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.