Volatility is back but gold's price move is not rational

Periods of low volatility are often harbingers that volatility will increase again and that the market will move strongly in one direction. This had been the case last week in the gold market. After trading back above the 1700$/oz mark, gold dropped almost 70$ to the low of the week, which is a move of 4% from the weekly high to the low.

Normally such strong moves are the result of new information, which change the fundamentals driving the price development of a particular market. This has not been the case. Gold dropped on Tuesday and Thursday and analysts blamed the looming fiscal cliff for the fall. However, on Tuesday, they argued that avoiding the fiscal cliff would reduce the appeal of gold as a safe haven. Investors who bought gold as a hedge against the impact of the US economy falling over the fiscal cliff would now sell gold and would move into more attractive assets. However, according to analysts, the plunge on Thursday was triggered by the failure of House speaker Boehner to push through a plan B, which did not found enough support from his own party. Especially the Tea Party fraction of the Republicans opposed any tax increase.

Even if reporters asked different analysts, the point is that the arguments provided for the fall of the gold price on both days are contradicting. Either falling over the fiscal cliff is negative for gold (then reaching a compromise should be positive for gold) or avoiding the fiscal cliff is negative, but then withdrawing plan B should be positive for gold.

From our point of view, avoiding the fiscal cliff should be positive for gold. The impact of the automatic tax hikes and spending cuts kicking in would be a far stronger drag on the US economy. Thus, reducing the overall size of measures to reduce the federal budget deficit in a situation where US GDP growth is still anemic would be positive for the economy. It could also end the hesitation of companies to invest, which is the result of the uncertainty whether the fiscal cliff could be avoided. Monetary policy would remain extremely accommodative as long as the thresholds set by the recent FOMC decision where not reached. This would be positive for the major fundamental factors of the gold price. Therefore, we regard avoiding the fiscal cliff as positive for gold and not as negative. A further upward move of stock prices, a recovery of crude oil and a weaker US dollar are all beneficial for gold.

Last week, we briefly mentioned that Goldman Sachs revised their forecast for gold in 2013 and got bearish on precious metals. During this week, we found in media reports more about the reasons why the perma bulls on commodities turned negative for gold. According to these reports, Goldman Sachs expects that the US economy develops better and that the Fed would have to increase interest rates earlier than the FOMC indicated. Real interest rates would get positive again and this would increase the opportunity costs of holding gold. Therefore, investors would sell gold and invest in notes and bonds. This argument is logically flawed and not convincing!

In the case that the fiscal cliff will be avoided, it is a possible scenario that the US economy surprises and grows stronger than expected. Companies might create more jobs and the unemployment rate reaches the threshold of 6.5% far earlier than the majority of the FOMC currently expects. So far, one might agree with Goldman Sachs that the period of extremely accommodative monetary policy ends sooner than the market has priced in currently. However, for real Fed Funds target rate to become positive again, the FOMC would have to hike the nominal rate by at least 175bp in 2013. Which conditions would have to be fulfilled for the Fed to change monetary policy so aggressively? The US GDP growth would have to accelerate dramatically from below to far above potential output growth and the output gap had to be closed. A real economic miracle would have to come true. But in this scenario inflation would not remain well behaved. Rising energy costs would already lift headline CPI inflation. But also an increase of the core PCE deflator above the Fed’s 2% target had to be expected in this scenario. Thus, nominal Fed funds target rates would have to be hiked by more than 2%-points that the real Fed funds rate (adjusted by the core PCE deflator) turns positive. However, some investors have bought gold as a hedge against inflation, especially as some buyers of gold feared that quantitative easing by major central banks would eventually lead to higher inflation rates. Why should those investors lift the hedge when it is needed most?

Furthermore, what would be the impact of the Fed hiking the Fed funds target rate earlier than the consensus currently prices in and especially in the case of aggressive rate increases as the Goldman Sachs forecast of positive real rates suggests? Bond markets would not remain unaffected. It is not likely that the Fed would lift the Fed Funds target rate aggressively higher but maintains buying in the US Treasury and mortgage bond market at the magnitude of 90bn US$ per month. QE would probably end abruptly in this scenario. Thus, demand for bonds will drop. And it is not likely that the potential shortfall of bond demand by the Fed will be compensated by other investors. 

US Treasuries already provide a yield below the inflation rate. As the conditions for a strong turnaround of the Fed policy imply an increase of the inflation rate, the appeal to invest in conventional notes and bonds would be reduced further. Some investors accept the negative real coupon income of US Treasuries based on risk aversion and/or expectations of capital gains. But capital gains could no longer be expected once the Fed starts to increase the Fed Funds rate. Thus, some investors in the US bond market might turn into sellers.

Currently, the spread between the yield on 10year US Treasury and the Fed Funds rate or 3m Libor is rather small given the extremely accommodative stance of the monetary policy. However, at 150bp above Fed Funds or around 145bp above 3m Libor, it is still at a level attractive for carry trades. This situation would change once the outlook for the Fed policy would turn negative. If the buffer between coupon income and funding costs narrows further, the risk of capital losses exceeding this buffer increases. Thus, speculations of a reversal of Fed policy would trigger unwinding of carry trades in the US Treasury market. Another source of demand for US Treasury notes and bonds would dry out.

If Goldman Sachs were right about real interest rates turning positive again in 2013, then the bubble in safe haven US government bonds would deflate. However, also mortgage and corporate bonds would not be immune and also suffer losses. The necessary conditions for real positive interest rates by the Fed increasing rates as well as the implications for the fixed income markets don’t argue for selling gold and investing proceeds in bonds. Quite the opposite! There is only one scenario of real interests rates getting positive again, which could be negative for gold. In this scenario, the US economy would have to head towards outright deflation. However, in this case the Fed monetary policy would get even more extremely accommodative. But was not more QE an argument for buying gold provided by many analysts?

We wish all readers a Merry Christmas and a happy New Year. The next blog article will be published on January 6, 2013.     

On gold, the Fed and the BIS

In this article, we will comment on the impact of the most important central bank and the bank of central banks on gold. The most important central bank is of course the Fed, not only because many central banks hold part of their gold reserves in the vaults of the Fed, but also because the recent FOMC statement moved gold last week. The Bank of International Settlements, the BIS, is the bank of the central banks. According to many web-sites and e-mailed newsletters, the BIS should be responsible that the price of gold would double overnight on January 1, 2013. In both cases, there is a major lack of understanding from our point of view. The FOMC statement should not be negative while the BIS would not be positive for gold.

According to Sir Karl Popper, one example that proofs a theory being wrong would be enough to falsify the whole theory. Developed primarily by economists from the Chicago School, it is now mainstream economic theory that financial markets would be information efficient. The reaction in financial and commodity markets after the release of the FOMC statement provide another example that markets are not always information efficient.

What caused the negative market reaction in equity and commodity markets had been the following lines of the FOMC statement: “In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.”

According to some comments made in the media, markets reacted negatively because they were surprised by the link of the highly accommodative stance of monetary policy to certain levels for the unemployment rate and the inflation outlook. This argument was especially given as explanation of the plunge of gold the next day in early Asian trading hours.  However, already the minutes of the preceding FOMC minutes highlighted that the FOMC discussed those links. Also several members of the FOMC referred to providing more guidance to financial markets and the real economy by stating explicitly at which levels of its two targets a change in monetary policy has to be expected.  Thus, if markets were really information efficient, this part of the FOMC statement should not have surprised many traders and investors.

Another argument had been that this link would have increased the uncertainty about the end of QE. Especially politicians of the Republican Party dubbed QE3 as “QE infinity” expressing their disgust of the Fed policy. However, it should have been clear to every professional investor or trader that QE will end someday. The FOMC provides now strong indications under which circumstances this would be the case someday in the future.

In addition, some commentators argued that markets would fear that the FOMC might end the period of exceptionally low Fed Funds rates earlier than the FOMC indicated in fall, when the members expressed their conviction that rates would be at the current level until 2015. However, this fear is also not justified as the FOMC states further. “The Committee views these thresholds as consistent with its earlier date-based guidance.” Therefore, nothing indicates that the FOMC has changed its assessment and intends to increase the Fed Funds rate before 2015.

But even in the case that the FOMC would have to hike interest rates earlier than currently indicated, would it be really a rational argument to sell gold? After the December 2012 FOMC statement, the markets know under which conditions an end of the current monetary policy would occur. It is either a fall of the unemployment rate below the 6.5% threshold or a worsening of the medium-term inflation outlook. In the case that a fall of unemployment is the trigger, this would imply that companies hire more workers. But companies hire only more staff if the demand for their products increases, which also implies that corporate profits will grow further. This would lead to higher stock market prices and the demand for risky assets would also lead to higher prices for gold. If on the other hands higher inflation is the reason for hiking interest rates, then gold should profit as a safe haven against accelerating inflation rates. Thus, there is no rational reason to sell gold only because the Fed might end its current monetary policy before 2015. The conditions for a pre-mature termination are favorable for gold and not negative.

Many web-sites and e-mailed newsletters contain statements that the BIS would make gold to a tier 1 asset with effect of January 1, 2013. The current risk weighting of gold were 50% and thus, the new rules of the BIS would lead to banks buying gold and thus prices doubling overnight as the New Year will begin. This is nonsense! If the price of gold would really double on the basis of a BIS decision, it would double as soon as the decision is made public at latest and not only at the date the measure would become effective. Otherwise, there would be an arbitrage opportunity that many smart hedge funds and banks had already exploited.

A first warning that this story is probably wrong could be got by a search at Google for BIS, gold and tier 1. Among the list of web-sites returned, we did not find the internet site of the BIS. Strange, isn’t it? Normally you would expect that this site should be at the top of the list because it would be the official source for any change of the gold’s role in banking supervision. Also a search at the BIS web-site did not lead to any result supporting the claim made on many web-sites and e-mailed newsletters. In the best case, this story is based on a misunderstanding. In the worst case, it is an intentional misguiding of investors by snake-oil salesmen.

January 1, 2013 should be the start date for new rules of banking supervision, also known as Basle III. One part of Basle III is the definition of banks’ capital. This consists of equity capital and retained earnings. In a broader definition, also some hybrid financing instruments are counted as capital. However, in no case is gold part of banks capital! Banks might have some liabilities to deliver gold in the future. But those liabilities are not equity capital. If banks hold gold, then it is an item on the asset site of the balance sheet.

One part of the already existing bank regulation is that assets have to be backed by capital. Various assets have different percentages, the risk weighting, which are counted against the capital of banks. If all assets had a 100% risk weighting then banks could not be leveraged and all assets had to be funded by equity capital. The risk weightings range currently from 0% (government bonds) to 150%. If gold had to be backed by 100% instead of 50%, then the costs for banks to hold gold would increase. This would not be an incentive to buy gold, but to reduce the gold holdings. There are also provisions for liquidity holdings, but also in this case, gold should retain a 50% RSF (Required Stable Funding) weighting.

Another subject is the counter-party credit risk and the role of gold as eligible collateral. Under Basle II, gold is one of the eligible financial collaterals under paragraph 145. This paragraph will not change in Basle III. Also the haircut of 15% of current market value will not change under Basle III.

Most of those web-sites and e-mailed newsletters promoting gold based on changes in the BIS rulings are based in the USA. However, Basle III is probably not being implemented in the US. Thus, US banks have no interest in pushing the price of gold higher under the Basle III accord. 

Conflicting signals for gold

Gold and silver came under selling pressure again this past trading week. However, this time it was not at the start of trading in the US. On Tuesday, in the Asian afternoon, gold came under pressure and fell through the low made the Friday before. This triggered further selling, which pushed gold down another 10$/oz. However, as the US trading session began later, gold also fell through the 1,700$/oz mark, which was regarded as support. During the further course of the week, gold and silver recovered, but were unable to pare the loss and ended the week lower. The PGMs on the other hand held fairly stable at the start of the week and advanced later to end the week higher. Thus, the question arises, why do gold and silver underperform the PGMs lately?

One factor supporting the PGMs had been the Platinum interim report from Johnson Matthey, which predicts that the market would be in a deficit. Statements this week from Norilsk Nickel that Russian palladium exports would decline due to decreasing Russian palladium stocks gave the market further support. This would explain the outperformance of the PGMs, but not the diverging price movements, which had been observed on some days. Also quantitative models show that there is a mutual impact of precious metal prices on the price of other metals of this group. Thus, there must be other reasons for the underperformance of gold and silver.

There appears to be a shift in sentiment for gold and silver among analysts and investors. This past week, Goldman Sachs – usually one of the most bullish Wall Street investment banks on commodities – revised their forecast for gold next year downwards. Analysts polled weekly by Bloomberg are normally bullish on the outlook for gold during the following week. Bullish readings below 50 occur but are seldom. The most recent survey shows a drop of the bullish index from 64.52 to 45.16 and the bearish index increased from 19.35 to 32.26. Thus, analysts are still slightly bullish on balance. However, the difference between the bullish and bearish index is at such a low level, that it approaches the region of extreme lows for this survey. Extreme analyst pessimism is often a good buy signal for gold.

The net long position in Comex gold futures held by large speculators had risen in November. However, the increase of the preceding three weeks had been almost completely wiped out by reducing longs and increasing short positions in the week ending December 4, according to the recent CFTC report on the “Commitment of traders”. The net long position dropped from 193,742 to 165,736 contracts. However, the non-commercials increased their net long position in silver futures further by around 2,500 contracts to 41,272 contracts.

On the other hand, the holdings in the SPDR Gold Trust ETF have risen this week by around 4.5 tons to 1,353.35 tons. However, hedge funds investing in this ETF appear to hold the positions over a longer period. Short-term trading oriented hedge funds seem to prefer the futures market. Thus, we interpret the recent development as dominated by short-term traders, while long-term oriented investors still accumulate gold holdings. This short-term selling reflects the uncertainty about the result of negotiations to avoid the fiscal cliff in the US. It is more a reflection of increasing risk aversion among investors.

A negative factor for gold had been the firmer US dollar against the euro, especially after the ECB press conference. As Mr. Draghi stated that the council discussed to levy a fee for deposits at the ECB by 25bp (also referred to as negative deposit interest rate), the forex and government bond market immediately speculated on a cut of the lending rate at the next meeting from 0.75 to 0.5%. However, Mr. Draghi also explained that the council refrained from this step because it believes that the announcement of OMT had pushed yields on peripheral government bonds much lower than another cut of the lending rate could do. Furthermore, in some countries, there is growing opposition on reducing the refinancing rate further because some banks would use this opportunity to borrow funds from the ECB and invest them in corresponding national government bonds. The ECB did not lower interest rates despite cutting the forecasts for the GDP in the eurozone significantly. It appears that the council prefers to keep the powder dry. Thus, the speculation on another ECB rate cut might be short-lived. The euro might recover the longer the ECB hesitates to reduce interest rates further. This would then be a supportive factor for gold.

As stated several times, our base line scenario is the US fiscal cliff will be avoided by a final hour compromise. Therefore, the current negative sentiment among analysts and short-term oriented traders might present a good buying opportunity for medium-term oriented investors in gold and silver.

Safe haven gold hit by a tsunami

Over the last few years, not only gold bugs but also analysts at serious banks stated that gold would be a safe haven in the case of recession and deflation. Many of those analysts also pretended that gold would be a good hedge against inflation. Already economic logic indicates that gold could not perform well in both cases. And the development of precious metals during this past trading week underlines that it is not compatible to serve as a safe haven in the case of inflation and deflation.

On Wednesday, gold plunged with the start of trading in the US. Ross Norman, the CEO of Sharps Pixley (a UK based gold trading house), was the first who pointed out that futures representing 24 tons of gold had been sold within a few minutes at the start of gold futures trading at the CME. Also on Friday, gold and other precious metal came under selling pressure with the start of trading in the US. One explanation for the losses on both days was that investors sold gold on worries about the possibility of a looming fiscal cliff as talks to find a compromise made no significant progress. But is it really rational to sell 24 tons of gold within a few minutes if the US economy will fall over the fiscal cliff?

Let’s assume that no compromise to avoid the automatic tax hikes and spending cuts from kicking in. What would be the economic consequences? Only a few European economists, among them probably the former chief economist of the ECB, would argue that this fiscal austerity would lead to higher growth rates as the multiplier effect of fiscal policy measures is below unity and the reduction of the budget deficit would encourage the private sector to increase economic activity. However, most economists and investors at Wall Street fear that the fiscal cliff would lead to a pronounced recession of the US economy. The unemployment rate would rise again, which would induce the Fed to lift the size of quantitative easing. Many investors regard an inflated Fed balance sheet as positive for gold. Furthermore, a deep recession would also lead to some stress for the financial system and the number of bank failures could increase again. The core inflation rate would head lower and might flirt again with deflation in this scenario.

If increasing the magnitude of quantitative easing or the risk of deflation or the combination of both is really positive for gold, then it would be irrational to sell 24 tons of gold on worries about a failure to reach a compromise avoiding the fiscal cliff. However, if the sellers of the gold acted rationally, then the arguments for gold as a safe haven have no sound footing. From our point of view, the latter is the case. As the development of last week showed, if investors fear a recession or deflationary tendencies, instruments with a fixed nominal income like the conventional US Treasury notes and bonds, offer the better risk and return profile. Furthermore, we pointed out that quantitative easing by the Fed is not a necessary condition for rising gold prices.

Another argument for the plunge of gold and other precious metals prices at the start of trading in the US on Wednesday was that of the usual fat-finger suspect. We are also not convinced by this argument. The fat-finger describes an error at entering the order. In this case, it would imply that the number of contracts to sell has been a multiple of the intended size, often by a two or three digit factor. Usually, fat-finger orders leave a typical trace in the tick or one minute charts. After the order had been worked through and had been fully executed, the market normally rebounds for two reasons. First, the error will be detected by the seller sooner or later. If the exchange will not cancel the erroneous order, the seller would have to correct his error by buying back futures, which lift the price higher. Second, if the market still regards the drop as not justified by market fundamentals, bargain hunting sets in, which also pushes prices higher again. Fat-finger orders often lead to a rebound of the price close to the level before this erroneous order was placed and executed. This was not the case in the gold future, which pared only a small fraction of the loss on Wednesday and Friday and only some hours after the plunge occurred.

High frequency trading plays a more and more important role also in the electronic trading of commodity futures. In the grain markets, commercial hedgers already complained that HFT has increased volatility and makes commercial hedging more difficult. Thus, one possible explanation might be the combination of a fat-finger order triggering the drop, which was aggravated by algorithms of HFT companies switching to selling futures too. However, it appears as rather unlikely that this happened on Wednesday and on Friday.

During the last few weeks, it has been pointed out in this blog, that our base line scenario is a final hour compromise to avoid the fiscal cliff, but the road to such a compromise would be a bumpy one. Thus, the strong declines on Wednesday and Friday might be just the result of higher risk aversion among investors. Nervous investors fearing a failure to reach a compromise sold gold but due to the political uncertainty other investors were only willing to absorb the supply at far lower prices. As long as there are no signs for a compromise being reached, the downside risks prevail, even in the case that the fiscal cliff will be avoided. 

Precious metals head higher as risk appetite increases

Most precious metals got two strong impulses to move higher last week, one at the start and one at the end of the trading week. But neither of these two moves was related to quantitative easing or possible changes in the Fed policy as discussed at the recent FOMC meeting (linking current policy stance on certain levels for inflation and unemployment). The triggers were increases of investors risk appetite. However, this reduced risk aversion is related less to economic than more to political factors. If those political factors develop favorably then precious metals could climb further.

The push higher last Monday was based on hopes that US policy makers will avoid that automatic tax hikes and spending cuts kick in, which would lead to the US economy tumbling over a fiscal cliff. Politicians from both parties underlined the willingness to find a compromise. Due to the Thanksgiving holiday, there was not much movement. However, negotiations are likely to resume quickly. This could be positive for precious metals as long as there is progress towards a compromise. Our base line scenario is that a compromise will be found just in time to avoid a fiscal cliff. However, political bargaining is seldom leading to a quick compromise. One should always keep in mind the lack of patience in Wall Street in July 2011. Despite a compromise to lift the debt ceiling was found in the 11^th hour, the stock market declined as investors lost patience. Therefore, it can not be ruled out that sentiment among investors turns sour again and institutional investors withdraw funds from commodity markets.

On Friday, the push higher was also based on hopes that a political solution will be found, but this time the focus was on Greece. The next payment from EU and IMF is already overdue. However, eurzone finance ministers and the IMF could not find an agreement on whether Greece would need another debt restructuring. But now, it seems that a solution could be found next Monday. However, more important for Greece than just receiving funds to avoid bankruptcy, it would be to relax the imposed conditionality of the bailout. As long as requested fiscal austerity leads Greece deeper and deeper into depression, the less likely it will be that the Greek debt/GDP ratio will reach a peak. Nevertheless, a decision to release funds for Greece would be positive for the euro, stock markets and thus also for precious metals.

Positive news came also from various business surveys. The flash estimate of the HSBC manufacturing PMI for China surprised to the upside. The index rose again above the crucial 50 threshold. This manufacturing PMI now confirms what other economic data already indicated, namely, that the Chinese economy is growing again at a faster pace. But also the manufacturing PMI for the eurozone and some member countries showed a stronger rebound. In Germany, also the ifo business climate index posted a surprising increase, thus, paring the drop in the previous month. The recovery of the manufacturing PMIs indicates that also the eurozone economy is likely to stabilize and not to head further into recession. This is another positive factor for risky assets.

After China, the US and the UK, now also the eurozone shows signs of improving economic data. This should be positive for stock markets. It should also lead to a weaker US dollar as investors risk appetite is likely to increase and they invest also more outside the US financial markets. An improved economic outlook should also be a supportive factor for crude oil prices. However, here also the supply side has to be taken into consideration and new technologies (fracking) could lead to an increasing supply. However, the critical factors remain political decisions. If these political decisions will be also favorable for risky assets, then funds are likely to be flowing out of the safe havens of government bonds, the US Treasury notes and the German bunds. This could give precious metals another push higher. 

NEW SECTION: Research Papers and Products

In this blog, a new section had been added, where we will present some research of QCR Quantitative Commodity Research Limited. We will present summaries of the research free of charge. However, fully detailed research results might be available only for purchases, especially if this research could by applied for trading in financial and commodity markets.

The first contribution is titled:

A Timing Model for Stock Markets

Stock markets play a major role for the price developments of commodities, see also this weeks blog article below. The S&P 500 index is one explanatory variable in our fair value models for precious and base metals. Thus, it is essential to analyse the future direction of stock markets for drawing conclusions and providing forecasts for price trends in metal markets. QCR has developed a macro-economic indicator for this purpose. This indicator could also be used for timing long and short positions in stock markets. The following document provides a summary and shows the test result for a trading strategy based on the indicator. This document could be downloaded for free. However,  a document on constructing the macro-economic indicator could be purchased from QCR. Please, contact us by e-mail at qcr.research@t-online.de for further details.


  The free document is available as Rings on stock exchanges summary.pdf;   

Mixed bag for precious metals

Last week, we recommended remaining cautious as the post US election rally was not supported by the major fundamentals. This week, gold and silver gave back a part of the gains made during the preceding week. Only the PGMs performed better. While platinum ended the week slightly in the plus, palladium posted a stronger gain. The reason for this outperformance was the surprising 2012 interim report from Johnson Matthey, which predict a swing from a supply surplus to a deficit. But also for the PGMs, the further short-term development will depend essentially on stock market movements.

During the week following the US election, large speculators increased again their long position in gold futures and reduced slightly the short position according to the recent CFTC report on the commitment of traders. Thus, the net long position of the non-commercials increased 11,418 to 171,594 contracts.  The net long position in silver held by large speculators increased by only less than 300 contracts to 34,410 contracts in the week ending November 13. We interpret this development as hedge funds have channeled money back into gold on the relief that Mr. Bernanke will remain chairman of the Fed and that quantitative easing will not come to an abrupt end.

However, the development of the past week underlines that quantitative easing is not a sufficient condition for a rally in precious metal markets; it is only a supporting factor. And it is also not a necessary condition. As the case of the PGMs has demonstrated, the factors driving demand and supply are moving the prices.

In our quantitative models, the US stock market is a highly significant factor for the price development of the four precious metals. However, the S&P 500 index serves as a high frequency proxy for economic activity, which is measured in monthly or even only quarterly intervals. Expectations about future economic activity have an impact not only on the investment demand for precious metals, but also for consumer or industrial demand. This has been underlined last week with the release of the gold demand and supply report of the World Gold Council, which showed a decline of global gold demand in Q3 this year. Also demand in China declined as the pace of economic activity had slowed. Thus, it should not come as a surprise that precious metals often trade in line with risky assets.

One factor cited for the fall of major stock markets last week was the preliminary Q3 GDP data in the eurozone. Former ECB chief economist Stark always pretended that austerity fiscal policy would lead to economic recovery. However, the multiplier effect of fiscal policy measures is not below unity as Mr. Stark but also IMF officials tried to make believe. Flawless quantitative research shows that the multiplier effect is not a constant but varies with economic conditions. This has also been the result of a recent IMF working paper. In a recession, fiscal austerity is not leading out of the recession but could trigger a vicious circle. Greece provides currently the best example for this inappropriate economic medicine prescribed by the troika of EU, ECB and IMF. As more and more countries were forced to implement a restrictive fiscal policy, it is no wonder that the eurozone entered into the second recession after 2009. But the decline of the eurozone GDP was slightly less than the consensus of economists had predicted.

Normally, one would expect that the impact of the eurozone GDP data would not be that strong on international stock markets. However, combined with the fear of a fiscal cliff possibly looming in the US, the sentiment was bearish. Many stock markets posted the second weekly loss in a row, which dragged also gold and silver lower. Thus, the developments at major stock markets remain the key for precious metals.

Last Friday, the first meeting between leaders of both parties in the Senate and the House took place in the White House. Both sides made slight moves and emphasized to work towards avoiding the fiscal cliff. This has lead to stabilization in the US stock market, with the major indices posting the first daily gain since the US election. We expect that a compromise to avoid the fiscal cliff will be reached, but it might be an 11^th hour compromise. Therefore, precious metals might remain on a bumpy road during the final few weeks of 2012.  

US Presidential Election leads to rise of precious metals

Precious metals rose in the week of the US Presidential Elections with gold and silver recouping the loss of the preceding week. Gold and silver have also broken through the short-term downward trend line of the correction. However, this movement is not backed by all of the major fundamental factors. Furthermore, the strong move up on Tuesday was based on two conflicting arguments. Therefore, we would remain cautious, i.e. staying long but having tight stops in place.

On Tuesday, while the poll stations were still open and votes not counted, gold and silver triggered a rally in line with other risky assets. The US stock market rose on speculation that Mitt Romney would become the next US president. Gold and silver moved also higher after the US stock market was closed and votes were counted. As exit polls and first voting results showed a lead of Mr. Romney this move was consistent so far. However, these predictions were still in line with opinion polls, which showed that incumbent president Obama would win a second term. But after all major US TV-stations called Obama winning a second term in the White House, gold and silver advanced further. Now the argument of the gold bulls was that Fed Chairman Bernanke would stay in office at least until the end of his term and that quantitative easing would not end anytime soon. This behavior is not consistent. If a continuation of quantitative easing would be a necessary condition for precious metals to move higher, the initial trigger for the rise on Tuesday was not justified.  

In early computer trading, the US stock index futures turned negative again while the poll stations were still open at the US East coast. But after it was clear that president Obama won a second term, also stock index futures turned positive again. However, after Wall Street opened, the US stock market plunged. This behavior demonstrated again that stock markets are by no means always efficient and that all available information is already priced in. The projections based on opinion polls and scientific methods showed all that the incumbent president would also be the next one. Therefore, a victory of Mr. Obama should have been discounted. But it appears that donations of many Wall Street companies eclipsed rational behavior and led to a wishful thinking behavior in many trading rooms.

At the US stock market, the fear is now that the US is heading towards the fiscal cliff. However, also a Romney win would not have changed the situation, which should also have been discounted. The polls also showed that the majorities in the Congress would not change; the House would be dominated by the republicans and the Senate by the democrats. And the election results brought no surprise and confirmed the projection of the polls. This also should have been priced in.

Wall Street appears to react like Skinner rats, Obama is negative for stocks. This was also obvious last Friday. Positive economic data triggered a recovery of the US stock market. The statement of House majority leader Boehner had no negative impact. However, when president Obama spoke, the US stock market pared gains. Both underlined their positions but also affirmed the willingness to find a compromise.

From our point of view, the risk for not finding a compromise is neither president Obama nor Mr. Boehner, who showed willingness to compromise already in the summer last year. The problem is the fundamental opposition by the Tea Party fraction within the republicans. But Wall Street does not understand the political behavior in Washington. A compromise is probably not found quickly, but more likely towards the last hour. Agreeing to a compromise quickly is regarded often as a sign of weakness and not negotiating hard enough. This leads to the risk, that the US stock market might be driven more by fears of falling off the fiscal cliff then by the economic data, which shows more and more signs of economic improvement.

If Wall Street will be driven more by political fears instead of sober rational analysis then it remains doubtful whether precious metals would move higher. A weak US stock market and a firmer US dollar are usually negative for precious metals. And even more quantitative easing would not be able to prevent the negative consequences if the automatic tax hikes and spending cuts kick in at January 1, 2013 in the USA. Therefore, we would keep tight stops for long positions in precious metals. However, in the case that a compromise to avoid the fiscal cliff should be found quickly, then precious metals are likely to rally further strongly.

Strange reaction in precious metals markets, better keep the powder try

The US labor market report has the reputation of causing higher volatility in financial and commodity markets. Last Friday, this had been the case again. While it appeared before the release of the non-farm payroll figure and the unemployment rate that precious metals might end the week higher, the labor market report triggered a u-turn and precious metals posted strong losses on the day. Gold and silver closed near the low of the week and lost 2% and 3.75% respectively. Only the PGMs managed to hold quite well in the week over week comparison with palladium even ending slightly higher than the Friday before. However, what is puzzling is the reaction in financial and commodity markets following the release of the US labor market report. Thus, for the time being, we would keep the powder try.

The non-farm payroll figure came in much stronger than expected by Wall Street economists. While the consensus was looking for 123K new jobs, the US economy added 171K persons to the non-farm payrolls. Also the figure for the September was revised up from 114 to 148K and August number was revised to 192K from 142K (already revised higher in the October report from originally reported 96K). The unemployment rate edged up from 7.8 to 7.9%, which was essentially unchanged as the Bureau of Labor Statistics stated in the official release.

Some commodity analysts argue that the drop of precious metals prices is based on expectations the Fed would not provide more liquidity following the strong labor market report. However, those traders selling precious metals based on this argument should read the two recent statements of the FOMC more carefully. At 7.9% the unemployment rate is still far above the target level of the Fed and also far away from a level the FOMC would consider to withdraw further monetary stimuli. Thus, US economy is improving after the weak second quarter and this labor market report provides further evidence. However, it requires a miracle that the US economy would produce so many new jobs that the Fed would terminate QE3 anytime soon. Nevertheless, it is a widespread misperception that precious metals would require further liquidity injections to move higher.

We pointed out several times that precious metals trade in line with other risky assets and therefore, the risk aversion of investors is crucial for the price movements. The reaction in markets for risky assets following the release of the US labor market report was very strange. Initially, stock index futures rallied. But only shortly after Wall Street opened, the market turned direction and closed down around 1% lower on the day. Position liquidations were not limited to stocks, but spread also to other commodities. Crude oil, another major fundamental factor for the price of precious metals, plunged by more than 2.6% on the day. As the labor market surprised strongly on the upside, the selling pressure across the markets for risky assets could not be attributed to the buy the rumor and sell the fact behavior of some traders and investors.

Some commentators argued that financial markets would now price in a victory of incumbent US president Obama at the election next Tuesday. Furthermore, they stated that Wall Street would regard a victory of president Obama as positive for safe haven Treasury paper while a victory of Mr. Romney would be positive for stocks. However, the weakness of this argument is that opinion polls showed for some time already that president Obama would win at least the Electoral College votes, even before hurricane Sandy hit the northern parts of the US East coast. Thus, it appears as really strange that investors start to price in a re-election of US president Obama just a bit more than one hour after the release of the US labor market report, which normally should have lifted stocks and commodities higher.

The sentiment of large speculators for commodities has definitively changed during the month of October. We pointed out that the sentiment worsened with the earnings reporting season as many companies provided a very cautious economic outlook. Some commentators also pointed to window dressing operations by hedge funds as for many managers the business year ends with the October ultimo. The recent CFTC report on the commitment of traders shows that the net-long position of non-commercials dropped further in the week ending October 30 to 170,222 from 182,043 in the preceding week. This would be fully compatible with window dressing operations. However, the massive position liquidations on Friday and the flight into safe haven assets can not be explained any longer as window dressing.

So far, we regarded the correction of precious metals more as a buying opportunity as the fundamental economic data surprised on the upside. Economic data of the two major economies is still better than economists predicted. However, the reaction of various markets for risky assets last Friday indicates that something is wrong when markets do not react positive on good news. Maybe markets react again normally after the Presidential Election next Tuesday. Until the markets show again normal reaction, we would keep the powder try. 

Increasing risk aversion hits precious metals

As pointed out over the last few weeks, the risk on and risk off trades of investors not only move stock and the safe haven government bond, but also the metals markets. Given the movements of the major fundamental drivers over the last week, gold and silver held quite well, while the PGMs and other industrial metals have been hit hard. However, is the pessimism among investors and traders really justified?

Economic data released during the course the week in the two major economies came in stronger than expected. In China, the flash estimate of the HSBC manufacturing PMI increased from 47.9 to 49.1. While this reading is still below the threshold of 50, it is the turn-around that matters. Also the recent Chinese data on Q3 GDP growth showed a strong 9% annualized quarter-on-quarter growth, which also points to a rebound. These figures are good indications that the slow-down of the Chinese economy has come to an end. Also US economic data surprised positively. The GDP growth increased from 1.3% in the second quarter to 2.0% in Q3 according to the first estimate. Durable goods orders rose 9.9% on the month, while the consensus was looking for a smaller rebound. Also the core durable goods orders rose stronger than predicted by 2.0% while the consensus expected only an increase of 0.8%. Nevertheless, the US stock market ended the week lower.

We pointed out over the last two weeks, that many corporate companies give a very cautious outlook for their business going forward. To some extent, this is part of a strategy to dampen expectations of analysts, which then makes it easier to beat earnings estimates in the next quarter. However, to some extent, it also reflects the uncertainty by business leaders. Again, the Fed did not provide a positive guidance. The assumption that business leaders base their decisions on rational expectations had been falsified by reality again and again. Akerlof and Shiller were right in pointing out that animal spirits, a term coined by Keynes, have a strong influence on decisions. Thus, part of any economic policy should be to influence the psychology of decision makers. The FOMC statements of the latest two meetings appear more as a self-defense for the implementation of QE3 instead of providing an encouraging outlook now that QE3 has started. Therefore, it appears that investors’ sentiment is worse than justified by the economic data and outlook of the two major economies.

In Europe, the United Kingdom surprised with reporting GDP growth in the third quarter. However, the major problem is still the eurozone. It gets more and more obvious that the German narrative that fiscal austerity would lead the eurozone out of the crisis is absolutely wrong. The mercantilistic German economic system is now feeling the result of describing the wrong medicine. Germany’s economy relies on exports and car sales. But with pushing Southern Europe into a recession, the demand for German export goods declines. Also car sales in Europe plunged. Business leaders postpone or even cancel big ticket orders, which have a negative impact on new orders of the German manufacturing industry. Therefore, it is not surprising that the German manufacturing PMI flash estimate showed another drop and the ifo-index was dragged down by a fall of the current situation assessment.

The automotive sector had been hit hard. Car sales in the eurozone plunge. France intends to provide financial support for its car companies. Ford considers closing three plants in Europe. The German manufacturer Daimler had to revise down the earnings forecast. All these factors had negative impacts on stock prices of European automotive companies. Therefore, platinum and palladium were under stronger pressure this week. But also the easing of the strike situation in South Africa contributed to the decline of PGM prices.

“Those fundamental things apply as time goes by”. This line from the lyrics of the famous song of the movie Casablanca also describes quite well the behavior at financial and commodity markets. At the end, the fundamentals are the major factors driving prices. As some major economies like the US, China and the UK show signs of an economic improvement, the outlook for gold and silver remain positive. However, the PGMs might continue to underperform as long as political leaders in the eurozone do not find a solution to solve the crisis quickly. 

“Get greedy when others are fearful …”

“… and fearful when others are greedy”. This quote from Warren Buffet applies not only to stock markets but also for precious metals. Precious metals dropped on the first and the last trading day of this week. However, the economic outlook is better than the markets are currently pricing in. Thus, we regard the current weakness as a buying opportunity and not as a reason to sell.

The drop on Monday, where gold fell more than 1% while silver and palladium dropped around 1.7% and platinum plunged 2.2%, was attributed to selling by funds, which took profits. This view is supported by the statistics on holdings of the underlying metal by the biggest ETF for gold and silver. The SPDR Gold Trust ETF recorded a decline of gold holdings by almost 7 tons on Monday to 1,333.9 tons on Monday. Silver holdings in the iShare Silver Trust ETF fell by around 9 tons to 9,885.5 tons. Also the CFTC report on the “commitment of traders” showed a strong drop of long positions in gold futures held by the large speculators. They fell by 14,413 to 232,988 contracts in the week ending October 16. As the non-commercials also increased the short positions, the net long position declined even stronger by 17,329 to 194,020 contracts. In silver, the large speculators reduced the long position only slightly, nevertheless, the net-long position even increased by 303 to 40,128 contracts as closing short-positions was stronger.  

The drop of precious metals prices on Friday was triggered by the fall of stock prices on Wall Street. While the S&P 500 index manage to post a small gain in the comparison with the close of the week before, the index lost almost 1.7% from the previous day. It was not the 25^th anniversary of the crash in 1987, which drove prices lower, but disappointment about earning reports. Even if a company met earnings expectations, analysts wrote negative comments based on some figures being lower than estimated. Also the cautious outlook given by the companies weighed on sentiment. Investors feared the economic outlook would darken and uncertainties would rise.

However, this pessimism is not justified by the economic data released during the week. US retail sales in September rose 1.1% from the previous month while the consensus expected an increase of 0.7% only. Industrial production increased by 0.4%, twice as fast as the consensus predicted. Headline CPI inflation rose 0.6% compared with a forecast of 0.4% and core inflation was a modest 0.1%. This should be negative for US Treasury notes, but positive for precious metals. Furthermore, data from the housing sector also surprised on the upside with housing starts and permits coming in stronger than expected. Also the Philly Fed manufacturing Index rose far stronger than the consensus forecast. Beside positive data in the US, also the ZEW sentiment index for Germany and for the eurozone increased further.

Thus, the economic data indicates that the economic situation is improving and not worsening. As pointed out already in the article last week, companies provide often a more cautious outlook to lower earnings expectations. If analysts then revise down their earnings estimates, it would be easier for the companies to beat the lower earnings estimate. Therefore, we put more emphasis on the economic data, which is pointing towards stronger growth. This should be positive for the risky assets and negative for the so-called safe havens of US Treasuries and German Bunds, which offer yields below the headline inflation rates. These negative real yields are another argument to prefer real assets like precious metals as the opportunity costs are rather low. Also the risk/reward perspectives are more promising for precious metals than for safe government bonds. Thus, we regard the current weakness as a buying opportunity.  

Give Greece and growth a chance

Many commodity analysts currently recommend gold based on the argument that quantitative easing by central banks in industrialized countries would lead rather sooner than later to accelerating inflation. Only a few days ago, commodity analysts from Germany’s number two bank, Commerzbank, gave such a recommendation. But how is this compatible with the development of last Friday? Gold lost 0.76% on the day and ended the week near the low. Silver and platinum lost around 1.75% and palladium even plunged by almost 3.5% on the day. This all happened on the same day the US Department of Labor released the producer price index of finished goods for September jumped by 1.1% mom, which was far above the consensus forecast of 0.8%. This divergence could not be explained by a buy the rumor sell the fact behavior as precious metals weakened already during the whole last week. However, it underlines that inflation fears are currently not the main factor behind the demand for precious metals. It is still more the swings between risk aversion and risk appetite of investors, which move the price of precious metals.

However, also the reaction in the US Treasury market appears as not being rational. The core PPI remained unchanged in September. We have pointed out several times in this blog that there is a difference between inflation and change in relative prices. Thus, the core PPI figure indicates that there is no inflationary pressure in the pipeline. But this is not an argument for buying instruments with a fixed nominal coupon. In order to preserve the purchasing power of the capital invested, the return should be sufficient to buy the same basket of goods in the future. This is currently not the case in the US Treasury market. Yields on conventional 10yr T-Notes are even below the core inflation rate. Investments in US Treasury paper produce losses in real terms for a broad range of maturities. That investors buy T-Notes indicates that investors’ risk aversion is increasing currently.

Two factors contribute currently to the higher risk aversion. First, the World Bank presented its forecasts for global growth, which had been revised down surprisingly more than expected. Also the IMF lowered its forecast for GDP growth in its Global Economic Outlook ahead of the IMF autumn summit, which took place this weekend in Tokyo. The track record of official forecasts from the two Washington twin-institutions is not the best one. Quite the opposite, they usually are ranked in the lower quarter. Political considerations seem to have an influence on the forecasts. Currently, the IMF recommendation is to reduce deficits further, but not at a pace that strangles economic growth. This is also reflected in the recommendation of the Tokyo summit to the US and Europe.

In this context also Greece is back in the spotlight. Last week, the German economic research institutes presented their semi-annual expert report. Beside lowering the GDP forecast for this and next year, they also commented on Greece. Several members voiced the opinion that Greece would not manage to solve its problems and would have to leave the eurozone. Also Sweden’s finance minister Anders Borg talked about a Greek exit on Saturday. However, already last Tuesday at a visit in Athens, German chancellor Merkel affirmed that Greece would be kept in the eurozone. This Sunday, also German finance minister Schaeuble rebuffed speculations on Greece leaving the eurozone. Furthermore, he stated there would not be a Greek default on government debt.

The recent comments indicate that Germany softens its stance on Greece. The German government appears now determined to provide further support to prevent a Greek exit. Thus, Germany might follow the advice from IMF head, Christine Lagarde, to give Greece the time of two more years for reaching the budget target. However, this would also require that the IMF delegate of the troika softens the demands for further austerity measures. Contrary to statements of former ECB chief economist Stark, fiscal austerity in a recession is not leading to a recovery. This has been demonstrated by the development in the eurozone periphery. It has also been shown with empirical evidence in a recent IMF working paper. It is time that finance ministers recognize this fact. Giving Greece more time would be an important step to solve the debt crisis. At the IMF summit, there was also talk that Spain would apply for help from the ESM in November, which would pave the way for the ECB to buy Spanish debt in the secondary market.

Another interesting proposal came from ECB council member Asmussen. He recommended Greece to borrow fresh money and to buy back old outstanding debt. This proposal is not new and had been made already last year by the head of the ESM, Mr Regling. If official holders of Greek government debt would sell the bonds back to Greece at current market prices or even book entry levels, Greece could reduce its outstanding debt significantly. A volunteer sell back at book entry values could hardly be classified as illegal government financing by the ECB.

The second factor has been the start of the earnings season. Alcoa usually kicks the reporting season off and beat earnings expectations after adjusting for one-off items. However, the outlook, which Alcoa gave for the aluminum market, weighed on market sentiment. This also explains the pressure on aluminum prices at the LME and the Shanghai Futures Exchange. But not only Alcoa, also other companies provided a more cautious outlook for the current and future quarters. This lead to a series of losing days at Wall Street and also other major international stock markets. Also that Apple lost a trial against Samsung on patent violations dragged stock prices lower.

Stock markets have ignored positive economic data released in the US but also in other economies since the start of this month. It is also a traditional behavior of companies in uncertain times to paint a more cautious outlook. However, the recent economic data indicates that the economic situation is improving, not only in the US but also in several European countries as rising industrial production figures in Italy, Greece and France underline.

The comments from the German government on Greece avoiding a government default and remaining in the eurozone are positive. It could be expected that the EU will provide further support to Greece. Also the hints that Spain would ask for help from the ESM should be positive for risky assets. And the recent economic figures indicate that economic activity might get traction again, just at a time when institutes revise growth forecasts lower. Thus, we expect that investors risk appetite will increase soon again. This would be also positive for the precious metals. The current consolidation is probably a buying opportunity and not the start of a trend reversal.

Trend remains up for precious metals

It was a positive week for precious metals on balance. The PGMs performed especially well while silver, which rose strongly in the weeks before, just managed to post a small gain. However, all four precious metals ended down on Friday. This already led to questions whether the upward trend in precious metals would be over. From our point of view, it is not and precious metals have further upside potential in the weeks and months to come.

Last week, the focus had been again on Spain and the question when the government will ask for a full rescue by the EFSF/ESM. Reports Spain could already apply for a bail-out as early as this weekend had been rejected by the prime minister and later also by the finance minister. But the statements by ECB president Draghi during the press conference led to a recovery of the euro, which was also positive for the precious metals.

The first Friday of a new month is usually the day where US labor market data will be released. Trading activity in many financial and commodity markets remains often range-bound ahead of the data release. But it was the reaction of precious metals after the numbers of new jobs created and the unemployment rate had been published, which was rather strange. The non-farm payroll figure came in just as expected by the consensus of Wall Street economists, but the previous months had been revised up. The surprise was the development of the unemployment rate. The consensus among economists predicted an increase from 8.0 to 8.2%. However, the unemployment rate declined 7.8%, the lowest rate since January 2009 when president Obama took office.

One reaction in commodity markets, especially in the crude oil pits, was that traders stated they do not believe the numbers were true. Also the comment by former CEO of GE, Jack Welch, on twitter that the numbers were manipulated by the administration to help the re-election of incumbent president Obama increased the disbelief in financial and commodity markets. The decline of the unemployment rate had been the result of people leaving the workforce. We pointed out some weeks before, that this is the normal behavior if jobs are hard to get. However, when the conditions in the labor market improve again, some workers return to the workforce and apply again for jobs. Thus, there is no rational reason to believe the allegations that the labor market report was faked.

Reuters wrote in a market report, that gold had been sold as the labor market report dimmed the safe haven demand. This statement does not make much sense as an increase of the unemployment rate is usually not a reason to buy gold. One factor behind the recent rally of precious metals had been the third round of quantitative easing by the Fed. The FOMC decided in mid-September to buy $40bn of mortgage backed securities per month until the unemployment rate had reached the target of the FOMC. Some fund managers voiced at TV stations like Bloomberg that this would be QE indefinite. As also the consensus forecast indicates, markets had priced in that the Fed would buy MBS for quite some time. However, if the unemployment rate continues to decline at the pace of the last two months, the target of the FOMC might be reached far quicker than assumed. Thus, some traders might fear that the Fed would provide much less liquidity through QE3 than assumed and therefore also less capital would flow into precious metals.

From our point of view, it is rather unlikely that the unemployment rate in the US will decline to full employment level only due to workers leaving the workforce. Also an increase of the pace of new job creation per month would be required. This will only be the case, if also economic activity accelerates stronger. At the recent GDP growth, the Fed is not expected to end the expansionary monetary policy anytime soon. Thus, the reaction in precious metals markets on the labor market report is overdone. A pick-up of economic activity would also be positive for precious metals. Stronger GDP growth should be positive for stock markets and should lead to higher equity prices. An increase of investors’ risk appetite is normally also positive for the demand for precious metals. Furthermore, stronger growth would also be supportive for crude oil prices, which are another fundamental factor for the price development for precious metals.

In our base line scenario, we expect the situation in the eurozone to stabilize. Furthermore, we expect that there will be a last minute compromise to prevent the US economy falling from a fiscal cliff. Thus, US GDP growth is assumed to increase again, which would be positive for stock markets and the oil price. Also in China, we expect further stimulus measures. This all should contribute to a decline of risk aversion by investors, which would be positive for precious metals. The rally is just taking a breather and is far from being over already.

Precious metals expected to perform positive in Q4

Precious metals are still in consolidation but held quite well during the past trading week. This is a positive indication given the fact that the debt crisis in the eurozone is back in the spotlight and fears over economic growth had a negative impact on the main fundamental drivers of precious metal prices. Thus, the chances are still good for a positive final quarter in the precious metals market.

In this blog, we pointed out several times that precious metals perform better when the risk appetite of investors increase and that a flight into the safe havens of government bonds is a burden for metal prices. This has been the case again last week. There were two factors, which caused a rise of investors’ risk aversion around the middle of the week. Both were not rational.

The German ifo-index surprised with another decline while the consensus among economists predicted an increase after the ECB presented the details of the OMT program for purchasing government bonds in the secondary market and the German constitutional court paved the way for the ratification of the treaty to create the EMS. However, the recession in many countries of the eurozone had a negative impact on the assessment of the current business conditions and the expectations for future developments. This initially weighed on stock markets. However, on Tuesday, the S&P 500 index pared the loss of the previous day and was also trading above the close of the previous week when suddenly the risk aversion of investors rose again. The triggers were two statements. First, asset management company Blackrock stated that the rally in the US stock market were over. This prediction of one of the biggest funds managers already led to some profit taking. However, more devastating was the statement by Philly Fed president Charles Plosser that he voted against QE3 because it would be ineffective and would lead to inflation.

The market reaction on the comments by FOMC dissenting voting member Plosser is another demonstration that the Chicago School theory of rational financial markets is falsified by the reality. Animal spirits, as first described by John Maynard Keynes, also play a major role in financial and commodity markets. Traders and investors in the stock market did not recognize the contradiction of Mr. Plosser’s comment. First, if Mr. Plosser were right that QE3 would not stimulate economic growth then the US GDP would grow further below output potential. In this case, production capacities and the labor force would not be fully utilized. Even if the unemployment rate and the capacity utilization rate would stagnate then there would be no risk of rising inflation, quite the opposite! However, if QE3 were leading to rising inflation rates then GDP growth would have to accelerate, capacity utilization would have to reach full employment levels and the unemployment rate would have to fall quickly towards the natural rate of unemployment. Thus, a rise of inflation rates would require that QE3 is highly effective in reaching the target of the FOMC. Furthermore, at the Jackson Hole seminar in late August, Fed chairman Bernanke presented sufficient empirical evidence that QE I and II were already working and contributed to stronger GDP growth compared to a situation without quantitative easing. Therefore, markets reacted irrationally on the Plosser comments and acted more according to the shoot first and ask later behavior.

Also irrational was the reaction of markets on the protests against austerity measures in Spain and Greece, which partly turned violent. Even a failure of Germany in an auction of 10yr Bunds and a successful auction of Spanish government paper could not prevent a flight into the safe haven of Bunds and US Treasuries combined with weaker stock markets. However, governments in Western democracies don’t bow to pressure of demonstrations. Investors are wrong to compare the situation with upheavals in Arabian countries. The Spanish government passed the 2013 budget with the required austerity measures, which are mainly spending cuts, on Thursday. This led to some relief among investors and the euro recovered against the US dollar. Also the result of the stress tests of Spanish banks did not bring negative surprises, which calmed further the nerves of jittery investors.

The Fed is likely to be successful again with QE3. Thus, we expect US GDP growth to pick up again. Also Spain will ask for a rescue by the EFSF/ESM sooner or later, which will also trigger buying of Spanish government bonds with maturities of up to 3 years by the ECB. Furthermore, also China is expected to take measures to stimulate GDP growth. This all should be positive for the major fundamental drivers of precious metal prices. Therefore, we expect that precious metals to perform also positively in the final quarter of this year.