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.