Metals on the decline, but for how long

Base metals and precious metals posted losses this week with the exception of gold, which managed to end the week marginally higher due to a rebound on Friday. While the US dollar on balance was a supportive factor for metals, the two other major drivers were not. After investors preferred risky assets in the week before, safe haven government bonds were in demand again since the middle of the week. The reason for the increased risk aversion is a renewed fear about global growth.

A well received auction of 2yr German government notes (Schatz) was the trigger for a rebound of safe haven buying. This move accelerated with the presentation of the UK budget. Furthermore, fears about Spanish public finances flared up again, which drove yields on Spanish government bonds up and the prices of safe haven German Bunds rallied. This recovery of bond markets had already a negative impact on stock markets and also on metal markets. This reaction in bond markets demonstrates again that financial markets are not always rational as academic theory postulates. The new Spanish government has made a wise decision. The austerity measures already implemented and the eurozone debt crisis cause a slower nominal GDP growth than previously expected. This has of cause an impact on the budget deficit, which would not decrease in per cent of the GDP as much as intended. Instead of imposing further austerity measures, the new government of PM Rajoy decided to accept a lower decline of the deficit/GDP ratio. Another round of spending cuts or tax hikes would have a much more severe impact on GDP growth and could be even counter-productive as the case of Greece shows. The bond vigilantes also overlook that Spain has already included rules of balancing the budget in the constitution. Spain also pledged to reduce the budget deficit further, but will not take measures, which could deepen the recessionary developments.

Metals markets came under stronger selling pressure on Thursday after the release of flash PMI surveys. In China, the HSBC manufacturing PMI dropped from 49.6 to 48.1. The official Chinese PMI is currently above the 50 mark. Furthermore, it is not always moving in the same direction as the HSBC PMI. However, also in the eurozone, the manufacturing and the service sector PMIs surprisingly declined and even Germany was not immune against a weaker economic outlook in other eurozone countries.

There is a widespread believe that a reading of the PMI below 50 would imply that economic activity is contracting and that a reading over 50 would imply expanding activity. This also explains that journalists at a business TV station stated that China would be in a contraction for the fifth months in a row. However, this 50 mark is not a sharp threshold. Quantitative analysis shows that even with a PMI at 48 the industrial production might increase compared to the same month of the preceding year.

A further point to keep in mind, when interfering from the PMI level to economic activity, is the construction of this index. The PMI is a diffusion index. A sample of purchasing managers is surveyed and the percentage of negative replies is subtracted from the percentage of positive responses. This balance fluctuates around zero. In order to keep the values of the PMI positive, 50 is added to the balance of positive vs. negative replies. However, not all companies included in the sample have the same size and the same contribution to industrial activity. Larger sized companies usually contribute more to industrial production than smaller ones. Thus, the distribution of responses over various classes of company sizes also plays a crucial role. Consider the following scenario where there might be more negative replies from small companies than from large companies. This would be negative for the PMI and could lead to a reading below 50. However, the production increase at large companies could over-compensate the shortfall at smaller companies and thus, overall industrial production could increase.

Chinese recent economic data is sending some conflicting signals. According to the latest figures from the customs office, Chinese copper imports reached the third highest level last month. Rising copper imports don’t argue for a massive slow-down or even contraction of economic activity in China. Some analysts argued that copper was only imported to serve as collateral for short-term funding. This argument is rubbish because it does not make any economic sense to buy copper solely for the purpose of using it as collateral. Of course, companies use copper inventories as collateral for short-term funding. However, importing copper serves the primary purpose of maintaining a certain level of inventories. If companies import more copper then they expect a pick-up of future domestic copper consumption. Furthermore, copper inventories at LME warehouses are declining.

All in all, we expect that metal markets are likely to remain in a consolidation and trading range market for the time being. Growth concerns bias the risk to the downside. However, monetary policy is expansionary in the US and Europe. Also the Chinese central bank started to loosen monetary policy. This should prevent a hard landing. We expect therefore that metal prices would be higher, in particular in the second half of this year.    

Precious metals and the Fed

The major driving factor for precious metals, which all ended the week lower with gold and silver suffering most, was the FOMC meeting. Thus, we look closer at the impact of the Fed policy on precious metals. We conclude that the risk is more biased to the downside.

The flight into safe haven assets was not only driven by the development in Greece, but also by the monetary policy of the Federal Reserve System in the US. On the one hand, the current “Operation Twist” has pushed yields on longer dated US Treasuries lower as private investors also bought US Treasury paper ahead of the Fed purchases. On the other hand, the market speculated that the Fed would implement another round of quantitative easing, called QE3. This has kept the price fluctuations of the 10yr US T-Note future in a narrow trading range for several months and yields on 10yr T-Notes hovered slightly below the 2% level.

The precious metals profited from this development via three channels. The first one is the link between the price of precious metals and the US Treasury yields. The ultra-low yield level had reduced the opportunity costs of holding precious metals, which don’t yield any direct returns. The second link was via the foreign exchange rate. The expansionary monetary policy has lead to a weaker US Dollar against some major currencies. For the EUR/USD exchange rate, also the debt crisis in the euro zone played a role. Nevertheless, the stronger precious metal markets in the first two months of this year were accompanied by a weaker US dollar.

The third channel is via the stock markets. After the plunge in August, the expansionary monetary policy of the Fed was supportive for the stock markets. The tensions in the eurozone debt crisis caused some set-backs. However, after also the ECB took unconventional measures to flood the banking system with liquidity, the tensions eased. Of course, it was also helpful that economic data in the US surprised to the upside.

The FOMC provides an improved outlook for the US economy compared with the preceding statement. The committee has not provided any hint that QE3 would be implemented. While the FOMC continues “Operation Twist”, it also does not give any indication that this program would be extended beyond the scheduled end in June this year.

After the release of the FOMC statement, the US dollar came under pressure and a sell-off in the US Treasury market set in. However, the S&P 500 index still ended the week with a gain of 2.4%. This development explains that the PGMs declined far less in percentage terms than gold and silver.

Recent economic data indicates that the US economy is likely to expand further. The surveys of the Federal Reserve Banks in New York and Philadelphia rose stronger than the consensus of Wall Street economists predicted. The University of Michigan consumer sentiment index declined according to the preliminary data for March. However, the link between consumer sentiment and spending is not a very close one. Spending has increased also in the past despite falling sentiment. Therefore, we expect the US economy to expand further at around the pace seen in the final quarter of last year. But at a GDP growth of 3%, the Fed is unlikely to change its current policy stance. This implies even the risk that the current program of extending the maturity of its US Treasury holdings might not be extended.

Thus, the yield on 10yr US Treasuries might climb higher towards the 2.5% mark. Furthermore, the US dollar is probably going to hold fairly stable against major currencies or even to appreciate. Both factors would be negative for precious metal prices. However, an expanding US economy is likely positive for the stock market, which should also profit from shifting funds out of bonds into equities. This would be a supportive factor for precious metals and especially for the PGMs, which might perform better than gold and silver in the short-term horizon. But all in all, it has to be expected that the correction in precious metals markets is probably not over yet.

Also the flow of funds data points to a further correction. According to the latest CFTC report on the “Commitment of Traders”, large speculators have reduced their net long positions again. In the week ending March 13, they reduced the long positions in gold futures by almost 8,000 contracts to 190,477 contracts but increased the short positions by almost 5,000 to 39,571 contracts. Thus, the net long position fell by 12,359 to 150,906 contracts.

Some weeks ago, we argued that from a technical perspective gold should find support around 1,640$/oz. Gold has found indeed support at this level. However, also from a technical perspective, gold is not yet out of the woods. Some indicators point to an oversold market, which would argue for buying at support. However, the downward trend is still strengthening as the rising ADX indicates. This indicator is furthermore not yet at a level, which would indicate that the downward move is overdone. Also the MACD is still declining faster than its signal line. Thus, the knife appears to be still falling. Currently, we would stick to the old advice of never catching a falling knife.

Focus is still on Greece

At the beginning of the new trading week, the focus in precious metal markets is likely on Greece. After more than 85% of holders of Greek government bonds issued under Greek law accepted the offer of a debt swap, the Greece government activated the collective action clause. Late last Friday, the International Swap Dealers Association decided that this action would be a credit event, which triggers payments from credit default swaps. Normally, this should not be negative for the precious metals as this decision should have been expected. However, it can not be ruled out that stock markets react again negative, especially in Asian and European trading, and drag the precious metals lower.

Last week, precious metals prices came under pressure at the start of the week. The major reason was a drop in stock markets after China revised down the GDP forecast to 7.5%. However, the markets focused only on the headline in the media and fully ignored that the Chinese government also announced to take measures to promote domestic consumption. Also the uncertainty over the result of the Greek debt swap offer weighed on the markets. However, as it became clear ahead of the dead line that Greece would reach the required volume of debt swaps, stock markets as well as crude oil prices recovered, and thus, also precious metal prices moved up again. However, only gold managed to end the week in the black.

A negative factor was the US dollar, which strengthened further against the euro but also other major currencies. The euro initially weakened on the uncertainty about the Greek debt swap. However, on Thursday, the euro rallied against the US dollar on two factors. The first factor was the acceptance of the Greek debt swap offer. The second factor was the ECB. The council kept the refinancing rate unchanged. But more importantly, at the press conference, ECB president Draghi dampened hopes on further monetary stimulus. While the ECB staff projections lowered the forecast for GDP growth, inflation appears to remain a concern for some council members. But all the gains of the euro were given back the next day following the release of the US labor market report. The number of new jobs created exceeded again the consensus forecast of Wall Street economists. Thus, remaining hopes for QE3 vanished further. Some commentators at Bloomberg TV already talked about a Fed rate hike. While this is definitively far too early, the outlook for no further monetary stimulus is currently sufficient to support the US dollar. But as the ECB is probably also not going to provide any further expansionary monetary impulse, the upside for the US dollar appears to be capped.

After the plunge in the preceding week, it should not come as a surprise that the recent CFTC report on the “Commitment of Traders” shows that large speculators massively reduced long positions in the gold future. However, they have also closed short positions. Nevertheless, at the week ending March 6, they had lowered the net long position still by almost 30,000 contracts to 163,265 contracts. In silver, the large speculators have reduced their net long position by almost 7,000 contracts to 23,192 contracts. The holdings of the SPDR Gold Trust ETF remained unchanged this week. As precious metals recovered after the dead line of the latest CoT-report, we would not be surprised, if net long positions held by large speculators did not decline further.

Precious metals have stabilized in the second half of last week. However, they are not yet out of the woods. The technical indicators are still bearish. Thus, the consolidation is likely to continue for the time being.

Black Wednesday for Gold

While the other precious metals ended the month of February with a gain, gold suffered a huge one day loss, which wiped out the gains made during the month. Gold even fell below the close of January and thus, ended February with a loss. The trigger for this sell-off was disappointed irrational expectations.

Last Wednesday, Fed chairman Bernanke had one of the semi-annual testimonies at the Congress. And the sell-off set in with the release of the written text of his testimony. Normally, it is the case that words said move the markets. Just remember all the reports citing official sources from the German government, which moved markets during the last two years of the eurozone debt crisis. However, in the case of the Bernanke testimony, it was words not said which sent gold sharply lower. While the markets awaited an announcement that another round of quantitative easing would be implemented, the Fed chairman provided no hint about QE3.

Expecting that Fed chairman Bernanke would announce further measures of quantitative easing at a Congress testimony was rather irrational for several reasons. Central banks are eager to defend their independence. Thus, announcing policy measures at a Congress hearing could easily create the impression that the policy instruments were only applied due to political pressure or to please the Congress. Furthermore, it is not just the Fed chairman deciding about monetary policy measures, but all voting members of the Federal Open Market Committee. Decisions of the FOMC are released after the meeting in the official statement. In addition, the minutes of the recent FOMC meeting should include hints that the majority of the FOMC voting members would be ready to embark on QE3 at the next FOMC meeting. All one could find is the standard phrase that the Fed would be ready to act when needed. However, it is rather irrational to interpret this as a hint for announcing QE3 at the semi-annual testimony at the Congress.

When the Fed speaks, markets normally listen. However, this has not been the case recently. Only a couple of days before the Bernanke testimony, the governor of the Federal Reserve Bank of New York warned that Wall Street would have too high expectations for QE3. That still many hedge funds and traders expected an announcement of QE3 could only be interpreted as an irrational case of selective perception. This is another example for falsifying academic theory that financial markets follow rational expectations and are always information efficient.

The US labor market is improving, but the pace of job creation is too slow from the Fed’s point of view. However, this is not automatically leading to further monetary stimulus measures. The growth of US GDP also plays a role for the FOMC members in the process of decision making. The GDP growth in the final quarter of 2011 had been revised up to 3.0%. The capacity utilization is also pointing upwards and is not far below the levels prevailing before the financial crisis of 2008. Thus, the Fed could maintain the speed of monetary expansion but it is unlikely to accelerate further.

The US dollar strengthened after the Bernanke testimony disappointed traders hoping for another round of quantitative easing. However, QE3 is not a necessary precondition for a weaker US dollar. The Fed projected that exceptionally low interest rates will prevail until late 2014. The ECB is currently now showing any willingness to cut the refinancing rate below 1%. Thus, it is still attractive to borrow in US dollars and to invest in other currencies. Therefore, the US dollar is probably to remain a supportive factor for gold in the medium-term. However, it could not be ruled out that the US dollar would be regarded as a safe haven in a geo-political crisis, especially in the Middle East. But in such a crisis, gold would probably also be sought as a safe haven.

The technical picture for gold has worsened considerably due to the plunge on Wednesday. It could not be ruled out that the rise on Thursday is just a typical “dead cat bounce”. However, there should be some solid support in the range between 1640 – 1650$/oz. Currently, we would regard a test of this level as a good buying opportunity.