Central banks fuel rally in precious metals

All four precious metals have rallied last week and broke out of consolidation ranges last week. The main forces behind these moves are expectations about further monetary policy measures of the major central banks. Platinum and palladium also profited by the labor unrest in South Africa. Therefore, prices metals prices have further scope to the upside. Nevertheless, one should not overlook the stumbling blocks on the road to further monetary easing.

The trigger of the rally had been a report in the online edition of a German weekly magazine, Der Spiegel, that the ECB would intend to implement ceilings for the yields on government bonds for countries asking for a bailout. This report had been denied by a spokeswoman of the ECB pointing out that no decision has been made yet on how to proceed under the new bond purchase program announced at the recent ECB press conference. At the same day, the mighty Deutsche Bundesbank voiced again strong opposition to any secondary market bond purchases in its monthly report. In addition, there was an outcry also from German politicians, normally praising and defending the independence of the ECB as indispensable for price stability.

The Lisbon Treaty allows the ECB to buy government bonds in the secondary market. The preamble states that purchases in the secondary market should not circumvent the prohibition of direct government financing. However, the treaty neither sets any limit to government bond purchases in the secondary market nor provides any guideline when such purchases would be no longer an instrument of monetary policy but would constitute direct government financing. Furthermore, the Bundesbank president, Mr. Weidmann, and the German politicians miss the point for the decision made by the ECB earlier this month. The ECB council rightly came to the conclusion that there is a severe malfunctioning and that exceptionally high risk premia observed in government bond prices in several countries and financial fragmentation hinders the effective working of monetary policy. Therefore, it is not only the task of fiscal policy of those countries with high risk premia to restore confidence, but also the ECB has to take measures to re-establish the effectiveness of the monetary transmission mechanism. Reducing the yield spreads of government bonds over Germans Bunds as benchmark for the eurozone by bond purchases in the secondary market is the most efficient way to achieve the target of bond markets functioning again properly.

During last week, several other plans had been leaked. According to one proposal, the ECB might set a limit for government bond yields but keep it secret. However, if ECB staff members already pass information on draft proposals for the decision in the council to the media, one has to expect that such secret limits would not be kept secret for a long time and would also be leaked to the media. Furthermore, secret limits for bond yields would open doors for rumors flying around. And it is not a secret that many traders are not scrupulous to spread rumors to manipulate the market moving in the direction beneficial for their positions held – and their bonus payments of course. Thus, it would be better to communicate target yields openly to the public.   

A widespread argument against those purchases is the fear of inflation accelerating in the near future. Thus, many advisors recommend buying precious metals as a hedge against rising inflation rates. However, government bond purchases by the ECB do not necessarily lead to higher future inflation rates. As with the first security market program (SMP), the ECB can sterilize the impact of bond buying on the provision of liquidity. From our point of view, the more important aspect for buying precious metals is the impact of the ECB bond purchase program on the risk appetite of investors.

Decisive interventions of the ECB would probably have a positive impact on stock markets, not only in the eurozone but also outside Europe. We pointed out several times, that the development of the S&P 500 index has a significant impact of the price movements of precious metals. Furthermore, ECB interventions would probably also lead to a more positive assessment of future growth rates in the eurozone and other regions. Thus, it would probably also have impacts on the oil price, which is another significant factor in our econometric fair value models for precious metals. Normally, a relatively more expansionary monetary policy is expected to weaken the currency in foreign exchange markets. However, in the case of ECB bond buying, the euro could even strengthen. In FX markets, such steps could be seen as a determined defense of the single currency to prevent a collapse of the currency union. Confidence in the euro could be restored and traders and hedge funds speculating on a failure of the euro might be forced to cover their euro short positions. Thus, ECB interventions in the bond markets could lead to a firmer euro, which would be another positive factor for the development of precious metals prices.

But whether the ECB will intervene in government bond markets by buying bonds with exceptionally high risk premia will not depend on the Bundesbank giving up its opposition. The crucial feature of the decision made at the August rate setting ECB council meeting is the conditionality. Only in the case that a country asks the EFSF/ESM for a bailout, it would open the way for the ECB to decide on bond purchases in the secondary market. Despite some rumors that Spain would already told talks about possible conditions for a bailout, the bailout conditions might lead to some hesitation to apply for help from the EFSM or ESM. Furthermore, the ECB announced that a final decision on the procedure of the bond buying program will be taken only after the German constitutional court has decided on the ESM and fiscal stability pact. This decision should be announced on September 12. Thus, there are still some stumbling blocks on the road for ECB bond purchases in the secondary markets.

Also the Fed had a positive impact on the development of precious metal prices in the second half of last week. The release of the FOMC minutes of the July31 – August 1, 2012 meeting revived the speculation on QE3 again. However, at least from our point of view, the minutes do not contain any new information. Based on the information available at the time of the meeting, the majority considered that further monetary easing might be needed. However, they obviously did not regard the economy as weak enough that immediate action would be required. The July labor market report released after the FOMC meeting was stronger than expected. Also some other economic data had surprised positively. Until the next FOMC meeting, there will be another labor market report due for release. Also the ISM purchasing manager indices for the manufacturing and service sector will be released. The markit PMI for the US came in a bit stronger than the consensus expected. Also the weekly initial jobless claims do not point to a worsening of the labor market situation being sufficient to tip the balance for embarking on QE3 at the September 12/13 FOMC meeting. At the end of the new trading week, the annual Fed seminar at Jackson Hole, Wyoming, will take place. Financial markets will watch this event closely because in the recent past, it provided some insights in the immediate FOMC actions.

At the current juncture, we can not rule out that FOMC will already decide at the September meeting to implement another round of QE. However, in that case, the focus might be no longer on buying US Treasury paper but on mortgage backed securities. Unless the economic data released before the FOMC meeting comes in weaker, we would not be surprised if the FOMC keeps the powder dry for a bit longer after the presidential elections.

After the break out of the recent trading ranges, the outlook for precious metals prices has improved. We expect that monetary policy will be supportive for investment demand in precious metals. However, further monetary stimulus measures might take a bit longer than the market currently anticipates. Therefore, set-backs and corrections can not be ruled out. But from the current point of view, they present more buying opportunities. 

No QE3 is not necessarily negative for precious metals

The major fundamental drivers for gold and silver had been positive on balance. Nevertheless, gold and silver ended the almost unchanged compared with the close of the preceding Friday. Especially the development in the first half of the week underlines that markets sometimes just react in the opposite way on positive news.

The US economic data came in mostly stronger than the consensus of Wall Street economists had predicted. Normally, positive economic surprises are positive for stock markets and other risky assets. However, during the first half of last week, the US stock market showed hardly any reaction. Currently, stock investors are too fixated on expectations of the Fed announcing soon another round of quantitative easing. What most investors and traders in the US stock market completely ignore is the fact that the monetary policy stance of the Fed is already extremely expansionary. It seems that the market is dominated by the thought that it first would have to get worse before it could get better. They completely deny the possibility that it might already get better after the soft spot in spring and that the worst might already be behind them. As another round of quantitative easing was already priced in, many traders and investors were now disappointed that the FOMC might see no need for further monetary policy measures. Thus, instead of buying stocks on bullish news, they reacted negative on stronger than expected economic data. Later during the trading sessions, losses were pared.

The US bond market, however, reacted in the normal way. As yields on medium- to long-term US Treasury notes and bonds had fallen to historic lows, they backed up and prices fell. Precious metals followed US Treasury paper prices lower as the expectation of QE had been also a supportive factor for gold and silver.

On Thursday, stock markets rallied, but also safe haven government bond markets and precious metals rose. Hopes for monetary stimulus returned into the markets. However, it was not primarily revived hopes for QE3 by the Fed. Instead, the financial and precious metal market got more optimistic on the ECB buying government notes in the secondary market. The trigger for this improved sentiment had been German chancellor Merkel. During her summer vacation, members of her coalition government attacked the ECB and in particular ECB president Draghi for the intention to intervene in the secondary market to bring down yields, and thus, to restore again the functioning of the financial markets, which is essential for the transmission mechanism of monetary policy to the real economy. At a visit in Canada, Mrs. Merkel fully supported the ECB and Mr. Draghi.

The ECB is expected to provide further details of its plan for buying bonds in the secondary market at the next press conference in September. However, the major weakness of the plan presented by Mr. Draghi at the August ECB press conference is its conditionality. Governments are likely to remain hesitant to ask the EFSF for a bailout by buying bonds. Therefore, for the time being, we remain skeptical whether the ECB will intervene anytime soon in the bond markets. However, the ECB might buy peripheral eurozone government bonds in the secondary markets even without a formal request in the case that Greece would decide to leave the eurozone. But in this scenario, bond buying by the ECB is probably not positive for precious metals as they might be dragged down by a sell-off in risky assets.

Thursday was also a turning point for the PGMs. Platinum and palladium rallied on a labor dispute at o mining company Lonmin - one of the world’s top platinum producer - which turned into deadly violence. South Africa accounts for about three quarters of global platinum production. This labor dispute is likely to have a lasting impact on the supply and demand balance. Thus, the PGMs are expected to perform better than gold and silver. This should especially be the case, if the global economic outlook improves again on monetary stimulus measures in Europe and Asia, in particular in China. But both PGMs are still clearly below their highs made in June. Only a break through those resistance levels would open the scope for considerably higher gains.

Gold and silver are expected to stay in recent trading ranges for the time being. However, even if the Fed waits longer with further monetary stimulus measures, the bias is still more towards a break-out to the upside.  

Quo vadis precious metals market?

ThomsonReuters reported recently that Analysts are bullish for gold. However, this poll is conducted quarterly, and thus, the assessment of precious metals analysts reflects more a medium-term view. The usual argument for the final four month of the year is physical demand for the festival season, especially in India. However, the high price of gold in Indian rupee as well as the import tax have led to a drop of gold imports into India. Therefore, on of the factors behind the seasonal pattern might fail to give gold a lift higher. Also the US dollar shows a seasonal behavior, which might be overshadowed by the ongoing debt crisis in the eurozone. Thus, there is considerable risk that analysts will have to adjust their forecast of rising precious metals prices by some month into the future. Therefore, a gold rally is probably more driven by investor demand than by physical buying from consumers.

Bloomberg polls analysts about their view on the move of gold over the coming week. This survey data is published on a weekly basis and analysts have to reply whether they are bullish, bearish of neutral.

For the coming week, the bullish reading has increased again to 50 and the bearish reading declined further. However, since the introduction of this survey, 50 per cent of the analysts polled being bullish is a quite low level. Only one third of the time, 50% or less of the precious metals analysts were bullish on gold for the coming week. Furthermore, our quantitative analysis shows that analysts’ responses reflect more the move of the gold price over the preceding week but have no significance for predicting the direction of gold over the next week. Thus, also that analysts got more bullish over the short-term is not a reliable indication that gold would head higher.

CTA’s and hedge funds usually go with the trend. The weekly report of the CFTC on the “Commitment of Traders” provides data on how these large speculators are positioned. After Mr. Draghi gave is speech in London and promised that the ECB would do whatever it takes to preserve the euro, financial markets interpreted this remark as indication the ECB would reactivate the dormant security markets program and would buy Spanish and Italian government bonds in the secondary market. This induced the large speculators to increase their long positions in gold futures. The net long position rose in the week ending July 31, by 13,087 to 126,064 contracts. However, after Mr. Draghi disappointed financial markets, the non-commercials reduced their long position in gold by 8,249 to 163,082 contracts in the week ending August 7. This is even below the level proceeding the Tuesday before the Speech of Mr. Draghi in London. The net long position also declined to 115,500 contracts but due to closing also short positions remained above the level of two weeks before. Thus, we have to conclude that even the trend following CTA’s and hedge funds currently do not see a clear trend in the gold market and expect further range trading.

Last week, most precious metals closed higher than the week before with only platinum ending the week lower. The US dollar strengthened again versus the euro as uncertainty about the ECB buying government bonds in the secondary market weighed on the single currency. The US labor market report did not lead to further selling in the safe haven government bond markets. The S&P 500 index as well as crude oil prices gained on the week and supported gold and other precious metals. The gain of the US stock market, which opened several days lower but managed to pare the gains, is remarkable, given the Chinese economic data. Usually, fears of global recession had been negative for stock markets. However, the decline of the Chinese CPI inflation and the almost stagnating Chinese exports, leading to a considerably smaller export surplus compared to consensus forecasts, give the PBoB and the administration enough leeway for more stimulus measures.

Thus, from our point of view, the major central banks are the key players for a rally in precious metal prices. However, it will not be by increasing reserve holdings in gold, but by monetary policy measures to stimulate the economies. The Chinese PBoP has already shifted to expansionary measures and we expect more cuts of key interest rates and minimum reserve requirements over the next weeks and months. The ECB has indicated to be ready to buy short-term government paper in the secondary market, but plays a game of chicken. Also the Fed stated again and again to stay ready to act when needed. However, the better than expected labor market report released earlier this month and also better than forecasted weekly initial jobless claims indicate that the FOMC might hesitate further with implementing QE3. Also the approaching US presidential election makes the timing of more stimulus measures for the Fed trickier. However, maybe the Fed conference in Jackson Hole later this month provides new indications. Thus, range trading might continue, but the chances for an upside break-out have improved.

The untalented Mario Draghi and precious metals

One week before the rate setting August ECB council meeting, Mr. Draghi made the following statement at a pre-Olympic investment conference in London: “Within our mandate the ECB is ready to do whatever it takes to preserve the Euro. Believe me, it will be enough!" In financial markets, these strong words from the president of the mighty ECB had been understood that the central bank of the eurozone would resume its security markets program again, which was dormant since March.

The chief-editor of a German business daily, the Handelsblatt, criticized Mr. Draghi for working some years with the investment bank Goldman Sachs. But obviously, he did not learn enough about financial markets as he demonstrated during the ECB press conference last Thursday. Or maybe, he just believed that financial markets were information efficient and form rational expectations, and thus, would interpret his statement in London correctly.

At investment banks, it is quite normal that at the annual review, underperformer would not only get no bonus but in addition have to leave the company. The performance, which the ECB president showed at the recent press conference, makes Mr. Draghi a top candidate as underperformer of the millennium. The week before, we had the impression that Mr. Draghi realized that the ECB would have to take measures for keeping his job. Now, we have doubts whether he deserved to get his current job. From our point of view, Mr. Draghi has damaged the credibility of the ECB seriously.

In the introductory statement, Mr. Draghi admitted a severe malfunctioning in the price formation process in the bond markets of eurozone countries. He continued: “Exceptionally high risk premia are observed in government bond prices in several countries and financial fragmentation hinders the effective working of monetary policy. Risk premia that are related to fears of the reversibility of the euro are unacceptable, and they need to be addressed in a fundamental manner. The euro is irreversible.”

The analysis of the ECB is right. But if the effective working of monetary policy is hindered, then the ECB would have to employ the available tools in its arsenal to restore it again. One tool available is the security markets program introduced under Mr. Draghi’s predecessor, Jean Claude Trichet. But instead of announcing the resumption of buying government bonds of Spain and Italy, the ECB under the leadership of Mr. Draghi failed miserably.

The ECB blamed again fiscal policy for its inability to restore a proper working of monetary policy. Pushing ahead with fiscal consolidation, structural reform and European institution-building with great determination were needed for such risk premia to disappear. Furthermore, governments would have to stand ready to activate the EFSF/ESM in the bond markets. And of course, this would have to be with strict and effective conditionality in line with the established guidelines.

It is the mantra of the ECB and German politicians that austerity measures have to be implemented. One argument for the rating downgrades of various government bonds in the eurozone had been that austerity measures lead to recessions, which undermine the ability to redeem outstanding debt. It has been observed again and again over time - also in history of Germany during the Great Depression - that austerity measures during a recession lead to a downward spiral. Therefore, investors in government markets demand higher risk premia for bonds from countries, which would have to implement further austerity measures, another vicious circle. Thus, the insistence of the ECB on strict and effective conditionality is counter-productive.

However, prime ministers are not only hesitant to apply for financial assistance for economic, but also for political reasons. As the developments in Greece demonstrated, at the start there is support for measures to curb the budget deficit. However, as more and more spending cuts and tax hikes are required without improving the economic outlook, the support declines and turns into resistance. This has also been the case lately in Spain. Furthermore, radical parties at the right and left wing of the political spectrum become stronger. Instead of intensifying the economic and political integration in the eurozone, the remedy prescribed from Berlin and the ECB could lead to more separation and a collapse of the euro could not be ruled out, too.

Mr. Draghi declared that the ECB may undertake outright open market operations of a size adequate to reach its objective. However, “the adherence of governments to their commitments and the fulfillment by the EFSF/ESM of their role are necessary conditions.” Thus, instead of acting decisively, as Mr. Draghi created the impression at the conference in London, the ECB just takes a wait and see attitude. The council did not even give a firm commitment for open market operations. It is just an option the ECB might exercise. The ECB has the big bazooka in its armory, but Mr. Draghi only wants to use a popgun, and this is the big disappointment and underperformance.

The malfunctioning of bond markets in the eurozone will continue for the time being. This has, of course, also a negative impact on the euro exchange rate versus major currencies. A stronger US dollar is usually negative for precious metal prices. In addition, as we expected, the Fed was not ready yet to implement further measures of quantitative easing, which is another negative factor for precious metals.

The US labor market report for July came in far better than the consensus of Wall Street economists predicted. The number of new jobs created was 60% higher than the consensus forecast of 100,000 new jobs. This reduces the likelihood that the FOMC would decide to embark on QE3 at the September meeting. However, the positive surprise of the US labor market report triggered a rally in stock markets. Increasing risk appetite is currently positive for precious metals. Thus, it will depend on further economic data whether the risk appetite will advance further and will lead to further gains in precious metals prices. But buyers should not count any longer on the ECB to be supportive for precious metals.