Further range trading of precious metals despite tapering being delayed

The positive week for precious metals does not change our forecast that gold and silver are likely to remain in a broad sideways trading range. Only the PGMs might break out to the upside, but this depends on the supply from South Africa, as there is always the risk that labor unrest could lead to production shortfalls.

One factor contributing to the positive performance was the flash estimate of the HSBC manufacturing PMI for China. While the consensus forecast predicted an increase from 50.2 to 50.5, the index rose to 50.9, which points to a far stronger expansion of the manufacturing sector. However, this is not only a positive indication that the GDP growth of the Chinese economy is probably accelerating further in the final quarter of 2013. Given the strong dependence of China on exports, it is also a positive sign for the global economy after the recent forecast downgrades by the IMF and World Bank.

Just a few weeks ago, Eugene Fama was rewarded with the Noble laureate in economics. However, his theory rational expectations in financial markets, which leads to information efficiency, has been proven wrong again. Several members of the FOMC already stated that a decision to taper would be delayed into next year given the uncertainty about the economic situation caused by the government shutdown. Thus, it should be already priced in that the FOMC will not decide to reduce bond purchases at the last two meetings in this year. However, only after the release of the September US labor market report this week the financial and the precious metals markets reacted strongly.

Instead of creating 182K new jobs outside of the agricultural sector, the US economy added only 148K persons to the payrolls. The July figure was revised down to 89K (from 104K) while the August figure was revised up to 193K from 169K previously reported. However, for the FOMC, the unemployment rate is more important than the number of non-farm payroll additions. The unemployment rate edged further down to 7.2%. But there was only a slight decline of the number of unemployed persons. The negative aspect is that the number of persons not being in the work force increased further to 90,609K. The number of persons leaving the work force exceeded the decline of the persons being unemployed.

The FOMC already pointed out in the statement following the September meeting that the labor market has not developed as expected. However, the markets did not understand the message and only complained that the FOMC did not decide as the majority of Wall Street economists predicted. But as the recent labor market report shows, the majority of the FOMC voting members was smarter than most Wall Street economists despite also not having the September labor market report.

All information was not reflected in the prices. It took the market more than one month to recognize that the FOMC took the right decision and that tapering will be delayed into 2014. Thus, it has been demonstrated again that rational expectations and market efficiency does not always prevail in financial and commodity markets.

The yield on 10yr US Treasury notes came down to 2.5% again. In its statement released after the September FOMC meeting, the committee also mentioned the increase of financing rates as a reason to postpone tapering. We argued that the FOMC would probably feel more comfortable to reduce the amount of monthly bond purchases at a rate of around 2.5% on the 10yr US T-note. However, given outlook that tapering is likely to be delayed for several reasons into 2014 and that the debt ceiling has also been lifted, there is still some downside potential for yields on US Government paper. Thus, we would currently remain overweight duration on a US Treasury portfolio. But as the yield on 10yr US Treasuries approaches the level of 2.25%, we would start switching out of long-term into short-term US Treasury paper and thus, reduce the duration of a portfolio to neutral. Yields on 10yr US T-notes below 2.25% would be a reason to be duration underweight.

Gold and silver should profit from the outlook for tapering being delayed into 2014 and for further declining yields on US Treasuries. Thus, also the precious metals have still some upside potential. However, many analysts are still bearish for the precious metals in the final weeks of this year and for 2014. Some bank analysts have even reduced their forecast for gold and silver prices next year. Also the development of gold holdings in the SPDT Gold Trust ETF sends a warning signal. Thus, the most likely scenario is that gold and silver remain caught in the trading range of the third quarter this year. The chances for a breakout to the upside are higher for the PGMs, but this depends crucially on the supply from South Africa.     

Gold Price Movements during the US Government Shutdown

While the US government was shut down, we were also offline for almost two weeks. However, this was not related to any political decisions but due to some technical problems.

In this blog, it has always been argued that it is not just one factor having an impact on the development of precious metals prices. Nevertheless, we were surprised by the price movement of gold since the last Friday in September. Already at this weekend, it was obvious that there would be no last minute compromise to pass the budget in time and that the government shutdown was unavoidable. Given the stance of the Tea Party fraction within the Republicans, it was even doubtful whether the debt ceiling would be increased right in time to avoid a default of the US Treasury. Therefore, it was rather likely that the FOMC would postpone a decision to taper the bond buying program further into the future. Now, recent comments from some – even hawkish - FOMC members point in this direction.

In addition, the political wrangling in Washington DC argued for a weakening of the US dollar as foreign investors might reduce holdings of US Treasury paper and repatriate the funds or invest in more secure government bonds like UK Gilts or German Bunds. And indeed, as the risk of a default of the US government increased, the US dollar index declined, which reflects a weaker US dollar against the major currencies.

Thus, there were three factors – safe haven demand, postponing of tapering by the FOMC and a weaker dollar – pointing to a firmer price of gold and other precious metals. But gold was during this past three weeks the weakest precious metal. Even after the rebound following the last minute compromise to lift the debt ceiling for buying time for further negotiations on the budget, gold is still ended the trading week below the close of the last Friday in September, while all other precious metals posted gains on balance during this period.

Thus, the question is, why did gold trade lower to around 1,250$/oz and then rallied 65$/oz after the US Congress passed the bill to increase the debt ceiling? One possible answer might be a trade recommendation issued by Goldman Sachs to go short gold. The precious metals analyst of Goldman Sachs recommended to short gold already earlier this year and he was right in the second quarter. Thus, some large speculative accounts might have followed his recommendation. This would also be a possible explanation for the stronger price swings at the open of the gold futures trading session at the COMEX division of the CME group.

Unfortunately, due to the government shutdown, the CFTC had not been able to release the weekly “Commitment of Traders” report. The only available data is on the gold holdings of the SPDR Gold Trust ETF. Over the last three weeks, the gold holdings in the ETF dropped from 906 to 882.2 tons. It is well known that the whale in this ETF is John Paulson and his hedge funds. The performance of his funds was very poor in the first half of 2013. Thus, some investors might have regarded the recovery of gold during the third quarter as a good opportunity to withdraw money. Therefore, forced hedge funds liquidations might be another reason for the weak start of gold into the final quarter of 2013. However, even if John Paulson had been forced to liquidate positions in the SPDR Gold Trust ETF, it would not explain the strong rebound of gold after US President Obama signed the bill to increase the debt ceiling and to re-open the government.

Many commentators attributed the strong rise of gold to short-covering. The trading volumes of gold futures at the CME are no proof for this theory as for each contract bought there is one contract sold. Fortunately, there is other data available, which could provide some clues about covering of short positions, the gold forward rates – or short GoFo – as provided by the LBMA and the corresponding gold lease rates.

In mid-September, the 1mth gold forward rate turned positive again and rose up to 0.122% by the end of last month. During the first two weeks of October, the 1mth GoFo edged lower, but clearly remained positive. The picture changed completely during this past week, with the 1mth gold forward rate falling from 0.08 to -0.06% and the gold lease rate for the same maturity increased from 0.09 to 0.235%. The movements for other maturities are similar. Often, a rise of the gold lease rate is accompanied by a fall of gold inventories held in CME warehouses. But this was not the case this time. While the gold lease rate rose, the gold inventories remained unchanged until Tuesday and the decline on Wednesday was not at an unusual size.

Central banks play a major role in the gold lease market. However, they are also a major gold investor. In a recent report, central banks as a group had been criticized as being the worst gold investor buying at the peak and selling at the low. Furthermore, depending on accounting rules and book entry levels, the revenues from leasing gold might not be sufficient to compensate the loss due to write downs on gold holdings. Thus, central banks might have become less willing to lease gold to hedge funds, which speculate against central banks as gold investors.

Thus, the rise of gold lease rates and less gold available for leasing is probably the reason for the rebound of gold. Hedge funds following the advice of Goldman Sachs to sell gold short might have still made some profits. However, those profits are much smaller than the ones during the second quarter. The reason that Goldman Sachs trade recommendation was less successful or even might have led to losses for some short sellers is a basic mistake of the precious metals strategist. He obviously violated the old rule that one should never fight against the central banks.