Fed in panic lifts precious metals

Just when it seemed that disappointment over the still ongoing negotiations between Greece and the International Institute of Finance (IIF - an association of international banks) over the private sector involvement (meaning the voluntary hair-cut in a restructuring of Greek debt) would send gold prices lower again, the Federal Open Market Committee came to the rescue. After the release of the FOMC statement, gold rallied on a weaker US dollar and recovering stock markets. The announcement that it would be “… likely to warrant exceptionally low levels for the federal funds rate at least through late 2014” came as a surprise.

It appears as the Fed had acted in a panic mode. Compared with forecasts made in November, the Fed had reduced its central projection for GDP growth for the period 2012 – 2013, but increased the forecast for 2014. GDP growth in 2012 is now expected to be 2.2 – 2.7% and to increase to 3.3 – 4.0% in 2014. Inflation measured by the PCE deflator is expected to remain below 2% for core and headline inflation over the forecast horizon. While the Fed also lowered the projections for the unemployment rate, the decline is not fast enough from the perspective of the FOMC to reach the target level by mid-2013. Under these projections, it would be understandable if the Fed were keeping rates unchanged. However, communicating the projections and the implications for the Fed funds rate could have negative implications.

To some extent also due to the headlines in media, financial markets have understood the statement as a firm promise that the Fed funds rate would be held at the current level until late 2014. But forecasts are subject to revisions. If the assessment of the Fed turns out as being too pessimistic on GDP growth or as too optimistic on core inflation, then the Fed would have to tighten monetary policy before late 2014. This could damage the credibility of the Fed. But keeping the rates unchanged as promised and letting inflation rise above the target would also damage the credibility of the Fed. Thus, positive surprises for the economy could turn out as a problem for the credibility of the Fed. On the other hand, forecasts could become self-fulfilling. Signaling to keep the Fed funds rate unchanged for almost 3 more years might be interpreted by businessmen and –women as an indication that the economic recovery remains rather fragile. It could have a negative impact on expectations of future returns on investments and thus, lead to postponing business fixed investments further into the future. In this case, the announcement of keeping the Fed funds rate unchanged for such a long period could weaken instead of strengthening the economy.

In the FOMC statement, the Fed recognizes that “… growth in business fixed investment has slowed”. As a policy measure, the FOMC “…decided to continue its program to extend the average maturity of its holdings of securities…” Thus, operation twist is going to continue. We have some doubts that operation twist would lead to accelerating growth of business fixed investment. Empirical research showed that the steepness of the US Treasury curve is an important indicator for future US GDP growth. Certainly, we would not doubt that also the level of interest rates plays a role for business fixed investment. However, we are skeptical whether companies, which did not invest at yields on 10yr US T-notes at 2.0%, would invest at 1.5%. However, reducing the spread of corporate bonds or mortgage bonds over US Treasury paper might have a far bigger impact on business fixed and residential housing investment.

Fed chairman Bernanke pointed out that the debt crisis in the eurozone is one of the biggest risks for the US economy. We fully agree with this assessment. Probably, it already has a negative impact on US GDP growth. In many market comments on the US stock market, the debt crisis in the eurozone was a major factor weighing on sentiment and stock prices. The development of stock markets also plays a decisive role for business expectations and investment decisions. But, the Fed is not participating in solving the debt crisis in the eurozone. Due to legal reasons, the Fed can not provide funds to the IMF. However, the Fed could extend its balance sheet by acquiring foreign reserves – either by a swap agreement with the ECB or by interventions in foreign exchange markets. The later would also have the advantage of weakening the US dollar and stabilizing the euro. The increased foreign reserves could then be invested in government bonds of Italy, Spain and France. This would reduce the yields on bonds of these countries and would reduce the fears that these countries would have difficulties to place their bonds. As has been seen since the start of this year, easing tensions in the eurozone peripheral bond markets are positive for stock markets in Europe, but also in the US.

The Fed policy of keeping the Fed funds rate at record low levels until late 2014 has a positive impact on gold via a weaker US dollar. However, if the Fed would shift the focus of its policy from lowering yields on US Treasury notes and bonds towards strengthening the US stock market and thus, sending positive signals to US companies, but also consumers, then the precious metals probably would get an even stronger positive impulse. 

US Dollar again a supportive factor for precious metals

In the previous blog article, we discussed the temporary divergence between the US dollar and the price of gold. This week, the US dollar had been again a supportive factor contributing to strong gains of the precious metals compared with the previous week close.

At the time of writing this article, Greece has not yet reached a deal with its private creditors. However, Reuters reported that the Hellenic Republic would be close to reach an agreement, which would imply a debt reduction by 60 – 70%. Such a volunteer agreement might provide further support for the euro. However, it remains still unclear whether a sufficient percentage of private investors would accept such a deal. It has been reported that some hedge funds insist on being fully compensated, either by Greece or by the CDS bought. Greece on the other hand still has the option to pass a law that introduces a collective action clause, which would make an agreement with the majority of the bond holders binding also for those bond holders, which did not accept the deal. However, the rating agencies already announced that imposing a collective action clause would imply that the deal is not a voluntary but a forced agreement and thus, would be regarded as a default. But for triggering the credit event for the CDS, it is the decision of the ISMA, which is relevant. Nevertheless, even in the case that Greece is reaching a deal, there are still some stumbling blocks on the road for a recovery of the euro. Even some set-backs can not be ruled out. But in the case of a positive development, the euro might contribute further to rising prices of precious metals.

Another supportive factor had been auctions taking place last week after the downgrades by S&P. France and Spain met strong demand at their auctions and could place the paper at lower yields compared with preceding auctions. Thus, the downgrade, which had been already widely priced in, did not worsen the funding situation in the eurozone. Next month, the ECB will provide banks again with 3year funds, which should ease the tensions in the government bond markets further.

The ZEW indicators for Germany and the eurozone are based on a survey. However, unlike the PMI indices, these diffusion indices are based on surveys of fund managers and analysts at financial institutions. Therefore, the ZEW indicator is less reliable for indicating turning points of economic activity. The ZEW indicator is far more influenced by the recent movements in stock markets. Another feature of this indicator is that some of those polled by the ZEW also provide forecasts for this index. However, the economists often underestimate the magnitude of index changes. This had also been the case last week. The ZEW indices rebounded far stronger than the consensus of economists predicted. This was positive for the precious metals via two channels. On the one hand, it contributed to the recovery of the euro and on the other hand, it also contributed to further rising stock markets.

As in the week before, stock markets had again a positive impact on precious metal prices. Beside the ZEW indicator, also the Chinese GDP in the final quarter of last year contributed to rising stock market indices. The Chinese GDP growth at 8.9% was less than in the preceding quarter (9.1%), but it was stronger than the consensus forecast. This positive surprise reduced the fears of a global recession to some extent. Also US economic data contributed to the further increase of the S&P 500 index, which was positive for precious metals. After the strong rise of stock markets at the start of 2012, the markets are now overbought from a technical perspective. Thus, it could not be ruled out that stock markets enter a consolidation, which would also be a negative factor for gold and other precious metals.

Gold is facing some technical resistance in the range of 1,670 – 1,675$/oz, some reaction lows from late November last year. Taking out this resistance requires support from the fundamental drivers. The technical situation of crude oil already turned negative despite the geo-political tensions. The stock markets are in an upward trend, but vulnerable for a consolidation. The recovery of the euro against the US dollar might continue, however, the risk of a set-back due to the developments within the eurozone should not be neglected. Furthermore, also the technical situation of the precious metals is overbought. Therefore, the risk of failing to take out the resistance zone appears to overweigh the chance for a further rally. Thus, holders of long positions should tighten their stops.  

Gold and the euro – neither decoupled nor a crisis hedge

Gold and the euro – neither decoupled nor a crisis hedge

                                                            

The first nine trading days of the year 2012 had been positive for gold. Compared to the close of the preceding year, gold rose by almost 100$/oz. The euro, on the other hand, came already under pressure after the Christmas holidays. The trigger had been a big sell order in cable in a thin market, which also dragged the EUR/USD exchange rate lower. After rebounding at the first trading day of this year, the euro weakened again versus the US dollar. However, the US dollar also firmed against other currencies and the US dollar index increased. Therefore, some market commentators already talked about a decoupling of gold from the US dollar movement.

Correlation is not causation. Thus, a weaker or even inverted correlation over a short period of time is not an indication that the traditional relationship between gold and the US dollar has broken down. Furthermore, the correlation coefficient would only be a suitable indicator if the there were only a mono causal relationship between gold and the US dollar. In econometric models for the price development of gold, the US dollar index would have to be the only significant explanatory variable. However, this is not the case! In our quantitative fair value model for gold, other variables like the S&P 500 composite index or the price of crude oil also have a statistical significant impact on the price of gold.

The implication of various factors having an impact on the price of gold is that other factors could move stronger and thus could more than compensate the impact of the US dollar. This is exactly what happened during the first two weeks of this year. The increase of the official PMI in China but also better than expected US economic data including the ISM indices triggered a rise in stock market indices as fears of a global recession decreased somewhat. This also had a positive impact on the price of crude oil, which also profited from geo-political tensions. The Western countries are preparing an embargo of oil imports from Iran while the regime in Tehran threatens to block the Strait of Hormuz. Furthermore, crude oil got support from a strike in Nigeria.

A major factor is still the concern about funding requirements of various countries in the eurozone. The placements of short-term money market paper went well. Germany could even sell 6mth bills at a negative yield. But more important, other countries, which had to pay higher rates in late 2011, could place their papers at lower yields. The litmus test had been the auctions of longer dated paper by Spain and Italy on Thursday and Friday last week. Spain found strong demand and sold twice as much as initially intended. Also Italy’s auction on Thursday went well. This had been positive for gold as it supported the euro and also stock markets moved higher.

However, last Friday showed that gold is not a perfect hedge against the crisis in the eurozone. Italy could raise the amount announced at lower yields. However, the market was disappointed about the bid/cover ratio, which was much lower compared to Spain’s auctions the day before and Italian auctions in December (when yields were far higher). This example shows that expectations are not always rational in financial markets. The Italian auctions already weighed on the EUR/USD exchange rate and lead to stocks paring earlier gains. Gold also traded lower dragged down by the firmer US dollar and stock market indices giving back gains. However, the major blow came in the afternoon.

Some eurozone government sources acted like criminal market manipulators by leaking to Reuters and other media that Standard & Poor’s would downgrade several countries in the eurozone, without providing further details. Normally, the rating agency announces a downgrade of a sovereign debtor after the close of US markets. The agency stuck to this procedure also last Friday. The downgrade rumors and the uncertainty about which country would be downgraded by how many notches sent shock waves through markets. The euro dropped by more than 2.5 cents and stock markets turned negative. Gold could not escape and also traded lower.

The US stock market recovered and closed near the high of the day. France was expected to be downgraded by two notches, but S&P reduced the rating by only one step to AA+. Thus, the initial reaction during European trading hours might have been an overshooting to the downside. Nevertheless, as we have pointed out several times, bad news about the debt crisis in the eurozone is no longer positive for gold, as it might have a negative impact on the major factors for the price of gold.

Thus, we still expect that gold will trade rather volatile during the first quarter of 2012 and could fall below 1,500$/oz. However, improvements of the crisis situation in the eurozone might set the stage for a strong upward move.

Precious Metals in 2012

At the start of a new year, it is a tradition to provide an outlook for market developments during the year. Therefore, we will stick to this tradition also in this blog. We participated again at the annual forecast survey of the London Bullion Market Association LBMA, which released its survey for 2012 last Friday.

Reuters reported at the beginning of the New Year that Gold imports by India, which is the world’s biggest consumer of gold, in the fourth quarter of last year plunged by more than 50%. According to the Bombay Bullion Association, India imported last year a total of about 878 tons, down by 8% from 958 tons in the preceding year. Gold is used mostly for jewelry in India. Furthermore, gold is usually in demand during the final quarter of the year due to the festival season. This development indicates that the jewelry industry is probably again not the major driver for the price development for gold. As prices have risen also for platinum and palladium, the attractiveness of the PGMs as a substitute for gold in the jewelry industry has been reduced. Therefore, for all precious metals, we expect that the price trends in 2012 will be mainly depend on the demand of investors or central banks.

Some gold bugs argue that central banks would buy gold to back their currency by gold. We don’t expect a return to the gold standard in the foreseeable future. Another argument for central banks returning as net buyers of gold is that the ratio of gold held by some central banks would be relatively low compared to other major central banks. Thus, especially Asian central banks with high foreign reserves would have to catch up by buying more gold. We are not convinced by this argument as it assumes that central banks would adopt a rather primitive form of portfolio management. Central banks hold most of the reserves in US dollar denominated assets. However, they have to report the balance sheet and profit & loss statement in local currency. Thus, the return on the foreign reserves should compensate for a possible depreciation of the US dollar against the local currency. This implies that beside the return of alternative assets, also the foreign exchange rate movements are a major factor for the portfolio allocation. Yields on US government notes and bonds do not provide a sufficient cushion against a US dollar weakness. Furthermore, the yield on 1yr US T-Bills is currently at 0.1% while the 12 month gold lease rate is above 0.4%. Thus, lending gold already yields a higher return than an investment in US T-Bills. Longer maturities offer a slightly higher return but also the price risk increases with a longer duration of government notes and bonds. For the 10yr US T-Note, a rise of the yield by only a few basis points is sufficient that the coupon income for one year is lost by falling prices. The negative correlation between the US dollar and the gold price is another factor, which has to be taken into account. Normally, the price of gold rises more in percentage terms than the US dollar weakens. Therefore, it is more the risk and return consideration of portfolio management in the current environment instead of some dubious historical or international comparisons, which argue that central banks are likely to increase their gold holdings further.

The correction of precious metals in the final four months of 2011 was driven by fears of a global recession. The major cause for those fears is the debt crisis in the eurozone. In the US, the recession fears were overdone. Not only did the GDP expand further in H2, the economic data also came in stronger than economists predicted. The labor market is also improving. New jobs are created albeit not at the pace of former economic recoveries. Nevertheless, it provides support for the private consumption. The car sales figures also underline this development. In China, the central bank has reduced the reserve requirements after the headline inflation rate came down. Further monetary easing during 2012 is expected, which would prevent a recession. The Chinese economy is likely to grow at a rate of 9.0 – 9.5% this year. This is below the double-digit growth during boom periods, but also clearly above the 8% mark, which is often regarded as a recessionary level. Therefore, the industrial demand for precious metals should remain supported.

The debt crisis in the eurozone is very likely the most important driver for gold once more. The first quarter might be very critical and could lead to increased volatility of precious metals. Even a decline below the lows made during the final four months of 2012 could not be ruled out. The financial markets still fear that some countries might fail to attract enough capital for refinancing maturing bonds. The eurozone has to agree and ratify a treaty on a “fiscal compact” as agreed on the December summit. Greece has to reach a deal on a volunteer debt restructuring with private investors and also has to secure further financial assistance by the troika. The recent remarks by PM Papademos were targeted to Greek lawmakers. While they were intended to push through necessary reforms to avoid disaster, they underline which stakes are at risk.

During the first quarter, three possible scenarios might evolve. The worst case would include a default of Greece, which might lead to collapse of the euro in the current form and/or a shock to the financial system comparable to the bankruptcy of Lehman Brothers in 2008. In this scenario, gold might be in demand as a safe haven again. However, some investors might have to sell gold to cover losses of other assets, which would limit the upside of gold. Other precious metals might fall strongly in this scenario as fears of global recession are likely to intensify.

The second scenario would be that a default of Greece will be avoided but the debt crisis in the eurozone would not be solved. Instead, politicians continue with buying just time. This scenario might be the worst one for gold, but the second best for the other precious metals. Prices might decline below the lows recorded in the first quarter. The euro might weaken further against the US dollar, which would be negative. This would weigh on the prices for precious metals. However, if the debt crisis does not get worse, the precious metals might be more in a sideways market with increased volatility.

The best case for the precious metals would be a solution of the debt crisis. In this case, the euro is likely to recover against the US dollar. Maybe even more important, the fears of a global recession would subside. The stock markets are likely to recover and also crude oil is expected to head higher. In this scenario, all the major fundamental factors in our quantitative fair value models would be positive. Thus, precious metals with the exception of silver might reach new record highs toward the end of the year.