Fed scaling back bond purchases and the impact on precious metals

It was a volatile week for some precious metals. Silver plunged at the start of the week but ended the week even slightly higher. Gold came under pressure during the testimony of Fed chairman Bernanke to the Joint Economic Committee on the economic outlook and monetary policy. However, also gold pared the loss and closed the week with a gain of 2%. On the other hand, platinum managed to close at the same level as the Friday before while palladium posted a loss.

Initially gold traded higher when Fed chairman Bernanke started his testimony. He defended the quantitative easing and the bond purchase program. For the slower growth of the US economy, he made the fiscal policy responsible. This was interpreted as a continuation of QE. But during the Q & A session, the sentiment in financial and commodity markets changed. One reason was the release of the minutes of the recent FOMC meeting, which showed the committee had an intense and controversial discussion about scaling back the volume of bond purchases by the Fed. In addition, Mr. Bernanke pointed out at his testimony that the FOMC might take a step down in the pace of bond buying in one of the next few meetings.

Thus, the Fed chairman indicated that the balance among the voting members of the FOMC might tip in favor of scaling back the volume of purchases. Thus, the question arises whether a gradual reduction of QE would be negative for gold and silver. We have always argued that QE by the Fed is supportive for higher gold prices, but it is not a necessary condition. In addition, last week, we pointed out that QE per se is not leading to higher precious metal prices, but it is more important which central bank implements QE. The decision of the Bank of Japan to extend its balance sheet had already triggered a wave of Yen selling against the US dollar. The real yield on 10yr JGBs is still positive, while the yield on 10yr US Treasury notes just compensates for CPI inflation. However, to base a decision about capital flows on real yields implies that the purchasing power theory would have to apply in foreign exchange markets also in the short-run. But this is not the case and therefore, investors have an incentive to fund in Yen and to invest in US dollar denominated assets. Scaling back the volume of bond purchases by the Fed is increasing this incentive as the spread of US Treasury notes over 10yr JGBs probably will widen.

However, one also has to take into account the impact of QE on short-term interest rates and not only on bond yields. Especially in the case that scaling back bond purchases by the Fed could lead to yields on medium to long-term US Treasuries are likely to increase and lead to losses, which could quickly exceed the coupon income of one or two years. Given the outlook provided by the FOMC, the short-term interest rates remain unchanged well into 2015. Thus, short-term interest rate differentials are most likely not a strong incentive for flows into the US dollar. But all in all, taking the foot of the gas pedal has probably the effect of strengthening the US dollar, which would be negative for the precious metals.

Economists have the reputation to argue always “on the one hand and on the other hand”. But we can not avoid pointing out that there might be also an effect, which could work positive for gold and silver in the case the Fed reduces the volume of the monthly bond purchases. For many months last year, investors regarded also precious metals as risky assets. When risk appetite increased, stocks and precious metals together moved higher. The correlation was positive. But this has changed with the announcement of purchasing $45bn of US Treasury paper per month. In addition, the fiscal cliff had been avoided and the headwinds from fiscal policy blew less strong than feared. But now, the stance of investors towards commodities changed. The outlook for stock markets was far better as long as the Fed pumps billions of US dollars in the system each month. Investors shifted the asset allocation and preferred stock markets at the expense of commodity markets. Reducing the holdings in gold ETFs was one source of funding investments in stock markets.

As the reaction in the stock market during the Bernanke testimony shows, reducing the pace of bond buying could lead to a stronger correction in stock markets, which some market pundits already view as massively overbought and overvalued. Even if one disagrees with the view of stock markets being overpriced, as we do, one has to take possible herd behavior into account. Therefore, if investors no longer regard stock markets as the more attractive investment, it could be sufficient to stop outflows of gold ETFs for funding investments in equity markets. This could have a positive effect for gold and silver, which might at least partly compensate the expected negative impact from the foreign exchange market.