Volatility is back but gold's price move is not rational

Periods of low volatility are often harbingers that volatility will increase again and that the market will move strongly in one direction. This had been the case last week in the gold market. After trading back above the 1700$/oz mark, gold dropped almost 70$ to the low of the week, which is a move of 4% from the weekly high to the low.

Normally such strong moves are the result of new information, which change the fundamentals driving the price development of a particular market. This has not been the case. Gold dropped on Tuesday and Thursday and analysts blamed the looming fiscal cliff for the fall. However, on Tuesday, they argued that avoiding the fiscal cliff would reduce the appeal of gold as a safe haven. Investors who bought gold as a hedge against the impact of the US economy falling over the fiscal cliff would now sell gold and would move into more attractive assets. However, according to analysts, the plunge on Thursday was triggered by the failure of House speaker Boehner to push through a plan B, which did not found enough support from his own party. Especially the Tea Party fraction of the Republicans opposed any tax increase.

Even if reporters asked different analysts, the point is that the arguments provided for the fall of the gold price on both days are contradicting. Either falling over the fiscal cliff is negative for gold (then reaching a compromise should be positive for gold) or avoiding the fiscal cliff is negative, but then withdrawing plan B should be positive for gold.

From our point of view, avoiding the fiscal cliff should be positive for gold. The impact of the automatic tax hikes and spending cuts kicking in would be a far stronger drag on the US economy. Thus, reducing the overall size of measures to reduce the federal budget deficit in a situation where US GDP growth is still anemic would be positive for the economy. It could also end the hesitation of companies to invest, which is the result of the uncertainty whether the fiscal cliff could be avoided. Monetary policy would remain extremely accommodative as long as the thresholds set by the recent FOMC decision where not reached. This would be positive for the major fundamental factors of the gold price. Therefore, we regard avoiding the fiscal cliff as positive for gold and not as negative. A further upward move of stock prices, a recovery of crude oil and a weaker US dollar are all beneficial for gold.

Last week, we briefly mentioned that Goldman Sachs revised their forecast for gold in 2013 and got bearish on precious metals. During this week, we found in media reports more about the reasons why the perma bulls on commodities turned negative for gold. According to these reports, Goldman Sachs expects that the US economy develops better and that the Fed would have to increase interest rates earlier than the FOMC indicated. Real interest rates would get positive again and this would increase the opportunity costs of holding gold. Therefore, investors would sell gold and invest in notes and bonds. This argument is logically flawed and not convincing!

In the case that the fiscal cliff will be avoided, it is a possible scenario that the US economy surprises and grows stronger than expected. Companies might create more jobs and the unemployment rate reaches the threshold of 6.5% far earlier than the majority of the FOMC currently expects. So far, one might agree with Goldman Sachs that the period of extremely accommodative monetary policy ends sooner than the market has priced in currently. However, for real Fed Funds target rate to become positive again, the FOMC would have to hike the nominal rate by at least 175bp in 2013. Which conditions would have to be fulfilled for the Fed to change monetary policy so aggressively? The US GDP growth would have to accelerate dramatically from below to far above potential output growth and the output gap had to be closed. A real economic miracle would have to come true. But in this scenario inflation would not remain well behaved. Rising energy costs would already lift headline CPI inflation. But also an increase of the core PCE deflator above the Fed’s 2% target had to be expected in this scenario. Thus, nominal Fed funds target rates would have to be hiked by more than 2%-points that the real Fed funds rate (adjusted by the core PCE deflator) turns positive. However, some investors have bought gold as a hedge against inflation, especially as some buyers of gold feared that quantitative easing by major central banks would eventually lead to higher inflation rates. Why should those investors lift the hedge when it is needed most?

Furthermore, what would be the impact of the Fed hiking the Fed funds target rate earlier than the consensus currently prices in and especially in the case of aggressive rate increases as the Goldman Sachs forecast of positive real rates suggests? Bond markets would not remain unaffected. It is not likely that the Fed would lift the Fed Funds target rate aggressively higher but maintains buying in the US Treasury and mortgage bond market at the magnitude of 90bn US$ per month. QE would probably end abruptly in this scenario. Thus, demand for bonds will drop. And it is not likely that the potential shortfall of bond demand by the Fed will be compensated by other investors. 

US Treasuries already provide a yield below the inflation rate. As the conditions for a strong turnaround of the Fed policy imply an increase of the inflation rate, the appeal to invest in conventional notes and bonds would be reduced further. Some investors accept the negative real coupon income of US Treasuries based on risk aversion and/or expectations of capital gains. But capital gains could no longer be expected once the Fed starts to increase the Fed Funds rate. Thus, some investors in the US bond market might turn into sellers.

Currently, the spread between the yield on 10year US Treasury and the Fed Funds rate or 3m Libor is rather small given the extremely accommodative stance of the monetary policy. However, at 150bp above Fed Funds or around 145bp above 3m Libor, it is still at a level attractive for carry trades. This situation would change once the outlook for the Fed policy would turn negative. If the buffer between coupon income and funding costs narrows further, the risk of capital losses exceeding this buffer increases. Thus, speculations of a reversal of Fed policy would trigger unwinding of carry trades in the US Treasury market. Another source of demand for US Treasury notes and bonds would dry out.

If Goldman Sachs were right about real interest rates turning positive again in 2013, then the bubble in safe haven US government bonds would deflate. However, also mortgage and corporate bonds would not be immune and also suffer losses. The necessary conditions for real positive interest rates by the Fed increasing rates as well as the implications for the fixed income markets don’t argue for selling gold and investing proceeds in bonds. Quite the opposite! There is only one scenario of real interests rates getting positive again, which could be negative for gold. In this scenario, the US economy would have to head towards outright deflation. However, in this case the Fed monetary policy would get even more extremely accommodative. But was not more QE an argument for buying gold provided by many analysts?

We wish all readers a Merry Christmas and a happy New Year. The next blog article will be published on January 6, 2013.     

On gold, the Fed and the BIS

In this article, we will comment on the impact of the most important central bank and the bank of central banks on gold. The most important central bank is of course the Fed, not only because many central banks hold part of their gold reserves in the vaults of the Fed, but also because the recent FOMC statement moved gold last week. The Bank of International Settlements, the BIS, is the bank of the central banks. According to many web-sites and e-mailed newsletters, the BIS should be responsible that the price of gold would double overnight on January 1, 2013. In both cases, there is a major lack of understanding from our point of view. The FOMC statement should not be negative while the BIS would not be positive for gold.

According to Sir Karl Popper, one example that proofs a theory being wrong would be enough to falsify the whole theory. Developed primarily by economists from the Chicago School, it is now mainstream economic theory that financial markets would be information efficient. The reaction in financial and commodity markets after the release of the FOMC statement provide another example that markets are not always information efficient.

What caused the negative market reaction in equity and commodity markets had been the following lines of the FOMC statement: “In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.”

According to some comments made in the media, markets reacted negatively because they were surprised by the link of the highly accommodative stance of monetary policy to certain levels for the unemployment rate and the inflation outlook. This argument was especially given as explanation of the plunge of gold the next day in early Asian trading hours.  However, already the minutes of the preceding FOMC minutes highlighted that the FOMC discussed those links. Also several members of the FOMC referred to providing more guidance to financial markets and the real economy by stating explicitly at which levels of its two targets a change in monetary policy has to be expected.  Thus, if markets were really information efficient, this part of the FOMC statement should not have surprised many traders and investors.

Another argument had been that this link would have increased the uncertainty about the end of QE. Especially politicians of the Republican Party dubbed QE3 as “QE infinity” expressing their disgust of the Fed policy. However, it should have been clear to every professional investor or trader that QE will end someday. The FOMC provides now strong indications under which circumstances this would be the case someday in the future.

In addition, some commentators argued that markets would fear that the FOMC might end the period of exceptionally low Fed Funds rates earlier than the FOMC indicated in fall, when the members expressed their conviction that rates would be at the current level until 2015. However, this fear is also not justified as the FOMC states further. “The Committee views these thresholds as consistent with its earlier date-based guidance.” Therefore, nothing indicates that the FOMC has changed its assessment and intends to increase the Fed Funds rate before 2015.

But even in the case that the FOMC would have to hike interest rates earlier than currently indicated, would it be really a rational argument to sell gold? After the December 2012 FOMC statement, the markets know under which conditions an end of the current monetary policy would occur. It is either a fall of the unemployment rate below the 6.5% threshold or a worsening of the medium-term inflation outlook. In the case that a fall of unemployment is the trigger, this would imply that companies hire more workers. But companies hire only more staff if the demand for their products increases, which also implies that corporate profits will grow further. This would lead to higher stock market prices and the demand for risky assets would also lead to higher prices for gold. If on the other hands higher inflation is the reason for hiking interest rates, then gold should profit as a safe haven against accelerating inflation rates. Thus, there is no rational reason to sell gold only because the Fed might end its current monetary policy before 2015. The conditions for a pre-mature termination are favorable for gold and not negative.

Many web-sites and e-mailed newsletters contain statements that the BIS would make gold to a tier 1 asset with effect of January 1, 2013. The current risk weighting of gold were 50% and thus, the new rules of the BIS would lead to banks buying gold and thus prices doubling overnight as the New Year will begin. This is nonsense! If the price of gold would really double on the basis of a BIS decision, it would double as soon as the decision is made public at latest and not only at the date the measure would become effective. Otherwise, there would be an arbitrage opportunity that many smart hedge funds and banks had already exploited.

A first warning that this story is probably wrong could be got by a search at Google for BIS, gold and tier 1. Among the list of web-sites returned, we did not find the internet site of the BIS. Strange, isn’t it? Normally you would expect that this site should be at the top of the list because it would be the official source for any change of the gold’s role in banking supervision. Also a search at the BIS web-site did not lead to any result supporting the claim made on many web-sites and e-mailed newsletters. In the best case, this story is based on a misunderstanding. In the worst case, it is an intentional misguiding of investors by snake-oil salesmen.

January 1, 2013 should be the start date for new rules of banking supervision, also known as Basle III. One part of Basle III is the definition of banks’ capital. This consists of equity capital and retained earnings. In a broader definition, also some hybrid financing instruments are counted as capital. However, in no case is gold part of banks capital! Banks might have some liabilities to deliver gold in the future. But those liabilities are not equity capital. If banks hold gold, then it is an item on the asset site of the balance sheet.

One part of the already existing bank regulation is that assets have to be backed by capital. Various assets have different percentages, the risk weighting, which are counted against the capital of banks. If all assets had a 100% risk weighting then banks could not be leveraged and all assets had to be funded by equity capital. The risk weightings range currently from 0% (government bonds) to 150%. If gold had to be backed by 100% instead of 50%, then the costs for banks to hold gold would increase. This would not be an incentive to buy gold, but to reduce the gold holdings. There are also provisions for liquidity holdings, but also in this case, gold should retain a 50% RSF (Required Stable Funding) weighting.

Another subject is the counter-party credit risk and the role of gold as eligible collateral. Under Basle II, gold is one of the eligible financial collaterals under paragraph 145. This paragraph will not change in Basle III. Also the haircut of 15% of current market value will not change under Basle III.

Most of those web-sites and e-mailed newsletters promoting gold based on changes in the BIS rulings are based in the USA. However, Basle III is probably not being implemented in the US. Thus, US banks have no interest in pushing the price of gold higher under the Basle III accord. 

Conflicting signals for gold

Gold and silver came under selling pressure again this past trading week. However, this time it was not at the start of trading in the US. On Tuesday, in the Asian afternoon, gold came under pressure and fell through the low made the Friday before. This triggered further selling, which pushed gold down another 10$/oz. However, as the US trading session began later, gold also fell through the 1,700$/oz mark, which was regarded as support. During the further course of the week, gold and silver recovered, but were unable to pare the loss and ended the week lower. The PGMs on the other hand held fairly stable at the start of the week and advanced later to end the week higher. Thus, the question arises, why do gold and silver underperform the PGMs lately?

One factor supporting the PGMs had been the Platinum interim report from Johnson Matthey, which predicts that the market would be in a deficit. Statements this week from Norilsk Nickel that Russian palladium exports would decline due to decreasing Russian palladium stocks gave the market further support. This would explain the outperformance of the PGMs, but not the diverging price movements, which had been observed on some days. Also quantitative models show that there is a mutual impact of precious metal prices on the price of other metals of this group. Thus, there must be other reasons for the underperformance of gold and silver.

There appears to be a shift in sentiment for gold and silver among analysts and investors. This past week, Goldman Sachs – usually one of the most bullish Wall Street investment banks on commodities – revised their forecast for gold next year downwards. Analysts polled weekly by Bloomberg are normally bullish on the outlook for gold during the following week. Bullish readings below 50 occur but are seldom. The most recent survey shows a drop of the bullish index from 64.52 to 45.16 and the bearish index increased from 19.35 to 32.26. Thus, analysts are still slightly bullish on balance. However, the difference between the bullish and bearish index is at such a low level, that it approaches the region of extreme lows for this survey. Extreme analyst pessimism is often a good buy signal for gold.

The net long position in Comex gold futures held by large speculators had risen in November. However, the increase of the preceding three weeks had been almost completely wiped out by reducing longs and increasing short positions in the week ending December 4, according to the recent CFTC report on the “Commitment of traders”. The net long position dropped from 193,742 to 165,736 contracts. However, the non-commercials increased their net long position in silver futures further by around 2,500 contracts to 41,272 contracts.

On the other hand, the holdings in the SPDR Gold Trust ETF have risen this week by around 4.5 tons to 1,353.35 tons. However, hedge funds investing in this ETF appear to hold the positions over a longer period. Short-term trading oriented hedge funds seem to prefer the futures market. Thus, we interpret the recent development as dominated by short-term traders, while long-term oriented investors still accumulate gold holdings. This short-term selling reflects the uncertainty about the result of negotiations to avoid the fiscal cliff in the US. It is more a reflection of increasing risk aversion among investors.

A negative factor for gold had been the firmer US dollar against the euro, especially after the ECB press conference. As Mr. Draghi stated that the council discussed to levy a fee for deposits at the ECB by 25bp (also referred to as negative deposit interest rate), the forex and government bond market immediately speculated on a cut of the lending rate at the next meeting from 0.75 to 0.5%. However, Mr. Draghi also explained that the council refrained from this step because it believes that the announcement of OMT had pushed yields on peripheral government bonds much lower than another cut of the lending rate could do. Furthermore, in some countries, there is growing opposition on reducing the refinancing rate further because some banks would use this opportunity to borrow funds from the ECB and invest them in corresponding national government bonds. The ECB did not lower interest rates despite cutting the forecasts for the GDP in the eurozone significantly. It appears that the council prefers to keep the powder dry. Thus, the speculation on another ECB rate cut might be short-lived. The euro might recover the longer the ECB hesitates to reduce interest rates further. This would then be a supportive factor for gold.

As stated several times, our base line scenario is the US fiscal cliff will be avoided by a final hour compromise. Therefore, the current negative sentiment among analysts and short-term oriented traders might present a good buying opportunity for medium-term oriented investors in gold and silver.

Safe haven gold hit by a tsunami

Over the last few years, not only gold bugs but also analysts at serious banks stated that gold would be a safe haven in the case of recession and deflation. Many of those analysts also pretended that gold would be a good hedge against inflation. Already economic logic indicates that gold could not perform well in both cases. And the development of precious metals during this past trading week underlines that it is not compatible to serve as a safe haven in the case of inflation and deflation.

On Wednesday, gold plunged with the start of trading in the US. Ross Norman, the CEO of Sharps Pixley (a UK based gold trading house), was the first who pointed out that futures representing 24 tons of gold had been sold within a few minutes at the start of gold futures trading at the CME. Also on Friday, gold and other precious metal came under selling pressure with the start of trading in the US. One explanation for the losses on both days was that investors sold gold on worries about the possibility of a looming fiscal cliff as talks to find a compromise made no significant progress. But is it really rational to sell 24 tons of gold within a few minutes if the US economy will fall over the fiscal cliff?

Let’s assume that no compromise to avoid the automatic tax hikes and spending cuts from kicking in. What would be the economic consequences? Only a few European economists, among them probably the former chief economist of the ECB, would argue that this fiscal austerity would lead to higher growth rates as the multiplier effect of fiscal policy measures is below unity and the reduction of the budget deficit would encourage the private sector to increase economic activity. However, most economists and investors at Wall Street fear that the fiscal cliff would lead to a pronounced recession of the US economy. The unemployment rate would rise again, which would induce the Fed to lift the size of quantitative easing. Many investors regard an inflated Fed balance sheet as positive for gold. Furthermore, a deep recession would also lead to some stress for the financial system and the number of bank failures could increase again. The core inflation rate would head lower and might flirt again with deflation in this scenario.

If increasing the magnitude of quantitative easing or the risk of deflation or the combination of both is really positive for gold, then it would be irrational to sell 24 tons of gold on worries about a failure to reach a compromise avoiding the fiscal cliff. However, if the sellers of the gold acted rationally, then the arguments for gold as a safe haven have no sound footing. From our point of view, the latter is the case. As the development of last week showed, if investors fear a recession or deflationary tendencies, instruments with a fixed nominal income like the conventional US Treasury notes and bonds, offer the better risk and return profile. Furthermore, we pointed out that quantitative easing by the Fed is not a necessary condition for rising gold prices.

Another argument for the plunge of gold and other precious metals prices at the start of trading in the US on Wednesday was that of the usual fat-finger suspect. We are also not convinced by this argument. The fat-finger describes an error at entering the order. In this case, it would imply that the number of contracts to sell has been a multiple of the intended size, often by a two or three digit factor. Usually, fat-finger orders leave a typical trace in the tick or one minute charts. After the order had been worked through and had been fully executed, the market normally rebounds for two reasons. First, the error will be detected by the seller sooner or later. If the exchange will not cancel the erroneous order, the seller would have to correct his error by buying back futures, which lift the price higher. Second, if the market still regards the drop as not justified by market fundamentals, bargain hunting sets in, which also pushes prices higher again. Fat-finger orders often lead to a rebound of the price close to the level before this erroneous order was placed and executed. This was not the case in the gold future, which pared only a small fraction of the loss on Wednesday and Friday and only some hours after the plunge occurred.

High frequency trading plays a more and more important role also in the electronic trading of commodity futures. In the grain markets, commercial hedgers already complained that HFT has increased volatility and makes commercial hedging more difficult. Thus, one possible explanation might be the combination of a fat-finger order triggering the drop, which was aggravated by algorithms of HFT companies switching to selling futures too. However, it appears as rather unlikely that this happened on Wednesday and on Friday.

During the last few weeks, it has been pointed out in this blog, that our base line scenario is a final hour compromise to avoid the fiscal cliff, but the road to such a compromise would be a bumpy one. Thus, the strong declines on Wednesday and Friday might be just the result of higher risk aversion among investors. Nervous investors fearing a failure to reach a compromise sold gold but due to the political uncertainty other investors were only willing to absorb the supply at far lower prices. As long as there are no signs for a compromise being reached, the downside risks prevail, even in the case that the fiscal cliff will be avoided.