Range trading likely to continue in precious metals markets

Only a rally, which set in with the start of trading in Europe and accelerated in the afternoon, prevented on Friday that Gold ended the week lower. Many analysts expect gold to break out to the upside soon. In an interview with ThomsonReuters, we pointed out that an upside breakout from the current trading range appears more likely during the final quarter than during the current one. In this article, we provide a more detailed explanation for this assessment.

Precious metals currently trade most of the time in line with other risky assets. However, if there is a new wave of speculation that the FOMC will embark on QE3, then gold is more driven by falling yields on 10yr US Treasury notes. But safe haven flows into US Treasury notes and German Bunds as a result of the eurozone debt crisis are not positive for gold as it trades like a risky asset in this case. Therefore, from our point of view, either the risk appetite of investors has to increase considerably and stock markets have to trend higher or the market would have to speculate on the Fed implementing QE3.

The release of the recent FOMC minutes brought some bond bulls back to earth last week. The Fed is always ready to act if needed. However, to implement QE3, the economic situation of the US would have to worsen significantly. A dip of the ISM manufacturing index below 50 is not enough. New orders and industrial production would have to contract sharply over a few months. The labor market report also provides no convincing argument that the Fed would react quickly as the US economy still creates new jobs and the unemployment rate stagnated at 8.2%. Thus, unless there is a sharp deterioration of the economic situation in the United States, the FOMC is likely to extend just operation twist until the end of this year, but does not take further measures in the current quarter to stimulate the economy.

Also political considerations could play a role. Of course, the Fed is an independent central bank and would act if the economy requires monetary policy measures. However, the closer the US presidential election gets, the more the likelihood for a further Fed stimulus before the election date decreases. Furthermore, one has to keep in mind that both houses of the Congress have to find a compromise on reducing the budget deficit to prevent automatic cuts, which are regarded as a fiscal cliff. A failure of reaching an agreement can not be ruled out, given the experience from July and August last year. Thus, the Fed is right at keeping the powder dry.

After the release of Chinese GDP growth in the second quarter, which came in line with consensus forecasts, stock markets traded higher. Probably, some traders had already priced in a sharper deceleration of economic expansion. Furthermore, sentiment with respect to rate cuts by the PBoC has changed. Now the market welcomes the outlook for further rate cuts. However, is this positive news already enough to establish an upward trend in global stock markets? We have some doubts.

In the US, the earning season started last week. Wall Street traded higher last Friday after JP Morgan released its results. However, this was probably only a relief rally as JPM still posted a strong gain after losing up to 5.8bn US dollars on its credit hedge book by the ‘London whale’. On the other days of last week, earning warnings especially in the tech-sector dominated. Furthermore, companies gave a more cautious outlook. Against this backdrop, it appears as less likely that a new upward trend in stock markets will be established.

One has to keep in mind the seasonal factors also. August and September are traditionally among the weakest months of the year. Of course, there are exceptions and stock markets also performed well in August and September as it had been the case in 2009. However, in the current environment it appears less likely that 2012 will be an exceptional year and stock markets rally over the summer months.

Furthermore, the debt crisis in the eurozone is far from being over. The German constitutional court needs more time to decide whether the German president can sign the law on the fiscal pact and ESM. Without the president’s signature, the treaties can not be ratified. Given the weight of Germany, the ratification of the treaties by Germany is necessary for the start of the ESM.

Thus, a breakout of gold to the upside is not impossible. However, we would put a higher probability for this event to take place during the final quarter of this year. One should also keep in mind, that a fall below the support of the current trading range could also not excluded, especially in the case that stock markets and other risky assets get under pressure and fall to new lows of the year. But our base line scenario is a continuation of range trading for the time being.