Fed in panic lifts precious metals

Just when it seemed that disappointment over the still ongoing negotiations between Greece and the International Institute of Finance (IIF - an association of international banks) over the private sector involvement (meaning the voluntary hair-cut in a restructuring of Greek debt) would send gold prices lower again, the Federal Open Market Committee came to the rescue. After the release of the FOMC statement, gold rallied on a weaker US dollar and recovering stock markets. The announcement that it would be “… likely to warrant exceptionally low levels for the federal funds rate at least through late 2014” came as a surprise.

It appears as the Fed had acted in a panic mode. Compared with forecasts made in November, the Fed had reduced its central projection for GDP growth for the period 2012 – 2013, but increased the forecast for 2014. GDP growth in 2012 is now expected to be 2.2 – 2.7% and to increase to 3.3 – 4.0% in 2014. Inflation measured by the PCE deflator is expected to remain below 2% for core and headline inflation over the forecast horizon. While the Fed also lowered the projections for the unemployment rate, the decline is not fast enough from the perspective of the FOMC to reach the target level by mid-2013. Under these projections, it would be understandable if the Fed were keeping rates unchanged. However, communicating the projections and the implications for the Fed funds rate could have negative implications.

To some extent also due to the headlines in media, financial markets have understood the statement as a firm promise that the Fed funds rate would be held at the current level until late 2014. But forecasts are subject to revisions. If the assessment of the Fed turns out as being too pessimistic on GDP growth or as too optimistic on core inflation, then the Fed would have to tighten monetary policy before late 2014. This could damage the credibility of the Fed. But keeping the rates unchanged as promised and letting inflation rise above the target would also damage the credibility of the Fed. Thus, positive surprises for the economy could turn out as a problem for the credibility of the Fed. On the other hand, forecasts could become self-fulfilling. Signaling to keep the Fed funds rate unchanged for almost 3 more years might be interpreted by businessmen and –women as an indication that the economic recovery remains rather fragile. It could have a negative impact on expectations of future returns on investments and thus, lead to postponing business fixed investments further into the future. In this case, the announcement of keeping the Fed funds rate unchanged for such a long period could weaken instead of strengthening the economy.

In the FOMC statement, the Fed recognizes that “… growth in business fixed investment has slowed”. As a policy measure, the FOMC “…decided to continue its program to extend the average maturity of its holdings of securities…” Thus, operation twist is going to continue. We have some doubts that operation twist would lead to accelerating growth of business fixed investment. Empirical research showed that the steepness of the US Treasury curve is an important indicator for future US GDP growth. Certainly, we would not doubt that also the level of interest rates plays a role for business fixed investment. However, we are skeptical whether companies, which did not invest at yields on 10yr US T-notes at 2.0%, would invest at 1.5%. However, reducing the spread of corporate bonds or mortgage bonds over US Treasury paper might have a far bigger impact on business fixed and residential housing investment.

Fed chairman Bernanke pointed out that the debt crisis in the eurozone is one of the biggest risks for the US economy. We fully agree with this assessment. Probably, it already has a negative impact on US GDP growth. In many market comments on the US stock market, the debt crisis in the eurozone was a major factor weighing on sentiment and stock prices. The development of stock markets also plays a decisive role for business expectations and investment decisions. But, the Fed is not participating in solving the debt crisis in the eurozone. Due to legal reasons, the Fed can not provide funds to the IMF. However, the Fed could extend its balance sheet by acquiring foreign reserves – either by a swap agreement with the ECB or by interventions in foreign exchange markets. The later would also have the advantage of weakening the US dollar and stabilizing the euro. The increased foreign reserves could then be invested in government bonds of Italy, Spain and France. This would reduce the yields on bonds of these countries and would reduce the fears that these countries would have difficulties to place their bonds. As has been seen since the start of this year, easing tensions in the eurozone peripheral bond markets are positive for stock markets in Europe, but also in the US.

The Fed policy of keeping the Fed funds rate at record low levels until late 2014 has a positive impact on gold via a weaker US dollar. However, if the Fed would shift the focus of its policy from lowering yields on US Treasury notes and bonds towards strengthening the US stock market and thus, sending positive signals to US companies, but also consumers, then the precious metals probably would get an even stronger positive impulse. 

US Dollar again a supportive factor for precious metals

In the previous blog article, we discussed the temporary divergence between the US dollar and the price of gold. This week, the US dollar had been again a supportive factor contributing to strong gains of the precious metals compared with the previous week close.

At the time of writing this article, Greece has not yet reached a deal with its private creditors. However, Reuters reported that the Hellenic Republic would be close to reach an agreement, which would imply a debt reduction by 60 – 70%. Such a volunteer agreement might provide further support for the euro. However, it remains still unclear whether a sufficient percentage of private investors would accept such a deal. It has been reported that some hedge funds insist on being fully compensated, either by Greece or by the CDS bought. Greece on the other hand still has the option to pass a law that introduces a collective action clause, which would make an agreement with the majority of the bond holders binding also for those bond holders, which did not accept the deal. However, the rating agencies already announced that imposing a collective action clause would imply that the deal is not a voluntary but a forced agreement and thus, would be regarded as a default. But for triggering the credit event for the CDS, it is the decision of the ISMA, which is relevant. Nevertheless, even in the case that Greece is reaching a deal, there are still some stumbling blocks on the road for a recovery of the euro. Even some set-backs can not be ruled out. But in the case of a positive development, the euro might contribute further to rising prices of precious metals.

Another supportive factor had been auctions taking place last week after the downgrades by S&P. France and Spain met strong demand at their auctions and could place the paper at lower yields compared with preceding auctions. Thus, the downgrade, which had been already widely priced in, did not worsen the funding situation in the eurozone. Next month, the ECB will provide banks again with 3year funds, which should ease the tensions in the government bond markets further.

The ZEW indicators for Germany and the eurozone are based on a survey. However, unlike the PMI indices, these diffusion indices are based on surveys of fund managers and analysts at financial institutions. Therefore, the ZEW indicator is less reliable for indicating turning points of economic activity. The ZEW indicator is far more influenced by the recent movements in stock markets. Another feature of this indicator is that some of those polled by the ZEW also provide forecasts for this index. However, the economists often underestimate the magnitude of index changes. This had also been the case last week. The ZEW indices rebounded far stronger than the consensus of economists predicted. This was positive for the precious metals via two channels. On the one hand, it contributed to the recovery of the euro and on the other hand, it also contributed to further rising stock markets.

As in the week before, stock markets had again a positive impact on precious metal prices. Beside the ZEW indicator, also the Chinese GDP in the final quarter of last year contributed to rising stock market indices. The Chinese GDP growth at 8.9% was less than in the preceding quarter (9.1%), but it was stronger than the consensus forecast. This positive surprise reduced the fears of a global recession to some extent. Also US economic data contributed to the further increase of the S&P 500 index, which was positive for precious metals. After the strong rise of stock markets at the start of 2012, the markets are now overbought from a technical perspective. Thus, it could not be ruled out that stock markets enter a consolidation, which would also be a negative factor for gold and other precious metals.

Gold is facing some technical resistance in the range of 1,670 – 1,675$/oz, some reaction lows from late November last year. Taking out this resistance requires support from the fundamental drivers. The technical situation of crude oil already turned negative despite the geo-political tensions. The stock markets are in an upward trend, but vulnerable for a consolidation. The recovery of the euro against the US dollar might continue, however, the risk of a set-back due to the developments within the eurozone should not be neglected. Furthermore, also the technical situation of the precious metals is overbought. Therefore, the risk of failing to take out the resistance zone appears to overweigh the chance for a further rally. Thus, holders of long positions should tighten their stops.  

Gold and the euro – neither decoupled nor a crisis hedge

Gold and the euro – neither decoupled nor a crisis hedge

                                                            

The first nine trading days of the year 2012 had been positive for gold. Compared to the close of the preceding year, gold rose by almost 100$/oz. The euro, on the other hand, came already under pressure after the Christmas holidays. The trigger had been a big sell order in cable in a thin market, which also dragged the EUR/USD exchange rate lower. After rebounding at the first trading day of this year, the euro weakened again versus the US dollar. However, the US dollar also firmed against other currencies and the US dollar index increased. Therefore, some market commentators already talked about a decoupling of gold from the US dollar movement.

Correlation is not causation. Thus, a weaker or even inverted correlation over a short period of time is not an indication that the traditional relationship between gold and the US dollar has broken down. Furthermore, the correlation coefficient would only be a suitable indicator if the there were only a mono causal relationship between gold and the US dollar. In econometric models for the price development of gold, the US dollar index would have to be the only significant explanatory variable. However, this is not the case! In our quantitative fair value model for gold, other variables like the S&P 500 composite index or the price of crude oil also have a statistical significant impact on the price of gold.

The implication of various factors having an impact on the price of gold is that other factors could move stronger and thus could more than compensate the impact of the US dollar. This is exactly what happened during the first two weeks of this year. The increase of the official PMI in China but also better than expected US economic data including the ISM indices triggered a rise in stock market indices as fears of a global recession decreased somewhat. This also had a positive impact on the price of crude oil, which also profited from geo-political tensions. The Western countries are preparing an embargo of oil imports from Iran while the regime in Tehran threatens to block the Strait of Hormuz. Furthermore, crude oil got support from a strike in Nigeria.

A major factor is still the concern about funding requirements of various countries in the eurozone. The placements of short-term money market paper went well. Germany could even sell 6mth bills at a negative yield. But more important, other countries, which had to pay higher rates in late 2011, could place their papers at lower yields. The litmus test had been the auctions of longer dated paper by Spain and Italy on Thursday and Friday last week. Spain found strong demand and sold twice as much as initially intended. Also Italy’s auction on Thursday went well. This had been positive for gold as it supported the euro and also stock markets moved higher.

However, last Friday showed that gold is not a perfect hedge against the crisis in the eurozone. Italy could raise the amount announced at lower yields. However, the market was disappointed about the bid/cover ratio, which was much lower compared to Spain’s auctions the day before and Italian auctions in December (when yields were far higher). This example shows that expectations are not always rational in financial markets. The Italian auctions already weighed on the EUR/USD exchange rate and lead to stocks paring earlier gains. Gold also traded lower dragged down by the firmer US dollar and stock market indices giving back gains. However, the major blow came in the afternoon.

Some eurozone government sources acted like criminal market manipulators by leaking to Reuters and other media that Standard & Poor’s would downgrade several countries in the eurozone, without providing further details. Normally, the rating agency announces a downgrade of a sovereign debtor after the close of US markets. The agency stuck to this procedure also last Friday. The downgrade rumors and the uncertainty about which country would be downgraded by how many notches sent shock waves through markets. The euro dropped by more than 2.5 cents and stock markets turned negative. Gold could not escape and also traded lower.

The US stock market recovered and closed near the high of the day. France was expected to be downgraded by two notches, but S&P reduced the rating by only one step to AA+. Thus, the initial reaction during European trading hours might have been an overshooting to the downside. Nevertheless, as we have pointed out several times, bad news about the debt crisis in the eurozone is no longer positive for gold, as it might have a negative impact on the major factors for the price of gold.

Thus, we still expect that gold will trade rather volatile during the first quarter of 2012 and could fall below 1,500$/oz. However, improvements of the crisis situation in the eurozone might set the stage for a strong upward move.

Precious Metals in 2012

At the start of a new year, it is a tradition to provide an outlook for market developments during the year. Therefore, we will stick to this tradition also in this blog. We participated again at the annual forecast survey of the London Bullion Market Association LBMA, which released its survey for 2012 last Friday.

Reuters reported at the beginning of the New Year that Gold imports by India, which is the world’s biggest consumer of gold, in the fourth quarter of last year plunged by more than 50%. According to the Bombay Bullion Association, India imported last year a total of about 878 tons, down by 8% from 958 tons in the preceding year. Gold is used mostly for jewelry in India. Furthermore, gold is usually in demand during the final quarter of the year due to the festival season. This development indicates that the jewelry industry is probably again not the major driver for the price development for gold. As prices have risen also for platinum and palladium, the attractiveness of the PGMs as a substitute for gold in the jewelry industry has been reduced. Therefore, for all precious metals, we expect that the price trends in 2012 will be mainly depend on the demand of investors or central banks.

Some gold bugs argue that central banks would buy gold to back their currency by gold. We don’t expect a return to the gold standard in the foreseeable future. Another argument for central banks returning as net buyers of gold is that the ratio of gold held by some central banks would be relatively low compared to other major central banks. Thus, especially Asian central banks with high foreign reserves would have to catch up by buying more gold. We are not convinced by this argument as it assumes that central banks would adopt a rather primitive form of portfolio management. Central banks hold most of the reserves in US dollar denominated assets. However, they have to report the balance sheet and profit & loss statement in local currency. Thus, the return on the foreign reserves should compensate for a possible depreciation of the US dollar against the local currency. This implies that beside the return of alternative assets, also the foreign exchange rate movements are a major factor for the portfolio allocation. Yields on US government notes and bonds do not provide a sufficient cushion against a US dollar weakness. Furthermore, the yield on 1yr US T-Bills is currently at 0.1% while the 12 month gold lease rate is above 0.4%. Thus, lending gold already yields a higher return than an investment in US T-Bills. Longer maturities offer a slightly higher return but also the price risk increases with a longer duration of government notes and bonds. For the 10yr US T-Note, a rise of the yield by only a few basis points is sufficient that the coupon income for one year is lost by falling prices. The negative correlation between the US dollar and the gold price is another factor, which has to be taken into account. Normally, the price of gold rises more in percentage terms than the US dollar weakens. Therefore, it is more the risk and return consideration of portfolio management in the current environment instead of some dubious historical or international comparisons, which argue that central banks are likely to increase their gold holdings further.

The correction of precious metals in the final four months of 2011 was driven by fears of a global recession. The major cause for those fears is the debt crisis in the eurozone. In the US, the recession fears were overdone. Not only did the GDP expand further in H2, the economic data also came in stronger than economists predicted. The labor market is also improving. New jobs are created albeit not at the pace of former economic recoveries. Nevertheless, it provides support for the private consumption. The car sales figures also underline this development. In China, the central bank has reduced the reserve requirements after the headline inflation rate came down. Further monetary easing during 2012 is expected, which would prevent a recession. The Chinese economy is likely to grow at a rate of 9.0 – 9.5% this year. This is below the double-digit growth during boom periods, but also clearly above the 8% mark, which is often regarded as a recessionary level. Therefore, the industrial demand for precious metals should remain supported.

The debt crisis in the eurozone is very likely the most important driver for gold once more. The first quarter might be very critical and could lead to increased volatility of precious metals. Even a decline below the lows made during the final four months of 2012 could not be ruled out. The financial markets still fear that some countries might fail to attract enough capital for refinancing maturing bonds. The eurozone has to agree and ratify a treaty on a “fiscal compact” as agreed on the December summit. Greece has to reach a deal on a volunteer debt restructuring with private investors and also has to secure further financial assistance by the troika. The recent remarks by PM Papademos were targeted to Greek lawmakers. While they were intended to push through necessary reforms to avoid disaster, they underline which stakes are at risk.

During the first quarter, three possible scenarios might evolve. The worst case would include a default of Greece, which might lead to collapse of the euro in the current form and/or a shock to the financial system comparable to the bankruptcy of Lehman Brothers in 2008. In this scenario, gold might be in demand as a safe haven again. However, some investors might have to sell gold to cover losses of other assets, which would limit the upside of gold. Other precious metals might fall strongly in this scenario as fears of global recession are likely to intensify.

The second scenario would be that a default of Greece will be avoided but the debt crisis in the eurozone would not be solved. Instead, politicians continue with buying just time. This scenario might be the worst one for gold, but the second best for the other precious metals. Prices might decline below the lows recorded in the first quarter. The euro might weaken further against the US dollar, which would be negative. This would weigh on the prices for precious metals. However, if the debt crisis does not get worse, the precious metals might be more in a sideways market with increased volatility.

The best case for the precious metals would be a solution of the debt crisis. In this case, the euro is likely to recover against the US dollar. Maybe even more important, the fears of a global recession would subside. The stock markets are likely to recover and also crude oil is expected to head higher. In this scenario, all the major fundamental factors in our quantitative fair value models would be positive. Thus, precious metals with the exception of silver might reach new record highs toward the end of the year. 

Precious metals under renewed pressure

It had been pointed out several times in this blog that the status as a safe haven does not imply that precious metals were immune against stronger downside moves. This past week is another proof for this statement. Precious metals were under renewed pressure and only a rebound last Friday prevented even bigger losses. Gold ended the week down by 6.6% and platinum lost only slightly less at -6.4%. Silver and palladium are the more volatile precious metals dropping by 7.9 and 9.0% respectively.

The traditional fundamental factors for the precious metals were all negative again. The US dollar firmed not only against the euro but also against the other major currencies. The stock markets in Europe and the US headed all south and crude oil prices came under pressure. However, also the flow of funds data indicates that investors reduce holdings of precious metals. According to the latest CFTC report on the “Commitment of Traders”, large speculators have reduced their long positions in gold and slightly increased the short positions. Thus, the net long position has dropped by 9,208 to 150,503 contracts, the lowest value since the beginning of November. Also holdings in the biggest ETF, the SPDR Gold Trust, have been reduced last week by 15.4 tons to 1,280.0 tons.

The major factor weighing on precious metals remains the debt crisis in the eurozone. The rating agencies are not satisfied with the result of the EU summit on December 9. Standard & Poor’s already warned that all member states of the eurozone might be downgraded before the summit took place. Now also Moody’s has reduced the outlook for the eurozone to negative and Fitch also warns that six member states might face a lower rating. All three agencies refer to the outlook for GDP growth. However, the rating agencies became a part of the problem and are an obstacle for a solution. When the crisis broke out, the agencies demanded that austerity measures had to be taken to restore confidence. However, as soon as those measures had been taken, they lowered the rating of various states and referred to the lower growth prospects due to the austerity measures. This is now going on for various cycles and more and more countries face a downgrade. As long as the agencies threaten to cut the ratings of eurozone member countries, the market for government bonds in the eurozone has difficulties to calm down. This has also a negative impact on the euro exchange rate. Furthermore, fears of a global recession will not subside. Quite the opposite, they are more likely to get stronger like the warning of the IMF last Friday showed by comparing the current situation in the eurozone with the early 1930^th, the beginning of the global depression.

Have you ever wondered that there is only one German among the Noble laureates in economics? Just take a look at the German economic orthodoxy and it is no longer a wonder. The German government and the Bundesbank believe that a fiscal austerity policy would be sufficient to solve the debt crisis in the eurozone. However, they completely ignore the German past when the austerity policy of Chancellor Bruenning steered Germany right into the depression of the 1930^th. Furthermore, they are obsessed with the experience of the hyperinflation of the early 1920^th. This obsession leads to the refusal to accept any involvement of the ECB and national central banks in solving the debt crisis. Germany blocks the proposal to grant the EFSF or EMS a banking license, which would allow these institutions to buy government bonds in the secondary market and to obtain credit from the ECB, while the state owned Landesbanks in Germany and state owned savings institutions in other eurozone countries could also hold government bonds refinanced by loans from the ECB. Economically, this differentiation does not make any sense because the ECB is also indirectly involved in state financing if state owned commercial banks buy government paper.

At the EU summit on December 9, there was an agreement that central banks of the eurozone should lend 200bn euro to the IMF, which then could leverage the funds of the EFSF and the EMS. However, the Bundesbank is blocking this solution by demanding that the German parliament would have to approve such a loan and by insisting that further leading countries outside the eurozone also participate in providing loans to the IMF. However, the US already announced that they would not grant a loan to the IMF. The Fed can not participate due to legal reasons as chairman Bernanke explained. The president of the Bundesbank argues that providing a loan to the IMF, which then lends to eurozone governments, would be circumventing forbidden lending of the ECB system. However, the Maastricht treaty only rules out direct lending to governments. Without any involvement of central banks, the market for government bonds could not be stabilized in the short-run. As Lord Keynes ones said, “in the long run we all are dead”. Waiting for the austerity measures to restore investors’ confidence might take too long.

As long as Germany refuses that central banks play a direct or indirect role in stabilizing the government bond market in the eurozone, fears of a global recession will prevail. The markets already ignored positive economic data last week. The implications for the precious metals remain negative in this case. The rebound seen last Friday might just been some short covering.

This was the last article in this blog for 2011. The next article will be published on January 7, 2012. We wish all readers of this blog a merry holiday season as well as a happy and successful New Year 2012.

Precious metals down again on eurozone debt crisis

Most precious metals posted losses again the past week. Only palladium bucked the trend and gained 6.4% on the week. Palladium is driven by the outlook for a supply deficit in 2012 due to declining stocks and production in Russia. The usual drivers for the price of gold were mixed last week. The US dollar index firmed slightly, which was a bit negative. The price of crude oil declined and thus weighed on gold. The rise of the S&P 500 index was a supportive factor, but could not compensate the negative factors. However, one has to take into account, that the strong rise of the S&P index on Friday pushed the index back into the black. Gold followed the stock markets most of the week, but not on the last trading day of the week.

The S&P 500 has also been influenced by the developments in Europe. However, also US economic data had an influence. While a few month ago, most US economists were convinced that the US economy would head towards a double dip recession, the macro-economic data is by and large better than economists predicted. We pointed out several times in August and early September that we don’t expect a recession in the US. Also the labor market shows signs of improvement. Therefore, from our point of view, the S&P 500 index has further upside potential, especially in the case that the debt crisis in the eurozone gets solved. However, one caveat has to be made. The winter season could lead to slower economic activity as it had been the case in Q1 this year. Thus, our medium-term assessment of the price development in precious metal markets remains positive.

It could not be repeated often enough; the key for rising precious metal prices is a convincing solution of the debt crisis in the eurozone. This past week brought a major improvement, but also a major set-back. At the beginning of the week, France and Germany agreed on a proposal to change the EU treaty. According to this plan, national states would have to include the requirement of balancing the budget in their constitutions. Individual states violating the 3% deficit criterion of the Maastricht treaty would face an automatic procedure to get penalized. The EU commission would have to send the case to the EU court. At the EU summit, 26 of the 27 member states approved this proposal, only the UK opposed it. However, the 26 supporting states will go ahead without the UK in implementing the proposals. These proposals that eurozone member countries follow a responsible fiscal policy might be important in the medium-term, but they unlikely solve the problem in the short-run. As one of the five economic advisers to German chancellor Merkel put it, the German chancellor sees the problem of the debt crisis as one-dimensional while it is multi-dimensional in reality.

And it was this one-dimensional position of Germany, which prevented a solution convincing financial markets also in the short-term. However, Germany also had to make some concessions. The national central banks will lend 200bn US dollar to the IMF, which then can provide funds for leveraging the EFSF. In addition, the EMS, the stabilization mechanism, which should be a permanent institution, will start working already in July 2012 instead of January 2013. The major task is to restore confidence in the market for government bonds in the eurozone. These measures are probably insufficient to fulfill this task. Given the volume of bonds, which have to be refunded in 2012 by the countries being under attack in bond markets, the funds of the EFSF could be exhausted already in H1 next year in the worst case. Bond market strategists pointed this out already in their research papers.

Further measures to stabilize the government bond markets in the eurozone would be either to provide the EFSF or EMS with a banking license or that the ECB acts as lender of last resort. However, both measures have been blocked by Germany. It appears that Germany follows a new kind of beggar my neighbor policy as it is profiting from absurdly low interest rates on government bonds and notes, while other countries with similar or even better fiscal positions (Spain has a far lower debt/GDP-ratio than Germany) have to pay far higher interest rates to sell their bonds.

The ECB demonstrated again that a few words could do more harm than the benefits of some right measures taken. At the monthly rate setting meeting, the ECB Council decided to cut the refinancing rate by 25bp to 1.0%. Furthermore, the ECB extends credits to banks to up to 3years and accepts collateral with lower credit quality. The intention of these measures is to increase bank lending to the real economy. However, these measures are likely less effective as long as the tensions in the government bond markets persist. At the speech given to the EU parliament, ECB president Draghi created the impression that the ECB would be ready to buy government bonds in the secondary market more aggressively, if the EU agrees on stricter rules for fiscal policy in the eurozone. At the press conference following the council meeting, Mr. Draghi stated he was surprised by the interpretation of his remarks. He turned a cold shoulder to buying government bonds to reduce yields on bonds of pressured countries like Spain and Italy. That was not super, Mario!

As long as the ECB is not acting as a lender of last resort and uses its unlimited power to restore confidence in the market for eurozone government bonds, there is no lasting and convincing solution of the debt crisis in the eurozone. Furthermore, it is likely that the measures taken by the ECB fail to stimulate bank lending to the private sector sufficiently. The risk of stagnation of even recession in the eurozone is increasing. In this environment, also downside risks for the precious metals prevail. However, once the market for government bonds are stabilized and yields on Spanish and Italian government bonds come down to more sustainable levels, the precious metals might be in for another strong move upwards.         

Precious metals rebound, but not yet out of the woods

A report in an Italian paper last Sunday, that the IMF would lend 800bn US dollars to Italy, led to a rebound of precious metals in Asian trading on Monday. The amount stated in this report is above the lending limit of the IMF, thus, financial and commodity markets should have spotted this report easily as false. Also the IMF later denied being in talks with Italy about a bail-out loan. Nevertheless, precious metals rose and closed the day near the high of the respective trading ranges. On Wednesday, precious metals got another push higher by two measures from central banks. First, the Chinese central bank, the People’s Bank of China, reduced the reserve requirements by 0.5 percentage points. Second, the Fed and five other central banks agreed on mutual unlimited swap lines to provide sufficient US dollar liquidity to the banking system. This measure was targeted primarily for European banks after US investors withdraw funds from European banks and money market funds.

Among the precious metals, palladium posted the strongest weekly gain, soaring by almost 14.0%, the biggest weekly rise in 3 years. The cut of reserve requirements by the PBoC is probably positive for car sales and China and thus, for the palladium demand by the automotive industry. Furthermore, Norilsk Nickel, the world biggest palladium producer, expects the palladium market to be in a supply deficit next year.

After the rebound last week, also the technical situation for most precious metals has improved. However, does this imply that the assessment made last week in this blog was wrong? We still stick to our view that lasting and sustained rises of the precious metal prices require a convincing solution of the debt crisis in Europe. The rise last Monday was based at best on hopes that European politicians finally come to get their act together. However, there are many stumbling blocks on the road to a solution of the debt crisis in the eurozone.

On Thursday, the ECB will hold its rate setting meeting. After the swap agreement announced last Wednesday, some economists expect that the ECB might cut the refinancing rate again by 25bp. This would be helpful but would not eliminate the risk of a credit crunch in the eurozone with negative implications for activity in the real economy. At the hearing in the European parliament, ECB president Draghi repeated the stance that bond purchases would be limited and only temporary. However, one remark has been interpreted as keeping the door open for more active bond buying. Thus, the markets will also pay close attention to his statements at the ECB press conference.

At the EU economic summit on Friday, December 9, France and Germany want to push ahead to the formation of a fiscal union and want to present changes of EU treaties. German Chancellor Merkel insists on automatic punishments of countries violating the fiscal discipline and rules set in treaties. Also balanced budgets should be anchored in the constitutions of the eurozone member countries. While the creation of a fiscal union would repair at least to some extent the errors in the construction of the single European currency, the German demands do not provide a quick solution of the crisis. They might lead to a rebuild of confidence in the medium-term at best. Furthermore, Germany is only demanding what other countries should do but refuses to make any offer.

As we pointed out already earlier, the failure of politicians to act quickly and in a decisive manner contributed to the destruction of the government bond market in the eurozone. Government bonds are no longer a risk free asset. Investors have to fear that haircuts will not be only limited to Greece as a special case. Furthermore, the demand from Merkel and Sarkozy that a referendum considered in Greece should be about staying or leaving the euro, has opened the Pandora’s Box. Now, investors have to factor in the risk that they will get the redemption of a bond in a currency other than the euro. Furthermore, the European Banking Authority also contributed to the destruction of the government bond market in the eurozone by counterproductive regulations. The requirement, to value all government bond holdings at market values, not only those in trading books but also bonds intended to be held to maturity, has eroded the capital ratios of banks. In addition, they had to sell government bonds to reduce risk, which made the situation in the market only worse. In the short-run, the ECB is the only institution being able to act as a lender of last resort and to restore confidence. However, as long as German economic religion opposes such a step, the crisis will probably not be solved.

Thus, the second half of this new week will be very crucial for the further outlook for the precious metal markets. Currently, we regard the risks as more biased to the downside. We would not rule out that the announcement of an agreement would lead to a relief rally the following trading day. However, this relief faded more and more quickly after each EU summit. We remain skeptical that it will be different this time. But the next blog article provides an opportunity to comment on the EU summit. For those who went long precious metals, we recommend to keep tight stops.