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.