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.