Precious metals and economic recovery

It was a black Wednesday for precious metals this week. All four metals slumped on Wednesday and the PGMs continued the drop also on Thursday. In one market report, ease of concerns about the US economy was the reason for the plunge on Wednesday. However, is a better economy a good reason to sell gold and other precious metals?

First, we have doubt that it was really the US housing data, which sent the precious metals prices sharply lower. A look at intraday charts reveals a different picture. The euro reversed direction and turned negative in late European morning hours. At the same time, gold broke through support at 1,600$/oz and the fall accelerated hours before the US housing data had been released. It was just around this time that rumors emerged that a hedge fund would be in trouble and were forced to sell assets. Later, this rumor also dragged US stocks lower despite the positive economic data. In the case of gold, the fall had been accelerated by technical selling as many technical analysts and traders looked at a special constellation, which is called “dead cross”, a crossing of the 50dady below the 200day moving average.

Second, an economic recovery should be favorable for at least two of the major fundamental factors for the price development of precious metals. Stock markets tend to rise as the economy gains traction and growth rates increase. The Fed has indicated not to increase interest rates until the first half of 2015. Thus, GDP growth picking up pace should be positive for stocks as the traditional reason for an end of rallies in stock markets is not yet seen on the horizon. An end or reduction of bond buying by the Fed is also no reason that stronger economic growth would be negative for precious metals. In order to keep interest rates at the low levels promised, the Fed would have to provide more funds by the traditional instruments. In the UK, some members of the MPC council even voted to extend QE by buying more UK Gilts to foster economic growth.

Another factor, which should profit from stronger economic growth, is the price of crude oil. With a higher growth rate, also the demand for crude oil should increase. The supply situation in the US is still comfortable and with new technologies (fracking), the US production of crude oil might even increase. However, this might only have an impact on the spread to Brent crude oil. The production from the four fields in the North Sea, which qualify for delivery into the Brent futures, is on the decline. Thus, an increase in global economic activity is on balance more likely to lead to higher crude oil prices, which is an important factor for headline inflation rates.

The third factor is the value of the US dollar. As foreign exchange rates are always relative prices, also perspectives for other major economies have to be taken into account. The yen is likely to weaken further against the US dollar due to the target of bringing CPI inflation towards 2%, while the Japanese economy is currently faced with deflation. In the eurozone, a pick-up of economic activity especially in the southern member countries would dampen hopes for another rate cut by the ECB, which many investors and traders still price in. They currently ignore the statement of ECB president Draghi that the monetary policy is very accommodative. Thus, if the eurozone as a whole comes out of the current recession, the most likely scenario is a firmer euro against the US dollar.

Inflation is currently not a problem in many countries. However, in all countries or economic areas, where central banks have flooded the financial system with liquidity, the risk is that monetary policy makers take measures to reduce the liquidity in the system too late. In this case, inflation rates could increase and could accelerate far above the target levels. Holding real assets is a hedge against this risk. However, a necessary condition for this risk to become a threat, economic activity has to pick up. Without stronger economic growth, the liquidity might stay just in the financial system. Thus, the balance sheet of central banks had been inflated, but not that of the consolidated banking system. An increase in credit demand alone is not enough to induce banks to lend more, if the higher credit demand is accompanied by higher default risk of the potential borrowers. However, an improvement of the economic situation is probably leading also to a decline of the default risk and could thus lead to higher growth rates of bank lending to the non-financial sectors of the economy.

All in all, we come to the conclusion that an easing of concerns about the economic situation in many industrialized countries should not be negative for precious metals prices. Quite the opposite, it should be favorable. Certainly, some assets might have better performance perspectives. However, if economic activity strengthens, then fixed income instruments are likely to be the worst market to be invested in. Last year, fixed income funds recorded strong inflows. It makes more sense to leave the fixed income party before the bubble in the US Treasury and German Bunds bursts. Precious metals still appear to be a better investment than the so-called safe haven government bonds in the case of an economic improvement. 

Imperfect precious metals markets

Those believing in the theory that financial and commodity markets were perfect should have a look at the development of gold, silver and platinum during this past week. The major fundamental factors for the fair valuation were more or less neutral. Nevertheless, these three metals posted stronger losses between 2.1 and 5.2 per cent. Only palladium ended the week marginally higher.

The precious metals came under selling pressure on Monday and Friday. The reasons for the losses provided by market reports are demonstrating that markets do not react rationally. On Monday, analysts blamed the debt crisis in the eurozone as one reason for the losses. However, there were no news out of Spain and as we pointed out last week, it is not very likely that the Spanish PM would be forced to resign and that snap elections would have to be held. Fears about the Spanish government are like a storm in a tea cup. It was also quite clear that the meeting of eurozone finance ministers would not lead to a decision on a bailout for Cyprus as politicians wait for the presidential election before taking a final decision. In Italy, former PM Berlusconi reduced the difference in opinion polls to Mr. Bersani, who was still in the lead. And that Pope Benedict announced his resignation is by no means a reason to sell gold.

The second reason for the drop of precious metals prices on Monday was according to a market comment from Barclay’s the start of the lunar new year celebrations in many Asian countries. As Chinese investors absorb supply, analysts at the British investment bank feared that supply would weigh on prices in other trading centers. However, as the date of the lunar new year is not coming as a surprise and well known in advance, it should have been discounted already in the prices. Furthermore, if buyers of precious metals form rational expectations, they should have expected that prices might be under pressure when China is out of the markets for the week long holidays. Thus, a rational investor would defer buying to profit from the expectation of declining prices. Therefore, demand should have shifted towards the holidays in China and this should compensate the lack of demand from Chinese investors.

On the other hand, also short-sellers would know that Chinese investors would not be in the market during the lunar new year holidays. Thus, they also might defer selling short to have a stronger impact on pushing prices down. However, in this case, they would have to lease gold to meet the obligation to deliver in the spot market. As a result, gold lease rates would have to increase. Gold lease rates increased only slightly on Monday. Stronger increases took place later during the week and the week before. Nevertheless, the development of the gold lease rates indicates that large speculative investors are getting more bearish on gold. This is also confirmed by the recent CFTC report on the ‘Commitment of Traders’, which showed a further drop of the net long position held by large speculative accounts from 137,465 to 126,835 futures contracts at the CME’s COMEX division.

Unlike some well-known bond fund managers, who appear to talk their book almost daily on a television station, many hedge fund managers holding gold make no comments in public about their investments in precious metals or ETF’s on physical metals. Thus, the public has to wait until the filings of those hedge fund managers with the SEC will be released. During the final quarter of 2012, there were already indications that hedge funds turned more negative on gold. One of those indications was the development of the net long-positions in the CoT report. Now, the SEC filings revealed that Soros Capital and some other major hedge funds (Tiger, Moore) had reduced their investment in the SPDR Gold Trust ETF considerably in Q4 2012. This information was the trigger for the sell-off on Friday.

From a movie title, we know that “the postman always rings twice”. Many investors and traders appear also to react twice. The selling of shares in the gold ETF took place in the final quarter of 2012. When gold priced headed lower, they followed the price momentum and also sold. Now, they received the information why gold traded down some month ago and sell again. This is not a rational behavior but just following the herd instinct. First, the SEC filings provide no indication that Soros Capital and other hedge funds still reduce their position in the gold ETF. The selling in Q4, despite being massive, could be just part of reallocating funds to investments, which appeared to be more lucrative. It was also reported that Soros Capital made a gain of more than 1bn US dollars in speculating on a weaker yen, since it became official policy in Japan after the victory of PM Abe in November. Second, despite the liquidation of positions by major hedge funds, the gold holdings of the SPDR Gold Trust increased in Q4 by around 30 to 1,350.8 tons. However, since the start of this year, they fell back to almost the level at the beginning of Q4.     

Technically, gold is in a difficult position. With the plunge on Friday, gold has fallen below two stronger support levels, but managed to close above the lower support level at 1,600$/oz. The trend following indicators turned bearish and the increase of the ADX indicator points to a strengthening trend behavior of gold after many months of range trading. However, it is not yet an all clear for gold bears. First, the stochastic oscillator points to an already oversold market. Second, two support lines cross at 1,584$/oz, which is another hurdle the bears would have to surpass. Thus, a test of this support zone might be a good buying opportunity as long as the fundamental factors for precious metals remain positive.

Regime shift in precious metals markets

It was a mixed week for precious metals, with gold ending almost unchanged and platinum was the only metal posting a stronger gain, while silver and platinum closed lower in the weekly comparison. While gold and silver followed more the movements of the safe haven government bonds of the US Treasury and the German Bunds since the start of the year, the US dollar became the dominating factor after the ECB meeting. However, the reasons, which first led to a rise of precious metals and then triggered a drop on Thursday, are not based on a sound analysis. It is more following the herd instincts like lemmings.

At the start of the week, it was reports about political developments in Italy and Spain, which pushed German Bunds and US Treasuries higher. This also had a positive impact on precious metals. In Italy, the former PM Berlusconi is still lagging in polls behind the centre/left. However, he gained in popularity and reduced the lead of the centre/left to just 4 percentage points according to latest polls. But it is still not sufficient to form a new government. The centre/left under Mr. Bersani could form a coalition government with incumbent PM Mr. Mario Monti. Nevertheless, investors are worried that Mr. Berlusconi could become the next PM again. His promises made in election campaigns would be a clear end of the austerity policy. And this would also imply that Italy would not qualify for the ECB’s OMT program, which was the major factor for falling yields on Italian government bonds. However, analyzing past election campaigns of Mr. Berlusconi, analysts and investors should know that his campaigns are based on his media empire and populist promises. Mr. Berlusconi has to fight again for political survival to prevent from being sentenced to jail. But unlike in the past, the Italian industry association is not remaining silent but voices opposition to a return of Mr. Berlusconi to power. Thus, markets should have priced in that Mr. Berlusconi would catch-up in opinion polls.

The former treasurer of the leading Spanish Popular Party, Mr. Barcenas is subject of criminal investigations for some weeks already. On request from Spain for official aid, Swiss authorities found a bank account of Mr. Barcenas with a deposit of 22mn euro. One Spanish paper, El Mundo, reported that Mr. Barcenas delivered various leading members of the Popular Party cash in letters, but did not provide any proof. At the end of last week, another Spanish news paper, El Pais, published handwritten accounting notes, which link payments also to Spanish PM Mr. Rajoy.

As the Spanish opposition parties called for the resignation of Mr. Rajoy, many analysts and traders believed that the Spanish PM would have to resign. This demonstrates again the lack of political understanding among analysts. The opposition can not oust the incumbent PM. In the Spanish parliament, the Popular Party has a vast majority and it is rather unlikely that they force Mr. Rajoy to step down. Also snap elections are therefore not very probable. Fears among analysts and traders that a change of the government, which is not a likely scenario, would lead to an end of the austerity policy are also not rational. Markets have forgotten that it was the socialist government under Mr Rajoy’s predecessor, which included the obligation to balance the budget in the constitution even before this became part of the eurozone stability pact. Thus, the flight to the German Bunds and into the precious metals was not based on a sound rational analysis but driven only by fear.

On Thursday, the safe haven government bonds rallied, but the precious metals did not follow. Quite the opposite, they were pulled down by a weaker euro against the US dollar. The trigger was the reply of ECB president Draghi on a question about the euro exchange rate. However, markets did more react on what they wanted to hear than what Mr. Draghi actually said. First, Mr. Draghi pointed out that the ECB has no exchange rate target. This should be well understood by analysts and traders as the ECB emphasized again and again that its sole task is to maintain price stability. Second, Mr. Draghi attributed the recent appreciation of the euro as a result of confidence in the euro returning. As the fall of the euro against major currencies last year was based on fears of the euro falling apart, the fight of the ECB to do everything necessary to keep the euro intact would lead to a strengthening of the single currency. The ECB must have taken this into account and it was also welcome to reduce the inflation rate again towards the target.

Third, Mr. Draghi pointed out the the ECB council would have to observe the further development to assess whether the euro strength is only temporary or permanent and whether it would have an influence on its target. This was a more academic statement. Of course, the development of the euro must have a negative impact on the ECB’s target of price stability to trigger any policy action. So far, the strength of the euro is welcome, as it helps to reduce inflation. Only if a permanent appreciation of the euro would lead to inflation falling to dangerously low levels, the ECB would see a necessity for policy action. However, the markets took this as a signal for a further rate cut. The traders and analysts completely overlooked that Mr. Draghi emphasized several times that the current ECB interest rate policy is very accommodative. The ECB still expects that the Eurozone economy will pick up steam in the second half of this year. Thus, we would not rule out another rate cut if the economy situation worsens considerably. However, at present, another rate cut is not a very likely scenario.

           

Further speculation on a rate cut by the ECB to weaken the euro might prevail in the short run. However, as the ECB is likely to keep rates on hold, traders who sold the euro might have to buy back. The political development in Spain and Italy might be supportive for the precious metals. Thus, further range trading of gold and silver is the most likely scenario. Platinum and palladium are expected to perform still better than gold and silver. But some profit taking can not be ruled out.

Fed and US labor market report lift precious metals

After a weaker start, precious metals recovered lost ground. Only platinum failed to end the week higher. Last week, the precious metals decoupled somewhat from the movements of the safe haven government bonds. The influence of the usual major fundamental factors became stronger again.

There were two major events, which had an impact on precious metals, the FOMC meeting and statement as well as the US labor market report. For financial and commodity markets, the most important phrase of the FOMC statement was: “To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee will continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month.”

Markets were relieved that the FOMC continues quantitative easing. However, a rational investor should have priced in this decision by the voting members. The vast majority of the FOMC already voted for these measures in December. The US economy has slowed lately somewhat due to weather related disruptions as the FOMC noted also in the statement. Therefore, it was rather unlikely that a majority of voting members would now terminate QE only one meeting later. The FOMC will not stop quantitative easing also at the next couple of meetings; bar there would be a miracle in the US economy.

Nevertheless, we still expect that the minutes will also show that the discussion about the risks of quantitative easing for the balance sheet of the Fed and for the political independence of the Fed will go on. Yields on 10yr US Treasury notes have touched the 2% mark several times last week. The risk of a break through this resistance level is increasing. A break above this resistance could lead to a rise by another 25 basis points to 2.25%. Given the low coupon and the high duration of the on-the-run issue, such a small yield rise is sufficient to produce capital losses, which wipe out the coupon income of more than one year. Thus, rising yields pose a risk for the profit and loss statement of the Fed. Like any other bond investor, also the Fed would have to consider this risk seriously.

Even in the case that the FOMC would already decide to terminate buying bonds in the second half of this year, this would not change its interest rate policy. The target for the Fed Funds rate would remain at the exceptionally low level until one of the two thresholds, either for inflation or unemployment rate, are reached. Normally, this should still be positive for precious metals. However, as many investors have the wrong belief that QE would be necessary for rising prices of precious metals, discussions about an end of QE could cap attempts of precious metal prices to move higher.

Precious metal prices also rose after the release of the US labor market report. However, it was somewhat strange that also stock and bonds markets rallied after the figures were out. The report of January is always a bit difficult to interpret due to the annual benchmark revisions. Nevertheless, the report was not that bad to justify a rally in the bond markets. The non-farm payroll figure was slightly below consensus, but preceding months had been revised higher. Thus, overall, there were more new jobs created than economists predicted. Benchmark revisions also had an impact on the household survey. The increase of the unemployment rate from 7.8 to 7.9% was the result of annual population adjustments as the number of unemployed persons was little changed at 12.3 million. That the labor market report does not change the short-term outlook for the Fed policy did not justify the rally. Later during the trading session, US Treasury note and bond futures pared the gains and fell even below price level prevailing before the release of the labor market report. This pulled also precious metals lower again, but they managed to close higher on the day.

We still regard the major fundamental factors as positive for the precious metals. However, during the first month of 2013, gold and silver were more influenced by the movements of the safe haven government bonds, the US Treasuries and the German Bunds. These bond markets could continue to correct and yields increasing further. This could have a negative impact on gold and silver and might even more than compensate positive fundamentals.