Fed Tapering, Emerging Market Currency Crisis and Precious Metals

During the past week, we received some questions from journalists about Fed tapering, the currency crisis in some emerging markets and their impact on precious metals. Therefore, this blog article will deal with those questions and the corresponding answers.

The decision of the Fed to reduce the volume of monthly bond purchases by another $10bn to a total of $65bn should not come as a surprise. It has been well communicated by the Fed and the US labor market report with a further drop of the unemployment rate to 6.7% indicated that the FOMC would stick to the exit strategy. Furthermore, several new voting members in 2014 also stated that they would even prefer a quicker reduction of the monetary stimulus.

Some analysts quoted in the media expressed the view that the FOMC might pause due to the currency crisis in some emerging markets. However, this was only wishful thinking and not based on a proper analysis of the Fed policy. The US central bank is responsible for the monetary policy in the USA and has to take the measures in order to achieve its two targets. It is not the task of the Fed to correct policy mistakes by other central banks or governments. The Fed implemented quantitative easing despite some criticism from other G20 members. Therefore, one had to assume that the FOMC would stick to the statement of the December meeting. Thus, the decision should have been already discounted in the precious metals market. But this does not rule out that precious metals might react on indirect effects.

One of those effects is the reaction in the US stock market. While the S&P 500 index rallied in December after the FOMC, the US stock market extended losses this time. Thus, unlike after the last FOMC meeting in 2013, precious metals advanced after the FOMC decision was announced. However, this did not prevent that all precious metals ended the week significantly lower compared with the close of the preceding Friday.

The currency crisis in some emerging markets should increase the appeal of gold and other precious metals as a safe haven. Thus, it is not a surprise that some emerging market gurus like Mr. Faber recommended to buy physical gold. However, the return of holding gold comes from two sources, the currency and the gold price, which is quoted internationally in US dollars. The return of investing in the US dollar in the case of a currency crisis is positive as long as the crisis prevails. But the correlation between the US dollar and the price of gold is often negative. Therefore, a potential buyer located in a country with a currency crisis would have to expect that the return of gold would be diminished by a decline in the price of gold. The expected return for such an investor is higher if she buys a short-term US Treasury note. Also the expected volatility of a short-term US Treasury note is lower than the one of holding gold. Thus, there are better alternatives as a safe haven than precious metals.

However, the considerations above do not take into account the possibility that the government might impose measures of capital controls. If an investor has to fear that those measures could be taken by the authorities then buying physical gold might be the better choice even if the risk and return is less favorable compared to short-term US government paper.

Among the countries suffering under a currency crisis currently, only India and Turkey are major gold consumers. However, in India the central bank already took measures to curb the import of gold in order to improve the current account deficit. There was some speculation that this measures might be lifted, but this was very likely only wishful thinking. The Reserve Bank of India would risk that the deficit widens again. Thus, India’s gold imports are unlikely to recovery considerably anytime soon. It could not be ruled out that Turkey might take similar steps to curb gold imports in order to improve the current account deficit quickly. Therefore, on balance the currency crisis could even have the impact that demand for physical gold declines instead of rising due to safe haven buying.

The currency crisis could also have a negative impact on precious metals prices via indirect effects. Despite the IMF revised its forecast for global GDP growth in 2014 up to 3.7% just a couple of days ago, equity investors fear that the currency crisis would lead to slower growth. The hike of interest rates during this past week by the central banks in India and in Turkey increased this fear. Thus, weakness of stock markets could be supportive for gold. That  gold declined this week on balance, despite weaker equity markets, is due to the biggest gold consumer. As China celebrates the lunar New Year, markets are closed there and seasonal effects point to slower demand after returning from the holiday week. But all in all, we continue to expect that stock markets will be the major factor for the further direction of precious metals and that the recent negative correlation prevails further.