearish forecasts came again from Goldman-Sachs’ team. Some weeks ago, we argued that one important factor for a US recession has not emerged and would be very unlikely to emerge, an inverted yield curve of US Treasury paper. The flight to safe havens and the announcement of “Operation Twist” by the Fed has pushed the yield on 10yr US Treasury notes to record lows and thus, the yield curve flattened. However, as the Fed keeps the Fed Funds target rate at the current level of 0.0 – 0.25% until the middle of 2013, an inverted yield curve is rather unlikely.

A major factor for the fear of a US recession had been US statistics. The financial and commodity markets were already nervous due to the political wrangling over lifting the debt ceiling, when US statisticians revised four years of GDP statistics downward. However, the market participants completely overlooked that GDP growth in Q2 remained below expectations but was above the revised growth in the preceding quarter. There is a saying “there are lies, damned lies and statistics”. But even worse appear to be US statistics, especially for the labor market. In September, the markets got spooked by the non-farm pay roll figures, which came in flat and the two previous months had been revised down. Last Friday, the non-farm payroll figure surprised to the upside by creating 103K new jobs in September, while the consensus of economists was looking only for an increase by 55K. However, also the figures for July and August had been revised up. Instead of no new jobs, the revised figures show now that 57K jobs were added to the payrolls in August. The pace of creating new jobs is still too slow to reduce the unemployment rate. However, it is not pointing towards a recession of the US economy. Therefore, more monetary stimulus remains still on the agenda of the FOMC meetings.

The survey indices of some regional Federal Reserve Banks plunged over the summer months. This had also an impact on the index of purchasing managers. The ISM index for the manufacturing sector dropped from 55.3 in June to 50.9 in July and many economists already predicted a fall below the 50 threshold in August. However, the manufacturing PMI only declined to 50.6, which was already a positive indication. In September, the PMI reversed direction and rose again to 51.6, which indicates that economic activity in the manufacturing sector is increasing again after the summer vacations.

Nevertheless, the US economy is not yet out of the woods. A major threat is the debt crisis in the eurozone. After reaching a compromise in July, eurozone finance ministers now talk about a bigger participation of the private sector in a bailout of Greece. Also discussions of a Plan B, i.e. a default of Greece and shielding other eurozone countries and banks, move towards centre stage. The major problem in dealing with the debt crisis is that politicians rule out sound instruments for obscure ideological reasons. Thus, politicians will always be one step behind the markets and can only react instead of acting strongly and impressing the markets.

A positive development was also noticed in the recent CFTC report on the “Commitment of Traders”. After two months of declines, the net long position of large speculators in gold futures rose again. Compared with the week before, the non-commercials added 5,355 new contracts to there net long position in the week ending October 4. Thus, the net long position rose to 133,156 contracts. However, in silver, the large speculators reduced the net long position further to a mere 11,900 contracts.

The improved US economic data indicates that the risk aversion of investors might not increase further but is more likely to decline again. This would be positive for the precious and the base metals. However, the debt crisis in the eurozone is a factor that keeps uncertainty at a high level. Therefore, any decline of investors’ risk aversion is probably only gradually. Against this background, we expect that precious and base metals are likely to stabilize. The bias is likely to shift towards higher prices. However, as long as no convincing solution of the eurozone debt crisis is found, we do not expect a strong upward move of metal prices. In the worst case of a Greek default, gold might profit as a safe haven, but other metal prices might plunge again.  

The flight of hedge funds out of commodities

According to academic working papers, large speculators have no influence on commodity prices and the price fluctuations only reflect fundamentals. However, the recent developments in commodity markets show a different picture. Academic studies focus on the concept of Granger causality. The time series used in those studies are often the “commitment of traders” data and the price of the corresponding commodity future. Lagged values of the net positions of non-commercials would have to have a statistically significant impact on current commodity prices to assume that large speculators would Granger-cause commodity prices. If there is only a significant relationship between current values of the net position held by non-commercials and the current commodity prices, then the hypothesis of Granger causality is rejected and the academic researchers conclude that speculators have no impact on commodity prices.

This concept, however, is not appropriate to judge if speculators have a significant impact on commodity prices in efficient markets. An increase of the net position held by hedge funds is supposed to have an impact on commodity prices only in the next period. This would imply that increased demand for commodities driven by hedge funds would have no impact on prices now, but would lead to rising prices next week. This is an absurd assumption. Every student in microeconomics 101 learns that an increase of demand leads to an immediate increase in prices. The buying or selling of non-commercials has a significant influence on commodity prices. And the decisions of large speculators are not only driven by expectations how fundamentals will develop.

Commodity prices have declined over the board recently. In the case of energy and industrial metals, the fear of a global recession is one of the driving factors. For gold, the status as a safe haven also plays a crucial role. A global recession could have a negative impact on the demand for gold from the jewelry sector, but given the debt crisis in the eurozone and the troika of IMF, EU and ECB still having to decide whether Greece would receive the next tranche of bail-out funds, one would expect that gold would be relatively stable. Nevertheless, since early August, non-commercials have reduced the net long position in gold futures continuously. And gold could not escape the sell off, which drove gold to as low as 1,550$/oz last week.

For agricultural commodities, the development of supply caused by weather conditions should have a stronger impact on prices than demand changes due to slower GDP growth in the US and Europe. Nevertheless, also grain prices dropped due to position liquidations by hedge funds and other financial investors. The current harvest season as well as delays in planting of winter wheat in the US should have more a bullish impact on grain prices.

Therefore, we can conclude that changes in risk aversion or risk appetite of financial investors could have a stronger impact on commodity prices than the usual fundamentals. However, this does of course not imply that all commodities would fall by the same percentage change. While also gold could not escape the massive selling pressure, its price declined less compared to other precious metals, which have a higher share of total demand for industrial usage. In the case of platinum, a global recession would have an impact on platinum demand from the automotive industry for catalytic converters. Thus, gold traded above the price of platinum and the premium of gold widened to more than 100$/oz. There is no long-run equilibrium relationship between the prices of these two precious metals that would limit the price spread. Thus, the spread could even widen more, especially if stock markets fall further and economic data will be weaker than expected. However, a stabilization of stock markets and a stronger than expected US labor market report next Friday could also trigger a narrowing of the premium of gold over platinum.

The correction of precious metals reached bear market territory last week, i.e. a decline of 20% or more from the previous high. Some technical analysts and former gold bulls now call the end of the long-run bull market in precious metals. We can not rule out such a scenario, especially not in the case that European politicians remain stubborn and react furthermore only slowly to the risks of the debt crisis. The warning calls from US President Obama and his Treasury secretary Geithner are fully justified. However, the main scenario is one of slow growth in the US and Europe with the risk of a technical recession. Asian emerging economies still grow at high single digit growth rates. Thus, a plunge of levels seen in the second half of 2008 and early 2009 for precious metals is currently not the main scenario.