Performance of Precious Metals in 2013

Most analysts polled by the London Bullion Market Association at the start of 2013 were optimistic for precious metals in 2013. They predicted annual average prices to be higher for another year. However, after the first half of 2013 is over, it looks rather unlikely that average prices in this year will be above the average price of 2012.

The table below shows the spot price of the four precious metals as well as the percentage change over the end of the previous end of quarter and also the percentage change in the first half. The development of gold and silver in the first quarter of 2013 could still be interpreted as a correction after the end of the festival season, which is not uncommon. Platinum and palladium moved higher due to the development in South Africa and fears of supply shortage. But the second quarter had been a disaster for all precious metals.  

Based on our quantitative fair value model for gold, we investigate whether this plunge of precious metals in Q3 could be explained by the major fundamental factors driving the price of gold. Our model is based on weekly data. As also financial and commodity markets show seasonal influences, we did not use weekly, but annual percentage changes. Thus, there was no need to include also further seasonal adjustments in the model equations. All fundamental factors were included in the equations for the four precious metals. These factors are the 1) the US dollar Index, 2) the price of crude oil (WTI), 3) the S&P 500 composite index, 4) the yield on 10yr US Treasuries and the net long position of non-commercials in the futures traded at the Comex division of the Chicago Mercantile Exchange (CME). For the US Treasury yield, instead of percentage changes, the absolute yoy-change in basis points had been used. The net-long position has been divided by 1000.

Linear regression models based on time series of financial asset or commodity prices often lead to residuals, which are serially correlated. Therefore, the models include a first order autoregressive term for the residuals and the parameters for the exogenous fundamental factors and the autoregressive error term have been estimated simultaneously. The model was first developed in 2006, and therefore, data from January 1997 until September 2006 was used in the estimation. The regression coefficients are all significant at the 5% level and have the expected sign.

The following chart shows the development of the yoy percentage change of the spot gold price and the estimated values. At a first glance, the model appears to predict the development of the gold price still quite well. However, this good fit could be the result of the autoregressive error term, which might deviate further away from the fair value instead of oscillating around it.

Since the end of 2012, the yoy percentage change of gold dropped from 2.47 to -22.07% at the end of June 2013, which is a change of 24.54 percentage points. Thus, we investigated how much the five fundamental factors contributed to the dismal performance of gold. The US dollar index firmed on the strength of the US dollar against the Japanese Yen and thus contributed a -0.64 percentage points. Also the drop of the net-long positions held by the large speculators contributed with -2.15 percentage points to the negative performance of gold. However, crude oil, the S&P 500 index and the yield on the 10year US Treasury notes all made a positive contribution. In total, the five fundamental factors indicated that gold should have shown a decline of the yoy percentage change by 0.92 points to 1.55% instead of falling to -22.07%.  

This already indicates there must have been a structural change in the precious metals markets. Relationships collapsed, which held before the financial crisis and even in the first few years after the crisis.

One possible reason for a structural change might have been the speech by ECB president Draghi held in July 2012 in London, where he pledged to do everything necessary to keep the euro intact and announced what later became known as OMT.  A second reason might have been the introduction of Abenomics in Japan in the final quarter of 2012. Thus, the regression coefficients have been estimated again, but based on data from July 2012 until the end of June this year. Most of the variables or lag structures are no longer significant at the 5% level. Only the US dollar index and the S&P 500 index remained significant factors. However, the regression coefficient of the S&P index increased and changed the sign from positive to negative.

Slight modifications of the lag-structure led to a model, where the five fundamental factors are significant again. However, now also the regression coefficient for the annual change in the 10year US Treasury yield changed sign and magnitude. Rising yields, which had earlier been interpreted as a sign of rising inflation rates, are no longer positive for gold. They now lead to falling gold prices, which reflect the fear that an end of QE would eliminate any reason for holding gold.

Crude oil was the only one of the five factors, which made a positive contribution of 4.75 percentage points. The US dollar and the S&P 500 index both contributed less than one percentage point to the decline. The rise of the 10year US Treasury yield contributed -6.7 percentage points. The fall of the net-long position held by large speculators had the strongest negative impact on gold’s negative performance with -8.75 percentage points. All in all, according to the adjusted and re-estimated model the five fundamental factors contributed -12.45 percentage points to the fall of the yoy percentage change of the gold price in the first half of 2013.

The chart above shows the development of the yoy percentage change of the gold price and the estimate based on the adjusted model fitted for the period from July 2012 until June 2013.  It is obvious, that a good fit is only obtained for the period from early 2012 onwards. For the time before, the fit is worse. This clearly indicates that the structure of the gold market has changed last year.

It is uncertain, how long the US stock market and the US Treasury yield will have a negative impact on the development of the gold price performance. However, even if the regression coefficients of the adjusted model remain valid beyond the estimation period, the fundamental factors explained only 12.45 of the 24.54 percentage point drop in the yoy gold price change. Thus, almost half of the plunge could not be explained by the major fundamental factors of the model. This implies that gold overshoot on the downside. If the fundamentals don’t deteriorate further, there is some potential for a recovery. But the sentiment in the gold market is seriously damaged and the famous knife is still falling. Thus, it appears too early to try catching the knife now.

The Fed and selective information bias in markets

Many academic theories rely on the assumption that markets were information efficient. However, this assumption appears to be proven false in reality again and again. Reactions in financial and commodity markets after the release of the FOMC statement on June 19, 2013 provide the latest example. Moreover, the developments support more the thesis of behavioral finance that there are selective information biases among traders and investors.

For the time being, the Fed continues its bond purchasing program with an unchanged total volume of $85bn. However, the FOMC statement also pointed out that “the Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes”. This already indicates that the FOMC would also be ready to increase the volume of bond purchases again after tapering the volume if incoming economic data were suggesting a slower economic pace than expected. During the press conference, Fed chairman Bernanke explained the possible path of reducing step by step the volume of bond purchases. The FOMC might start later this year and end the program completely by the middle of next year.

However, the markets obviously totally overheard the conditions attached to this possible schedule. This scenario outlined depends on the condition that economic data coming in has to confirm the projections of the FOMC. Also during the press conference, Mr. Bernanke pointed out that the volume of QE3 could be increased again if the economic development is less favorable.

Many commentators stated that tapering the bond buying program would be the end of expansionary monetary policy. This is absolute nonsense for several reasons. First, even if the FOMC will reduce the volume of bond purchases as outlined by Fed chairman Bernanke during the press conference, the Fed will still increase the amount of bonds held until mid-2014. Second, an end of monetary expansion is usually defined as a shift in policy towards a restrictive regime. However, holding a constant amount of bonds by the Fed does not imply that policy gets restrictive. The Fed policy might only become less expansionary. Taking the foot from the gas pedal does not mean to step immediately on the brake!

Third, an end of unconventional ways to provide liquidity to the financial system does not imply that the conventional ones would be closed too. Financial institutions having access to the Fed could still obtain funds by borrowing from the Fed. The yields on medium- to long-term US Treasury bonds have still some upside potential. But the steeper the yield curve gets, the more attractive will be the risk/return profile of carry-trades. Banks could then buy US Treasury paper, which will be refunded by repo operations with the Fed. Thus, banks might even compensate the decline of demand for Treasury and mortgage bonds by the Fed.

An end of expansionary monetary policy furthermore requires that the FOMC would increase the Fed Funds target rate. Again, the FOMC statement does not provide any hint that this would be the case any time soon. The FOMC stated “the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent,…”. According to the projections, only three members expect a rate hike in 2014, while the broad majority expects the first rate hike in 2015.

The development of the US unemployment rate remains the key for the further direction of the Fed policy. During the months of falling unemployment rate, the bond bulls argued that the decline was only due to people leaving the workforce as conditions to find a job were hard. We always argued that this is a normal movement, which will reverse once conditions improve. The labor market figures released earlier this month indicate that this turning point might have been reached. Thus, the unemployment rate might decline at a slower pace than the consensus at Wall Street expects due to persons returning back to the workforce. But in this case, the monetary policy of the Fed is likely to remain expansionary longer than the market currently prices in.

The Fed Funds futures at the CME discount a hike of the Fed Funds target rate already by December 2014 with a probability of more than 50%. Thus, the market is far ahead of the Fed and probably will have to revise its expectations down again.

If the major buyer in a market declares that he will reduce his purchases, the normal reaction is that prices decline. Therefore, the rise of medium- and long-term US Treasury yields is justified. Thus, the crucial question is, how far will yields rise.  A good starting point is to look at the spread of the 10yr US Treasury yield over the 3M T-Bill rate or the 3M US Dollar Libor rate. Currently this spread is at 250 and 227 basis points, which is well above the mean of monthly data since January 1984. However, both spreads are less than 1 standard deviation above their respective mean. Thus, the spread still has some upside potential. But on the other hand, it is also less likely that the spreads would move deep into the extreme zone, which was normally reached after a period of strong growth and a shift towards a restrictive monetary policy. Therefore, a yield on the 10yr US Treasury note at 2.75% could already be a buying opportunity and close to 3.0% a strong one.

The reaction in the stock and commodity markets following the FOMC statement and the press conference by Fed chairman Bernanke are not justified. First, as shown above, the tapering of the bond buying program later this year does not constitute an end of an expansionary monetary policy. Furthermore, reducing the volume depends on economic growth and a decline of the unemployment rate. Both factors are normally positive for company profits and thus also for the stock market. Second, the yield spread is one of the best indicators for the stock market. A rising yield spread is usually leading to a higher yoy-change of the S&P 500 index. Since 1985, the percentage change of the S&P 500 index one year later was 3.5 times the spread (in percentage points) between the yield on 10yr US Treasury notes and 3m T-Bills. Thus, the spread widening should normally be positive for the stock markets going forward.

All in all, we come to the conclusion, that the market was very selective in interpreting the message send by the FOMC and Fed chairman Bernanke. Besides neglecting some of the information presented, the market also did not interpret the message correctly. Tapering the bond buying program is not the end of expansionary monetary policy. US President Franklin D. Roosevelt stated in his first Inaugural Address “the only thing we have to fear is fear itself”. However, the markets wanted to be fearful. Warren Buffet’s advice to be fearful when others are greedy and greedy when others are fearful might be invaluable again currently.   

Germany’s constitutional court hearing – a ticking time bomb for the euro?

About nine month ago, in a preliminary ruling, Germany’s constitutional court rejected complaints to stop Germany from joining the EMS and thus paved the way to calm the debt and currency crisis in the eurozone. However, a final ruling after closer examination of the case was still outstanding. The second factor to calm the debt and currency crisis was the decision by the ECB to announce the OMT program of buying government bonds in the secondary market. Constitutional complaints had also been filed at Germany’s constitutional court against the ECB. This past week, the court located in the city of Karlsruhe held a two day hearing on the two cases, the EMS and the ECB’s announcement of OMT.

The Bundesbank, although a member of the system of European central banks and thus part of the ECB, opposes the OMT program, which it regards as being direct state financing and thus violating the Lisbon treaty. Also the German professors of economics, which the court invited as experts followed the argument of the Bundesbank or regarded OMT as being in a legally gray area. It is understandable if lawyers and the seven judges of the court have difficulties to understand economic terms. However, the president of the Bundesbank and the professors should know what the term financing means. But as the DSGE models those professors and the Bundesbank applies does not even include a financial sector, how can one expect they know what this term means. However, a closer look in a dictionary of economic terms might have helped.

There are two ways of financing, either by debt or equity. The later is not possible for a state and can thus be neglected. State financing then implies that a state entity is borrowing from another party, which is the lender. Furthermore, it requires that funds flow from the lender to the borrower. If borrowing is conducted in the form of issuing securities (bills, notes or bonds), then the financing process takes place in the primary market. Transactions in the secondary market don’t constitute financing because no funds will flow to the issuer of a debt instrument but only from the buyer to the seller. However, in the government bond market there is one subtle exemption that government funding agencies retain a part of the issue volume for open market operations and could sell this paper in the secondary market. But the OMT is not designed to trade directly with funding agencies of governments. The counterparts are banks and as long as banks have to purchase the securities first before they can sell them to the ECB, the ECB only operates in the secondary market, which is explicitly allowed by the Lisbon treaty. Thus, the ECB and the German finance minister were absolutely right in their statement that OMT is within the framework of the EU treaty.

If the interpretation of the Bundesbank were correct, then the final consequence would be that all transactions of the ECB with banks refunding loans to government entities were forbidden and would violate the ECB mandate. Also interest rate cuts reduce the funding costs of some governments and thus were indirect state financing according to the Bundesbank argumentation.

The ECB is an EU institution and therefore, any ruling whether the OMT program is compliant with the Lisbon treaty is only in the competence of the European Court. The president of the German constitutional court indicated this also in his opening remarks. However, he also stated that OMT might violate the German constitution and thus, the court is hearing the case because it would be a complicated legal matter. The questions of the judges and their remarks during the hearing had been interpreted by many commentators as an indication that the court would tend towards regarding the OMT program as not in line with the German constitution.

In this respect, the other arguments brought forward by those who filed the legal complaint deserve closer inspection. The first argument refers to the risk of OMT for the national budgets. In the case of a default of a government on its bonds, the ECB would suffer a loss, which would have to be covered by the other governments. Thus, OMT would violate the budget rights of national parliaments. This argument is not convincing for two reasons. First, OMT reduces the risk that a country leaves the eurozone and defaults on obligations denominated in euro. The foreign exchange markets no longer speculate that the eurozone would fall apart. Furthermore, also funding costs of countries like Spain and Italy came down since the market no longer beliefs in a collapse of the euro. And this all took places without OMT being activated. Second, risks for losses exceeding the equity capital could also result from devaluations of other assets held by the ECB. Thus, also holding foreign reserves and gold could be a potential risk for national budgets and had to be forbidden according to the logic of the opponents to OMT.

Another argument put forward by those filing the complaint against the ECB is that the European Central Bank would lack any democratic legitimacy. True, the ECB council members are all not elected by the people of the eurozone directly. However, this is also the case of every national central bank. Furthermore, the ECB is politically independent and not controlled by a parliament. However, this is also the case with the national central banks, which are also independent and not responsible for their decisions to any parliament or government.   

The markets did not show much reaction to the hearing at the German constitutional court. The euro even strengthened against the US dollar in the weekly comparison. On the one hand, a decision is not expected to be announced before September. On the other hand, markets expect that the German constitutional court would not rule against the ECB. However, the court in all its rulings on rescue measures for the euro always emphasized the right of the parliament. Thus, it could not be ruled out that the majority of the judges decide that the Bundesbank is not allowed to participate in OMT. Such a ruling would most likely cause renewed tensions in the eurozone. But more important would be the question how could Germany stay in the EU and the eurozone if the German constitutional court rules that OMT would violate the German constitution while the European Court confirms the ECB’s position that OMT is fully compliant with the Lisbon treaty?

Thus, precious metals might be a good insurance against a negative surprise from the German constitutional court later this year.

US labor market report not strong enough to justify losses of precious metals

Until Friday noon (GMT), all precious metals were up compared to the close of the week before. However, after the release of the US labor market report, precious metals came under pressure. Gold and silver erased the gains made since the start of the week and posted another weekly loss. The PGMs, however, managed to close higher.

We pointed out several times that the major fundamental factors explaining the movements of the precious metals in various quantitative models are the US dollar index, the S&P 500 index as a proxy for economic activity and the price of WTI crude oil as the oil price is one of the major factor for the direction of CPI inflation. These three factors had been positive for precious metals even after the release of the US labor market report with the exemption of the US dollar index, which pared some of the losses suffered earlier last week.

Since the Bernanke testimony to the Joint Economic Committee, the US stock market consolidated as many investors and traders feared that the FOMC could soon reduce the volume of monthly bond purchases. The US labor market report had been regarded as crucial for the FOMC whether to maintain or reduce the magnitude of QE.

From our point of view, the June labor market report is most likely not tipping the balance towards scaling back the bond buying program. The number of additions to the non-farm payroll at 175 thousand was only marginally above the consensus forecast. However, the figure for the month of April was revised down from 165 to 149 thousand new jobs. Lately, the revisions were to the upside.  Thus, on balance fewer jobs than expected had been created. Furthermore, the unemployment rate edged up to 7.6% whereas the consensus among Wall Street economists was looking for an unchanged rate of 7.5%. All in all, this labor market report indicates that economic growth in the US is solid and robust but not strong enough to induce enough members of the FOMC to vote for a reduction of monthly bond purchases.

As the major fear in the US stock market has been the possibility that the Fed might remove the punch bowl, the reaction following the release of the labor market report is logical. Also the rise of crude oil price makes sense as a continued Fed stimulus should be positive for the demand for crude oil. However, the foreign exchange market appears to have come to a different conclusion. A strengthening of the US dollar against the Japanese Yen and the euro following the labor market report only makes sense, if it is interpreted as strong enough to tip the balance towards reducing QE at one of the next FOMC meetings. Also the reaction in the US bond market was very volatile. Obviously, some algo-traders had the report a few seconds before the official release time. Thus, the US 10yr T-note future dropped ahead of the release, but traded up to the high of the day within the first 5 minutes after the official release time. But during the trading day, the market turned around and the yield on the 10yr US T-note rose to 2.16%

Also many gold market analysts argued that reducing the volume of QE by the FOMC would be negative for gold. Thus, the market reaction last Friday indicates that the labor market report was interpreted in the precious metals market as strong enough to induce a sufficient number of FOMC members to vote for cutting the volume of bond purchases.

Some analysts might argue that the rise of the S&P 500 index on Friday by 1.3% was the result of shifts in asset allocation where stocks profited from moves out of US Treasury paper. However, before the release of the US labor market report, it had been argued that a shift in the Fed policy would be negative for stocks and bonds. If this argument were correct, it would not make any sense to allocate now funds out of US Treasuries and precious metals into stocks. Furthermore, it could not explain the price increases in the energy market. Thus, the implication of the June US labor market report for the Fed policy and the volume of QE had been interpreted differently in the various markets. Gold and silver were in the pessimistic camp. However, this might be wrong one as this report is most likely not tipping the balance.

The Fed, QE and stock markets

Hints of Fed chairman Ben Bernanke that the FOMC might decide in one of the next few meetings on modifications of the bond buying program stopped the rally at the US stock market. During the first five month of this year, institutional investors reduced their holdings in the SPDR Gold Trust ETF to invest proceeds in the stock market. Therefore, if the US stock market will become less attractive and enters into a correction, then also the outflows of gold ETFs might came to an end.

We have developed a series of quantitative models for various major stock markets, which are all based on the macroeconomic portfolio theory. This theory is based mainly on the contributions of James Tobin, who became known to a broader public outside the economic academic world due to his proposal to reduce speculation in foreign exchange markets by imposing a tax. The demand for an asset increases with rising wealth and income of an economy. Furthermore, demand will be higher if the rate of return of an asset increases, but higher returns of alternative assets reduce the demand.

In the quantitative model, we focused on macroeconomic variables with a monthly frequency. Therefore, we used some variables, which are closely related with the development of GDP, which is widely used to represent the income of an economy. For the monetary policy impulse, concepts of money stock aggregates could be used. However, better results were obtained for many countries by using interest rates instead. For the S&P 500 index, the yield on 2- and 10yr US Treasury notes entered the model, while for some other indices the spread between the yields for these two maturities of the corresponding government bonds yielded better results. The indicator is constructed as an oscillator to model the yoy percentage change of a stock index, therefore, also the yoy-change of the interest rates are used as explanatory variables in the quantitative model.

To analyze the impact of scaling down the bond purchases by the Fed, we have to analyze, which impact would a gradual reduction of QE have on US Treasury yields for the two maturities. At the short end, the upside potential appears as rather limited for two reasons. First, the purchases in the US Treasury market by the Fed were concentrated on medium- to long-term maturities. Thus, scaling back the volume of purchases by the Fed would not have a direct demand impact on the 2yr US T-notes. Second, the Fed indicated that the extremely low level of interest rates would prevail well into 2015. Thus, the Fed Funds target rate remains at below 0.25% for quite some time and this should be reflected also in the yield on the 2yr US T-Notes. Thus, the most likely case appears to be that the short end of the US Treasury curve does neither provide a stimulus nor a burden for the further development of the US equity market.

A stronger risk for stocks could come from the longer end of the US Treasury market. If the FOMC decides to reduce the volume of monthly bond purchases, the usual c. p. argument is of course that this would lead to lower demand and thus rising yields. However, one has to take also the supply into account. Furthermore, at a higher yield level, institutional investors might increase their demand and thus, compensate the shortfall of demand from the Fed. But one has to keep in mind that the US Treasury market already reacted and the yield on 10yr US T-notes rose in May 50bp from the low of the month. This was the major negative factor for the macroeconomic indicator in May. Last year, the low in the yield on 10yr US T-notes was during the months of May and July, during the rest of the year, yields were higher. Thus, the basis effect should also provide a buffer after July.

Currently, our macroeconomic indicator for the US stock market is still signaling a positive economic environment for the stock market despite the drop in May. Only a decline below a moving average line would indicate that the fundamentals turned negative for stocks. A further rise of 10yr T-note yields to around 2.5% over the next two month could have a negative impact and might be the trigger for a bearish crossing of the indicator and its average line. A gradual increase to 2.5% by year end would have a less severe impact on the indicator. However, even if the macroeconomic indicator turns negative, it is not an immediate reason to become bearish on stocks. A further condition would have to be fulfilled to trigger a sell signal for the S&P 500 index. Thus, gold and silver bulls better don’t bet that a possible FOMC decision to reduce bond purchases would lead to a major correction of the US stock market and would drive investors back into the precious metals markets.