Fed twists again, like it did last summer

The FOMC meeting disappointed markets and was the trigger for another sell-off in precious metals markets. Also weak economic data contributed to the plunge. Silver lost more than 6% on the week and was again the most volatile precious metal. But also the other three precious metals lost more than 3% compared to the preceding weekly close. However, we regard the reaction of financial and commodity markets after the FOMC meeting as overdone. QE3 remains on the agenda, but for later this year.

“Come on, let’s twist again like we did last summer”. This line from an old Chubby Checker song might also have been the appeal of Fed chairman Bernanke at the two-day FOMC meeting this week. The majority followed Ben Bernanke, only Jeffrey Lacker dissented as usual. The FOMC extends “operation twist” until the end of this year at the current pace. The total volume of operation twist will be 667bn USD by the end of 2012, which implies an increase of 267bn USD from the original volume of 400bn USD. However, market expectations had been irrational. Thus, markets did not like this song, which had been popular during the childhood of Ben Bernanke. Markets priced in a remake of quantitative easing, performed by the FOMC already twice.

The stage is not set yet for a third version of quantitative easing, but probably will be towards the end of 2012. The FOMC has revised down its forecast for GDP growth by half of a percentage point. This might not be the last downward revision in the current cycle. The regional surveys of the New York and the Philadelphia Fed plunged strongly. Also the Markit PMI for the US, a rather new survey, declined from 54.0 to 52.9 according to the flash estimate. This indicates that also the ISM manufacturing PMI is likely to decline towards the 50 threshold.

German chancellor Merkel agreed at a meeting last Friday in Rome with the leaders of Italy, France and Spain on a 130bn euro economic stimulus program, which will be discussed at the EU summit on June 28. However, Mrs. Merkel still rejects any proposal, which is suitable to break the link between public debt and banking crisis in the eurozone. German politicians believed that the strong domestic economy would mitigate the economic crisis in other eurozone countries. However, they have to wake up and to realize that it was only a dream. As the Markit PMI for the manufacturing and service sector as well as the ifo-index show, also Germany gets pulled down by the recession in the rest of the eurozone.

Fed chairman Bernanke stated rightly that the debt crisis in the eurozone has a negative impact on the US economy. The resistance of German chancellor Merkel and Bundsbank chief Weidmann, based on ideology and a lack of sound economic understandings, prevents a solution of this crisis. Therefore, Europe will remain a drag on US GDP growth for the time being.

According to the compromise reached last summer to lift the debt ceiling, the two parties have to find a compromise on reducing the federal budget deficit. Otherwise, at the start of 2013, automatic measures will kick in. This would imply a headwind from the fiscal policy in the magnitude of 5% of US GDP. It appears as rather unlikely that Republicans and Democrats will reach a compromise ahead of the presidential elections taking place on the second Tuesday in November. Thus, the risk is rather high that the US economy might fall over a fiscal cliff. For this possible case, the Fed has to keep the powder try.

Despite the billions of US dollars already spend for operation twist, it does not appear to be very effective in stimulating the economy. Since the FOMC decided to implement operation twist, the yield on 10yr US Treasury notes declined by just 25bp to 1.62% (constant maturity yield according to Fed data base) as of last Friday. However, for business fixed investments the relevant yield is not the one on US Treasury paper but on corporate bonds. The Moody’s yield index on seasoned corporate bonds with a BAA rating declined over the same time horizon by a mere 13 basis points to 5.05% (source Fed). Thus, the spread of corporate bonds over 10yr US Treasury notes widened by 12bp. In financial markets, a look at spreads instead of absolute yield changes is very widespread. Therefore, the spread widening might be regarded even as negative for corporate issuers. To promote investments in plants and machinery by companies or in residential housing, selling US Treasury paper and reinvesting the proceeds in corporate and mortgage bonds would probably have a stronger impact on economic activity.

As written last week, we expected the FOMC only to extend operation twist at the June meeting. However, implementing the third round of quantitative easing is still on the agenda, just not for now. Further monetary stimulus is still on the agenda as the FOMC stand ready to act when needed. Therefore, the Fed might embark on QE3 later this year. Weaker economic data could thus spark a new round of speculation on QE3, which would be supportive for precious metals. Range trading with days of high volatility might remain the name of the game in precious metals markets for some time.