Gold, the Fed and Chinese Inflation

After several weeks of consecutive losses, gold and silver managed to close the week slightly higher. The PGMs recovered stronger. While palladium closed 1.6% higher, platinum gained 4.6% on the week.  Also gold and silver were trading higher, but both metals declined last Friday by about 1% whereas the PGMs closed slightly higher. The reason for the fall of gold and silver given by a market report was the Chinese inflation rate in December.

The consensus of economists forecast predicted already an increase of the Chinese inflation rate from 2.0% in November to 2.3% in December. However, the inflation rate jumped to 2.5%, which led to the fear that the People’s Bank of China would provide less monetary stimulus to foster the GDP growth. China has been hit by a severe cold, which has a negative impact on cabbage, a main aliment during the winter season. Thus, the rise of cabbage prices was the major culprit for the jump in the inflation rate. That this increase of the Chinese inflation rate is the reason for the fall of gold and silver on Friday is not a convincing argument for several reasons.

China plays an import role for the demand of physical gold. If inflation were really a concern, then Chinese investors would be expected to buy more gold as a hedge against inflation. Selling the protection against inflation does not make sense in this case. And indeed, gold and silver did not come under stronger pressure during the Asian trading hours.

As it has been the case so often during the last couple of weeks when gold dropped, the plunge set in with the start of trading in the US. This was also the case last Friday that gold plummeted after the start of trading at the Comex. In the early US morning hours, also the stock market and US Treasury notes headed lower. US traders and investors having sold gold on the fear of rising cabbage prices in China would slow global economic growth did not act rationally. The PBoC follows the headline inflation but even central banks focusing on the headline CPI inflation usually take seasonal impacts into account. Therefore, as long as the PBoC does not expect that the seasonal distortion will have a lasting impact on the inflation rate, there is no reason to provide no further monetary stimulus.  Furthermore, even after the increase in December, the Chinese inflation rate is still well within the target zone.

Gold and silver trade more in line with risky assets and this was probably also the main reason that both metals came under pressure at the start of US trading. The wrong conclusion many investors and traders drew from the Chinese CPI figure was only one factor. The earnings season started in the US and on Friday, Wells Fargo reported its earnings for the final quarter in 2012. Despite a record gain beating earnings estimates, analysts found a fly in the ointment. The net interest rate margin declined. However, in an environment of falling yields and money market rates close to zero, this should not come as a surprise. Nevertheless, it was another reason for the negative start of the US stock market.

Another widespread misperception is that quantitative easing is a necessary condition for rising gold and silver prices. Flows into an asset could come from three different sources. The first is from reallocating funds from one asset into another one. Selling US Treasury notes and investing in gold is one possibility. However, it is not necessary that the buyer of the notes is the Fed. Only a few primary dealers have this access. Other investors would have to sell Treasury paper to primary dealers or other investors. Certainly, QE made it easier and provided many sellers with a better price compared with a situation without QE. Nevertheless, QE is not necessary for this process. The second source is by net savings, which is also not directly dependent on QE. The third source is from borrowing with current assets serving as collateral. Again the possible leverage does not depend directly on QE, but the purchases of central banks had a positive impact on asset prices.

The minutes of the latest FOMC meeting as well as comments from various council members during this week had a negative impact on the price of gold. Thus, the correlation between the price of gold and US Treasury notes has increased again lately. For an exit of the Fed from QE there are two possible reasons. The first is of course the economic development and the potential risk of future inflation getting out of control. The second is balance sheet considerations, which some members of the FOMC brought forward.

If the Fed will end QE for the first reason, it should not be negative for gold and silver but positive. In this case, the US economy will grow stronger and the output gap will narrow again. Risky as well as tangible assets will perform better. Also yields on US Treasury bonds and notes should increase and for some maturities should become positive again in real terms. However, also a slight positive real return for medium-term maturities should not be a reason to sell gold as along the Fed does not abandon the current Fed Funds target rate. The FOMC indicated that this would not be the case before mid-2015.

While operation twist was neutral for the balance sheet of the Fed, outright buying of mortgage backed bonds and US Treasuries will extend the balance sheet by $85bn every month. Despite the looming hit of the debt ceiling, the US Treasury is unlikely to default. As outlined last week, minting a super platinum coin could avoid this scenario. Thus, the Fed does not need to be worried about a default risk of the Treasury paper held. However, rising yields could pose a risk for the balance sheet in the case of marking-to-market valuation. Last Friday, Philly Fed president Charles Plosser pointed out the risk of rising bond yields on the exit from QE. Certainly, bond markets will anticipate an end of bond purchases by the Fed, which will lead to rising yields. And yields are also likely to increase after the Fed terminates QE as the shortfall of a total of $85bn of bond demand would have to be compensated. However, the US Treasury market misinterpreted the comments from Mr. Plosser, who is a long-time critic of QE. The risks of an exit do not imply that the FOMC will continue QE infinitely  But the US Treasury market rebounded after this comment, ignoring the inflation warnings of Mr. Plosser. This also supported gold and silver and prevented another weekly loss.

The current sentiment among large speculators is negative for gold, as the latest CFTC report on the commitment of traders underlines again. Thus, gold and silver are likely to be caught in a trading range, with the risk to downsides overweighing the chances for a breakout to the upside. But as we expect that the economic situation in the US will improve and that Asian economies will grow also stronger again, the outlook for the major fundamental drivers of gold remains positive. Thus, the current sideways market might offer good opportunities to buy gold and silver for a medium-term investment horizon.