Fearing the Fed not justified – FOMC statement already said all

Economic theory of the Chicago School states that participants in financial and commodity markets form rational expectations and thus, all information would be included in the prices. The developments in August demonstrated again that not all expectations and opinions voiced by traders and analysts are based on a rational analysis and information processing.

The US stock market reached an all-time high of the S&P 500 index following the FOMC meeting on July 31, 2013. But then the stock market for 2-1/2 weeks declined on fears the Fed could taper the bond purchasing program at the next FOMC meeting in September. Also the yield on 10yr US Treasury notes rose by almost 30 basis points in the same period and was only a whisker shy of the 2.90% mark.

But unlike in earlier situations, the fear in financial markets of the possibility the Fed might reduce the volume of bond buying played a role contributed to a recovery of precious metals prices. Quantitative easing is regarded as one reason for capital flows into emerging economies. With the fear the FOMC might decide to exit QE3 in September, international investors shifted funds from emerging economies back into Western economies. As a result, the US dollar weakened slightly against the major currencies as measured by the US dollar index.

The fears were driven to some extend also by comments from a few FOMC members. However, most of those members making statements about tapering opposed the program from the very beginning. But even more important, most critics of QE3 are non-voting members this year. Thus, many market participants expected more hints from the minutes of the recent FOMC meeting and at the same time feared the minutes would confirm the FOMC would decide to taper in September.

No doubt, minutes of a meeting could provide some further insights. Nevertheless, the FOMC statement already send the main message, namely that any decision to reduce the volume of bond purchases would be data dependent. And the economic data available at the FOMC meeting did not induce the committee to make a move towards tapering. Also data released after the July meeting does not provide a strong case for a decision to reduce the volume of bond purchases in September.

The minutes even provided arguments, which could reduce the likelihood for tapering at the next meeting. It has also been pointed out that tapering could increase the risk of moving towards deflation. This had also been discussed in this blog by turning the attention to the development of the core PCE deflator, which moved down towards the 1% level.

Unless there are shocks, there are normally no U-turns in the voting behavior of the FOMC members. This means that changes in monetary policy are indicated by an increasing number of members voting against the current stance of monetary policy instruments. However, the recent FOMC statement showed that one member voting against the majority at meetings earlier this year joint the majority at the July meeting and also voted for a continuation of the current policy.

Thus, the statement of the July FOMC meeting already provided enough hints that the minutes would not reveal new information, which would point to tapering in September. It could not be ruled out that the consensus of Wall Street economists might be right. However, the FOMC statement and the minutes as well as economic data released in August so far indicated that the odds are more for keeping the current volume of bond purchases of $85bn in total also at the September meeting.

At the US Treasury market, it should already be priced in that the FOMC will not continue to buy bonds at the current level forever. But given the moderate GDP growth and the low core PCE inflation far below the Fed target and that extremely accommodative monetary policy will keep the Fed Funds target rate at less than 0.25% well into 2015, the current yield level at the long end is attractive.   

Some Comments on Gold

During the course of a week, we receive some e-mails with comments on precious metals markets. Normally, those comments will not be commented in this blog. However, this week, we decided to write about two articles.

The first article was titled “Will gold break its negative correlation with dollar?” and was written by the head of research employed by a gold investment company. She wrote about the market action on Monday and noted that the US dollar index was up and gold continued to climb higher. Furthermore, she wrote that now many analysts were asking if the yellow metal were breaking the negative correlation with the US dollar. In addition, this possibility would displease Deutsche Bank which reiterated that they were bullish on the US dollar and a firm dollar would cause headwinds for gold.

First, one swallow does not make a summer and one day off opposite movements between the US dollar index and gold does not imply that the negative correlation is breaking down. Correlation is a measure of linear co-movement of two variables, measured by their deviation from the respective mean. Even a high correlation (positive or negative) does not imply that every pair of observation would have to show the same sign. Furthermore, the correlation coefficient does not provide information how many times the two variable move in the same or in opposite direction.

Second, this head of research confuses correlation with causation. The US dollar is not the only fundamental factor having an impact on the price of gold. Crude oil is an important factor for headline consumer price inflation. Therefore, crude oil also has an impact on the gold price. The development of major stock markets, money market interest rates and bond yields also have an impact as many econometric analyses show. Thus, on some days, the other factors could more than compensate the impact of the US dollar on the price of gold. For example, a rise of crude oil prices due to the tensions in Egypt could be sufficiently strong to push gold higher while the US dollar index declines.

Third, in our quantitative fair value model for gold, the US dollar index has a negative regression coefficient. For other variables, there has been a change of the sign in the period starting January last year compared with some years before. However, the sign of the US dollar remained unchanged. Thus, the hope for a break of the negative correlation between the US dollar and gold is probably in vain.

The second article is titled “The hidden agenda behind the bear raid”. Of course, this is another article on a conspiracy theory about gold being manipulated. The author wrote that after the December 2012 FOMC meeting “…gold was driven back below the key psychological $1700 level during an unnaturally high volume hit in the middle of the night. No normal trader seeking to maximize returns would dump that kind of volume into the thin overnight market.” The author completely overlooks that gold is traded not only in the US, but also in Asian and European financial centers. Thus, physical gold is traded around the clock. When it is night time in the US, then it is already morning of the next day in Tokyo and Shanghai. For many Asian investors or traders, this is the first opportunity to react on events in the US, which are important for the price perspectives of gold. One should also keep in mind that the USD/JPY exchange rate is trading with higher volumes during Asian trading hours. Furthermore, with the election of PM Abe in Japan, there was a landslide shift in Japanese economic policy. The target of ending deflation and reaching a 2% CPI inflation rate within two years had consequences for the yen exchange rate. We showed in this blog that the downward move of gold was mainly driven by a firmer US dollar against the Japanese yen.

Furthermore, the author highlights that Goldman-Sachs came out on April 10 with a public recommendation to sell gold short. Goldman-Sachs’ gold analyst was bearish for quite some time before he gave this recommendation. Thus, it was not really new for those reading reports on the gold market at Bloomberg or ThomsonReuters terminals. For an investment bank, it is normal business to make trade recommendations to clients and to send those reports also to the media. The author concludes that “It seems much more likely that Goldman Sachs traders were already short the gold market and were looking to juice the downside as they already knew a stop run was coming.” It cannot be ruled out that traders at Goldman-Sachs were already short gold before this paarticular research recommendation was published in April. However, there are strict rules research departments have to obey. Analysts are not allowed to inform traders about their trade recommendations before they are send out to clients and are in the public domain. Compliance departments have a close eye that analyst do not violate the law because the company can be punished heavily. The fact that this recommendation had a strong impact on the price of gold is due to the reputation of Goldman-Sachs’ analyst who earned his reputation by making many correct calls on gold. Only if an analyst has a good track record or convincing fundamental arguments, then hedge funds or other institutional investors take a story seriously and put money on a recommendation. Thus, also the second argument for a manipulation of the gold market is not based on sound reasons.

The third indication for a manipulation would be the accumulation during April and May of unusually large positions in GDX puts with expiration in June. Those positions would have prevented gold from closing and holding above 1,400$/oz. And miraculously (from the author’s view point) gold collapsed another 125$ before the expiration in June and thus, send the puts deep into the money. However, there is no hidden conspiracy, but these moves could be explained in hindsight after quarterly releases of SEC filings.

There has been much talk in financial markets about JP Morgan and the London whale, which led to a loss of $6bn for the US bank. But there was – or better still is - also a whale in the gold market and his positions were well known due to the quarterly reporting of positions to the SEC. Many hedge funds invested in the SPDR Gold Trust ETF, but the largest stake holder is John Paulson and his hedge fund. After suffering already severe losses in the first quarter of 2013, Mr. Paulson had to react. Hedge fund sponsors could force the manager to take actions even if the manager remains convinced that he holds the right positions. This week, the SEC published data showing that Mr. Paulson has halved his holdings of the SPDR Gold Trust ETF in the second quarter.

Knowing the sheer size of his position and which impact it would have to sell 50% of the position, it is natural that a hedge fund manager would apply several instruments to limit the losses. Accumulating a position in puts is a smart strategy in this context. The puts secures a price for at least a part of the position, which has to be sold. Mr. Paulson lost $736m in the second quarter and his PFR Gold fund is down 65% in the first half of this year. Therefore, cutting the losses and liquidating part of the holdings could hardly be regarded as a market manipulation. The gold bulls also did not complain and called it a market manipulation when the accumulation of Mr. Paulson’s position pushed the price of gold higher.

Thus, all the arguments for a gold market manipulation could be rejected by sound explanations. However, it is a characteristic of all conspiracy theories that their devotees deny the facts. But as the case of Mr. Paulson and his hedge fund demonstrates, it is not only dangerous to swim with sharks but also with a whale. 

Summertime and The Livin Is Easy

The title of the famous aria from George Gershwin’s opera Porgy and Bess might describe pretty well the living of those who could afford to spend currently their vacations. However, it certainly is not an appropriate description for those holding or trading positions in the metals markets. But there is also an exception in metals markets, spread traders being long in the PGMs and short in gold or silver could also enjoy an easy living.

Several factors make the life of a metals trader currently a hard one. Amongst those factors is the Fed.  While at Wednesday of the preceding week the FOMC statement provided no hint that tapering would be implemented at the next meeting, at the start of the week two hawkish FOMC members voiced that the FOMC should taper bond buying at the September meeting, while one dovish member would not rule out that the FOMC could decide as early as at the next meeting to reduce the volume of monthly bond purchases. Before the recent FOMC meeting, Fed chairman Bernanke calmed markets by emphasizing that the decision to taper would be data dependent.

However, the recent data does not provide any hint that the urge to reduce the volume of QE3 has increased. The recent revision of US GDP data is the result of a modification of the definition which items qualify as assets. But the economic activity did not become more or less dynamic due to the GDP revision. As pointed out last week, the core PCE deflator heads down and thus also provides no indication that tapering would be required to avoiding inflation. But the PCE deflator indicates that the FOMC would better wait and thus, might not make the same mistake as the BoJ some years ago. Nevertheless, the hawks within the FOMC oppose QE3 for orthodox beliefs instead of sound and rational economic reasons.

The problem is that the market is currently nervous and uncertain about the timing of the exit from QE3. Thus, many market participants do not distinguish whether a hawkish comment is made by a voting or non-voting member of the FOMC. Every statement from a hawkish FOMC member is immediately treated as it would be the next FOMC decision. Thus, it is no wonder that not only gold and silver, but also the US stock market and the base metals traded lower at the start of the week.

Three weeks ago, we wrote about the impact of Chinese macroeconomic data on base metal prices, in particular on copper. In this context, we noted that copper related data like copper imports have a lower explanatory power than general macroeconomic indicators like the Chinese manufacturing PMIs. This week, it were the import data for all goods and services as well as for come base metals (of course, copper was among them), which excited financial and commodity markets and lead to a turnaround. Factory production data on Friday pushed the precious and base metals further up to end the week in the plus.  

The Chinese trade balance in July was lower than expected at $17.8bn compared with a consensus forecast of $26.2bn. However, the data from the Customs Administration showed that exports rose 5.1% from a year ago while the consensus expected only an increase of 3%. Even stronger soared the imports, which jumped 10.9% from a year earlier. The surge of imports was more than five times of what economists predicted. The rise in exports is regarded as a sign that global demand is picking up, while the rocketing imports are considered as an indication that domestic demand in China is rebounding. While this interpretation is correct, analysts and traders might easily overlook one fact, which could lead to a disappointment later.

What counts for the calculation of the GDP and thus for GDP growth is not the percentage change of imports or exports, but the difference in local currency terms between ex- and imports. A widening of an export surplus leads to a bigger contribution of the external sector to the GDP and vice versa. Thus, July’s surge in imports could lead to a smaller surplus of the external sector and thus to a slower GDP growth.

The Chinese imports of unwrought copper and copper products increased from 380 thousand to 410.6 thousand tons in July. Compared to the same month of the previous year, this is an increase of 12%. Some analysts argued that this increase of copper imports would be due to financing reasons. However, this argument is not very convincing. Of course, inventories of copper or other base metals are used as collateral for short-term financing operations. But in this case, the inventory is held either voluntary in order to have sufficient metal for the production process or involuntary because the goods cannot be sold immediately and are stored. But copper imports have to be paid at a certain payment date, which could be some months into the future. Freight letters of copper shipped to China could be used to finance the imports and this is a usual procedure in international trade finance. But in this case, the copper will not be imported just to obtain a loan for paying the import. The driving reason for importing copper is the use for consumption and not for holding it at warehouses and using it as collateral. Thus, the rise of copper imports in July is a positive indication for economic activity in China.

Another positive indication for Chinese economic activity was the increase of industrial production in July. The industrial output rose 9.7% from the same month last year, while in June the year-over-year percentage increase was at 8.9%. Unlike the official Chinese manufacturing PMI, the HSBC manufacturing PMI slipped below the 50 threshold and indicated a slowdown of economic activity in the industrial sector. However, the industrial output expanded stronger as expected. Another example that markets better follow the official PMI because size matters. If large companies increase production, it has a stronger impact on overall output than the reduction of smaller companies.   

Overall, the Chinese data might improve sentiment towards the second biggest economy somewhat. However, the next official data release will be only in September. Thus, US economic data and the fear of Fed tapering in September might quickly regain the headlines and move the markets. Thus, even the second positive weekly close of gold is not a harbinger that gold might rally towards the 1,400$/oz level in the short run.  Also the industrial metals, which have stabilized, are not yet out of the woods.   

No reason to be afraid of the Fed

After three weeks of gains, gold declined and ended last week with a loss of 22$ at 1,311$/oz. Also silver closed slightly lower than the previous Friday, while the PGMs managed to post a gain. The yield on the 10yr US Treasury note edged higher by 4bp to 2.60%. For gold and silver as well as the US Treasury note, the same factor was responsible for the falling prices, the fear that the Fed could taper the bond buying program at the next FOMC meeting in September.

At its two day meeting, the FOMC kept monetary policy unchanged as it was widely expected. The Committee decided to continue purchasing agency mortgage backed bonds and longer-term US Treasury paper at an unchanged volume of $85bn per month. Furthermore, the FOMC stated that it “… will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability.

Thus, there are two developments, which could induce the committee to change the current pace of monthly bond purchases. The first one would be an increase of the inflation rate well above the target rate of 2 percent combined with an increase of inflation expectations. It is well known that the favorite inflation gauge of the Fed is the core PCE deflator. The year over year percentage change of the core PCE deflator is showing a downward trend and the most recent inflation rate in June was only 1.1%. Thus, inflation is definitively not a problem, which would induce the FOMC to taper the bond purchase program this year. Quite the opposite is the case. The FOMC should be more worried that the core PCE inflation could continue to head further down. Therefore, maintaining the current pace of bond purchases is also an insurance policy against the risk of heading towards deflation. Fed chairman Bernanke has studied the policy mistakes made by the Bank of Japan intensively. Under his chairmanship, the Fed is not going to repeat those mistakes.

The second factor is the labor market. Financial and commodity markets focused on the non-farm payroll figure of the labor market report for July, which was released last Friday. The number of new created jobs came in at 162,000 while the consensus expected an addition to the payroll of 184K. Also the figures for the two preceding months had been revised down. Especially the bond markets and also gold and silver welcomed this report and reversed earlier losses to end up on the day. However, the focus of the FOMC is not the number of new jobs, but the unemployment rate. Of course, the faster the pace of new job creation, the quicker the unemployment rate could fall. But in July, the unemployment rate declined to 7.4%, more than the consensus expected, despite fewer new jobs than in the month before were created.

The US Bureau of Labor Statistics reported that the civilian labor force participation rate in July was 63.4 percent, which was little changed over the month. However, the number of unemployed persons declined to 11.5 million, which led to the stronger than expected decrease of the unemployment rate to 7.4%. Despite the seasonal adjustment procedures, one has to keep in mind that July and August are vacation months. In May and June, it had been observed that persons, who left the work force, returned and were looking for a job. Those persons considering to join the work force again might postpone this decision during the main summer vacation months because they regard the chances to find a job less favorable when decision makers are on holidays. But they might start looking for a job in September after the US Labor Day. Therefore, it would not be surprising to see another slight decline of the unemployment rate in August followed by an increase in September.

Nevertheless, even after the recent decline, the FOMC might come again to the conclusion that the unemployment rate is at an elevated level when the committee meets again in September. Thus, unlike the majority of Wall Street economists, we do not regard it as a done deal that the Fed would start tapering bond purchases in September.

Just when markets were too convinced that QE3 would last infinitely, Fed Chairman Bernanke sent a wake-up call during the testimony in May. However, reading the statements carefully, it was clear from the very beginning that a decision to reduce the volume of bond purchases would be data dependent. But the bond and precious metals market overreacted. The fear of tapering is still widespread as the development last week demonstrated. Thus, the yield on 10yr US Treasury notes might increase further. But we maintain our view that at a yield level of 2.75 or above they are attractive given the outlook for short-term interest rates, which the Fed is likely to keep at current levels into 2015.

For gold and silver, there are two opposite forces. The market’s fear of tapering by the Fed is limiting the upside potential of both metals due to the firmer stock markets and crude oil prices. It could even lead to falling prices. However, as long as the Fed waits, the US dollar might weaken against some major currencies, which would be positive for gold and silver. Thus, as long as the incoming data points to a continuation of bond purchases at the current pace, gold and silver might trade sideways with the slight bias to the upside. But once the data points to a higher likelihood for tapering, the two metals might come under stronger selling pressure again.