Conflicting signals for gold

Gold and silver came under selling pressure again this past trading week. However, this time it was not at the start of trading in the US. On Tuesday, in the Asian afternoon, gold came under pressure and fell through the low made the Friday before. This triggered further selling, which pushed gold down another 10$/oz. However, as the US trading session began later, gold also fell through the 1,700$/oz mark, which was regarded as support. During the further course of the week, gold and silver recovered, but were unable to pare the loss and ended the week lower. The PGMs on the other hand held fairly stable at the start of the week and advanced later to end the week higher. Thus, the question arises, why do gold and silver underperform the PGMs lately?

One factor supporting the PGMs had been the Platinum interim report from Johnson Matthey, which predicts that the market would be in a deficit. Statements this week from Norilsk Nickel that Russian palladium exports would decline due to decreasing Russian palladium stocks gave the market further support. This would explain the outperformance of the PGMs, but not the diverging price movements, which had been observed on some days. Also quantitative models show that there is a mutual impact of precious metal prices on the price of other metals of this group. Thus, there must be other reasons for the underperformance of gold and silver.

There appears to be a shift in sentiment for gold and silver among analysts and investors. This past week, Goldman Sachs – usually one of the most bullish Wall Street investment banks on commodities – revised their forecast for gold next year downwards. Analysts polled weekly by Bloomberg are normally bullish on the outlook for gold during the following week. Bullish readings below 50 occur but are seldom. The most recent survey shows a drop of the bullish index from 64.52 to 45.16 and the bearish index increased from 19.35 to 32.26. Thus, analysts are still slightly bullish on balance. However, the difference between the bullish and bearish index is at such a low level, that it approaches the region of extreme lows for this survey. Extreme analyst pessimism is often a good buy signal for gold.

The net long position in Comex gold futures held by large speculators had risen in November. However, the increase of the preceding three weeks had been almost completely wiped out by reducing longs and increasing short positions in the week ending December 4, according to the recent CFTC report on the “Commitment of traders”. The net long position dropped from 193,742 to 165,736 contracts. However, the non-commercials increased their net long position in silver futures further by around 2,500 contracts to 41,272 contracts.

On the other hand, the holdings in the SPDR Gold Trust ETF have risen this week by around 4.5 tons to 1,353.35 tons. However, hedge funds investing in this ETF appear to hold the positions over a longer period. Short-term trading oriented hedge funds seem to prefer the futures market. Thus, we interpret the recent development as dominated by short-term traders, while long-term oriented investors still accumulate gold holdings. This short-term selling reflects the uncertainty about the result of negotiations to avoid the fiscal cliff in the US. It is more a reflection of increasing risk aversion among investors.

A negative factor for gold had been the firmer US dollar against the euro, especially after the ECB press conference. As Mr. Draghi stated that the council discussed to levy a fee for deposits at the ECB by 25bp (also referred to as negative deposit interest rate), the forex and government bond market immediately speculated on a cut of the lending rate at the next meeting from 0.75 to 0.5%. However, Mr. Draghi also explained that the council refrained from this step because it believes that the announcement of OMT had pushed yields on peripheral government bonds much lower than another cut of the lending rate could do. Furthermore, in some countries, there is growing opposition on reducing the refinancing rate further because some banks would use this opportunity to borrow funds from the ECB and invest them in corresponding national government bonds. The ECB did not lower interest rates despite cutting the forecasts for the GDP in the eurozone significantly. It appears that the council prefers to keep the powder dry. Thus, the speculation on another ECB rate cut might be short-lived. The euro might recover the longer the ECB hesitates to reduce interest rates further. This would then be a supportive factor for gold.

As stated several times, our base line scenario is the US fiscal cliff will be avoided by a final hour compromise. Therefore, the current negative sentiment among analysts and short-term oriented traders might present a good buying opportunity for medium-term oriented investors in gold and silver.

Safe haven gold hit by a tsunami

Over the last few years, not only gold bugs but also analysts at serious banks stated that gold would be a safe haven in the case of recession and deflation. Many of those analysts also pretended that gold would be a good hedge against inflation. Already economic logic indicates that gold could not perform well in both cases. And the development of precious metals during this past trading week underlines that it is not compatible to serve as a safe haven in the case of inflation and deflation.

On Wednesday, gold plunged with the start of trading in the US. Ross Norman, the CEO of Sharps Pixley (a UK based gold trading house), was the first who pointed out that futures representing 24 tons of gold had been sold within a few minutes at the start of gold futures trading at the CME. Also on Friday, gold and other precious metal came under selling pressure with the start of trading in the US. One explanation for the losses on both days was that investors sold gold on worries about the possibility of a looming fiscal cliff as talks to find a compromise made no significant progress. But is it really rational to sell 24 tons of gold within a few minutes if the US economy will fall over the fiscal cliff?

Let’s assume that no compromise to avoid the automatic tax hikes and spending cuts from kicking in. What would be the economic consequences? Only a few European economists, among them probably the former chief economist of the ECB, would argue that this fiscal austerity would lead to higher growth rates as the multiplier effect of fiscal policy measures is below unity and the reduction of the budget deficit would encourage the private sector to increase economic activity. However, most economists and investors at Wall Street fear that the fiscal cliff would lead to a pronounced recession of the US economy. The unemployment rate would rise again, which would induce the Fed to lift the size of quantitative easing. Many investors regard an inflated Fed balance sheet as positive for gold. Furthermore, a deep recession would also lead to some stress for the financial system and the number of bank failures could increase again. The core inflation rate would head lower and might flirt again with deflation in this scenario.

If increasing the magnitude of quantitative easing or the risk of deflation or the combination of both is really positive for gold, then it would be irrational to sell 24 tons of gold on worries about a failure to reach a compromise avoiding the fiscal cliff. However, if the sellers of the gold acted rationally, then the arguments for gold as a safe haven have no sound footing. From our point of view, the latter is the case. As the development of last week showed, if investors fear a recession or deflationary tendencies, instruments with a fixed nominal income like the conventional US Treasury notes and bonds, offer the better risk and return profile. Furthermore, we pointed out that quantitative easing by the Fed is not a necessary condition for rising gold prices.

Another argument for the plunge of gold and other precious metals prices at the start of trading in the US on Wednesday was that of the usual fat-finger suspect. We are also not convinced by this argument. The fat-finger describes an error at entering the order. In this case, it would imply that the number of contracts to sell has been a multiple of the intended size, often by a two or three digit factor. Usually, fat-finger orders leave a typical trace in the tick or one minute charts. After the order had been worked through and had been fully executed, the market normally rebounds for two reasons. First, the error will be detected by the seller sooner or later. If the exchange will not cancel the erroneous order, the seller would have to correct his error by buying back futures, which lift the price higher. Second, if the market still regards the drop as not justified by market fundamentals, bargain hunting sets in, which also pushes prices higher again. Fat-finger orders often lead to a rebound of the price close to the level before this erroneous order was placed and executed. This was not the case in the gold future, which pared only a small fraction of the loss on Wednesday and Friday and only some hours after the plunge occurred.

High frequency trading plays a more and more important role also in the electronic trading of commodity futures. In the grain markets, commercial hedgers already complained that HFT has increased volatility and makes commercial hedging more difficult. Thus, one possible explanation might be the combination of a fat-finger order triggering the drop, which was aggravated by algorithms of HFT companies switching to selling futures too. However, it appears as rather unlikely that this happened on Wednesday and on Friday.

During the last few weeks, it has been pointed out in this blog, that our base line scenario is a final hour compromise to avoid the fiscal cliff, but the road to such a compromise would be a bumpy one. Thus, the strong declines on Wednesday and Friday might be just the result of higher risk aversion among investors. Nervous investors fearing a failure to reach a compromise sold gold but due to the political uncertainty other investors were only willing to absorb the supply at far lower prices. As long as there are no signs for a compromise being reached, the downside risks prevail, even in the case that the fiscal cliff will be avoided. 

Precious metals head higher as risk appetite increases

Most precious metals got two strong impulses to move higher last week, one at the start and one at the end of the trading week. But neither of these two moves was related to quantitative easing or possible changes in the Fed policy as discussed at the recent FOMC meeting (linking current policy stance on certain levels for inflation and unemployment). The triggers were increases of investors risk appetite. However, this reduced risk aversion is related less to economic than more to political factors. If those political factors develop favorably then precious metals could climb further.

The push higher last Monday was based on hopes that US policy makers will avoid that automatic tax hikes and spending cuts kick in, which would lead to the US economy tumbling over a fiscal cliff. Politicians from both parties underlined the willingness to find a compromise. Due to the Thanksgiving holiday, there was not much movement. However, negotiations are likely to resume quickly. This could be positive for precious metals as long as there is progress towards a compromise. Our base line scenario is that a compromise will be found just in time to avoid a fiscal cliff. However, political bargaining is seldom leading to a quick compromise. One should always keep in mind the lack of patience in Wall Street in July 2011. Despite a compromise to lift the debt ceiling was found in the 11^th hour, the stock market declined as investors lost patience. Therefore, it can not be ruled out that sentiment among investors turns sour again and institutional investors withdraw funds from commodity markets.

On Friday, the push higher was also based on hopes that a political solution will be found, but this time the focus was on Greece. The next payment from EU and IMF is already overdue. However, eurzone finance ministers and the IMF could not find an agreement on whether Greece would need another debt restructuring. But now, it seems that a solution could be found next Monday. However, more important for Greece than just receiving funds to avoid bankruptcy, it would be to relax the imposed conditionality of the bailout. As long as requested fiscal austerity leads Greece deeper and deeper into depression, the less likely it will be that the Greek debt/GDP ratio will reach a peak. Nevertheless, a decision to release funds for Greece would be positive for the euro, stock markets and thus also for precious metals.

Positive news came also from various business surveys. The flash estimate of the HSBC manufacturing PMI for China surprised to the upside. The index rose again above the crucial 50 threshold. This manufacturing PMI now confirms what other economic data already indicated, namely, that the Chinese economy is growing again at a faster pace. But also the manufacturing PMI for the eurozone and some member countries showed a stronger rebound. In Germany, also the ifo business climate index posted a surprising increase, thus, paring the drop in the previous month. The recovery of the manufacturing PMIs indicates that also the eurozone economy is likely to stabilize and not to head further into recession. This is another positive factor for risky assets.

After China, the US and the UK, now also the eurozone shows signs of improving economic data. This should be positive for stock markets. It should also lead to a weaker US dollar as investors risk appetite is likely to increase and they invest also more outside the US financial markets. An improved economic outlook should also be a supportive factor for crude oil prices. However, here also the supply side has to be taken into consideration and new technologies (fracking) could lead to an increasing supply. However, the critical factors remain political decisions. If these political decisions will be also favorable for risky assets, then funds are likely to be flowing out of the safe havens of government bonds, the US Treasury notes and the German bunds. This could give precious metals another push higher. 

NEW SECTION: Research Papers and Products

In this blog, a new section had been added, where we will present some research of QCR Quantitative Commodity Research Limited. We will present summaries of the research free of charge. However, fully detailed research results might be available only for purchases, especially if this research could by applied for trading in financial and commodity markets.

The first contribution is titled:

A Timing Model for Stock Markets

Stock markets play a major role for the price developments of commodities, see also this weeks blog article below. The S&P 500 index is one explanatory variable in our fair value models for precious and base metals. Thus, it is essential to analyse the future direction of stock markets for drawing conclusions and providing forecasts for price trends in metal markets. QCR has developed a macro-economic indicator for this purpose. This indicator could also be used for timing long and short positions in stock markets. The following document provides a summary and shows the test result for a trading strategy based on the indicator. This document could be downloaded for free. However,  a document on constructing the macro-economic indicator could be purchased from QCR. Please, contact us by e-mail at qcr.research@t-online.de for further details.


  The free document is available as Rings on stock exchanges summary.pdf;   

Mixed bag for precious metals

Last week, we recommended remaining cautious as the post US election rally was not supported by the major fundamentals. This week, gold and silver gave back a part of the gains made during the preceding week. Only the PGMs performed better. While platinum ended the week slightly in the plus, palladium posted a stronger gain. The reason for this outperformance was the surprising 2012 interim report from Johnson Matthey, which predict a swing from a supply surplus to a deficit. But also for the PGMs, the further short-term development will depend essentially on stock market movements.

During the week following the US election, large speculators increased again their long position in gold futures and reduced slightly the short position according to the recent CFTC report on the commitment of traders. Thus, the net long position of the non-commercials increased 11,418 to 171,594 contracts.  The net long position in silver held by large speculators increased by only less than 300 contracts to 34,410 contracts in the week ending November 13. We interpret this development as hedge funds have channeled money back into gold on the relief that Mr. Bernanke will remain chairman of the Fed and that quantitative easing will not come to an abrupt end.

However, the development of the past week underlines that quantitative easing is not a sufficient condition for a rally in precious metal markets; it is only a supporting factor. And it is also not a necessary condition. As the case of the PGMs has demonstrated, the factors driving demand and supply are moving the prices.

In our quantitative models, the US stock market is a highly significant factor for the price development of the four precious metals. However, the S&P 500 index serves as a high frequency proxy for economic activity, which is measured in monthly or even only quarterly intervals. Expectations about future economic activity have an impact not only on the investment demand for precious metals, but also for consumer or industrial demand. This has been underlined last week with the release of the gold demand and supply report of the World Gold Council, which showed a decline of global gold demand in Q3 this year. Also demand in China declined as the pace of economic activity had slowed. Thus, it should not come as a surprise that precious metals often trade in line with risky assets.

One factor cited for the fall of major stock markets last week was the preliminary Q3 GDP data in the eurozone. Former ECB chief economist Stark always pretended that austerity fiscal policy would lead to economic recovery. However, the multiplier effect of fiscal policy measures is not below unity as Mr. Stark but also IMF officials tried to make believe. Flawless quantitative research shows that the multiplier effect is not a constant but varies with economic conditions. This has also been the result of a recent IMF working paper. In a recession, fiscal austerity is not leading out of the recession but could trigger a vicious circle. Greece provides currently the best example for this inappropriate economic medicine prescribed by the troika of EU, ECB and IMF. As more and more countries were forced to implement a restrictive fiscal policy, it is no wonder that the eurozone entered into the second recession after 2009. But the decline of the eurozone GDP was slightly less than the consensus of economists had predicted.

Normally, one would expect that the impact of the eurozone GDP data would not be that strong on international stock markets. However, combined with the fear of a fiscal cliff possibly looming in the US, the sentiment was bearish. Many stock markets posted the second weekly loss in a row, which dragged also gold and silver lower. Thus, the developments at major stock markets remain the key for precious metals.

Last Friday, the first meeting between leaders of both parties in the Senate and the House took place in the White House. Both sides made slight moves and emphasized to work towards avoiding the fiscal cliff. This has lead to stabilization in the US stock market, with the major indices posting the first daily gain since the US election. We expect that a compromise to avoid the fiscal cliff will be reached, but it might be an 11^th hour compromise. Therefore, precious metals might remain on a bumpy road during the final few weeks of 2012.  

US Presidential Election leads to rise of precious metals

Precious metals rose in the week of the US Presidential Elections with gold and silver recouping the loss of the preceding week. Gold and silver have also broken through the short-term downward trend line of the correction. However, this movement is not backed by all of the major fundamental factors. Furthermore, the strong move up on Tuesday was based on two conflicting arguments. Therefore, we would remain cautious, i.e. staying long but having tight stops in place.

On Tuesday, while the poll stations were still open and votes not counted, gold and silver triggered a rally in line with other risky assets. The US stock market rose on speculation that Mitt Romney would become the next US president. Gold and silver moved also higher after the US stock market was closed and votes were counted. As exit polls and first voting results showed a lead of Mr. Romney this move was consistent so far. However, these predictions were still in line with opinion polls, which showed that incumbent president Obama would win a second term. But after all major US TV-stations called Obama winning a second term in the White House, gold and silver advanced further. Now the argument of the gold bulls was that Fed Chairman Bernanke would stay in office at least until the end of his term and that quantitative easing would not end anytime soon. This behavior is not consistent. If a continuation of quantitative easing would be a necessary condition for precious metals to move higher, the initial trigger for the rise on Tuesday was not justified.  

In early computer trading, the US stock index futures turned negative again while the poll stations were still open at the US East coast. But after it was clear that president Obama won a second term, also stock index futures turned positive again. However, after Wall Street opened, the US stock market plunged. This behavior demonstrated again that stock markets are by no means always efficient and that all available information is already priced in. The projections based on opinion polls and scientific methods showed all that the incumbent president would also be the next one. Therefore, a victory of Mr. Obama should have been discounted. But it appears that donations of many Wall Street companies eclipsed rational behavior and led to a wishful thinking behavior in many trading rooms.

At the US stock market, the fear is now that the US is heading towards the fiscal cliff. However, also a Romney win would not have changed the situation, which should also have been discounted. The polls also showed that the majorities in the Congress would not change; the House would be dominated by the republicans and the Senate by the democrats. And the election results brought no surprise and confirmed the projection of the polls. This also should have been priced in.

Wall Street appears to react like Skinner rats, Obama is negative for stocks. This was also obvious last Friday. Positive economic data triggered a recovery of the US stock market. The statement of House majority leader Boehner had no negative impact. However, when president Obama spoke, the US stock market pared gains. Both underlined their positions but also affirmed the willingness to find a compromise.

From our point of view, the risk for not finding a compromise is neither president Obama nor Mr. Boehner, who showed willingness to compromise already in the summer last year. The problem is the fundamental opposition by the Tea Party fraction within the republicans. But Wall Street does not understand the political behavior in Washington. A compromise is probably not found quickly, but more likely towards the last hour. Agreeing to a compromise quickly is regarded often as a sign of weakness and not negotiating hard enough. This leads to the risk, that the US stock market might be driven more by fears of falling off the fiscal cliff then by the economic data, which shows more and more signs of economic improvement.

If Wall Street will be driven more by political fears instead of sober rational analysis then it remains doubtful whether precious metals would move higher. A weak US stock market and a firmer US dollar are usually negative for precious metals. And even more quantitative easing would not be able to prevent the negative consequences if the automatic tax hikes and spending cuts kick in at January 1, 2013 in the USA. Therefore, we would keep tight stops for long positions in precious metals. However, in the case that a compromise to avoid the fiscal cliff should be found quickly, then precious metals are likely to rally further strongly.

Strange reaction in precious metals markets, better keep the powder try

The US labor market report has the reputation of causing higher volatility in financial and commodity markets. Last Friday, this had been the case again. While it appeared before the release of the non-farm payroll figure and the unemployment rate that precious metals might end the week higher, the labor market report triggered a u-turn and precious metals posted strong losses on the day. Gold and silver closed near the low of the week and lost 2% and 3.75% respectively. Only the PGMs managed to hold quite well in the week over week comparison with palladium even ending slightly higher than the Friday before. However, what is puzzling is the reaction in financial and commodity markets following the release of the US labor market report. Thus, for the time being, we would keep the powder try.

The non-farm payroll figure came in much stronger than expected by Wall Street economists. While the consensus was looking for 123K new jobs, the US economy added 171K persons to the non-farm payrolls. Also the figure for the September was revised up from 114 to 148K and August number was revised to 192K from 142K (already revised higher in the October report from originally reported 96K). The unemployment rate edged up from 7.8 to 7.9%, which was essentially unchanged as the Bureau of Labor Statistics stated in the official release.

Some commodity analysts argue that the drop of precious metals prices is based on expectations the Fed would not provide more liquidity following the strong labor market report. However, those traders selling precious metals based on this argument should read the two recent statements of the FOMC more carefully. At 7.9% the unemployment rate is still far above the target level of the Fed and also far away from a level the FOMC would consider to withdraw further monetary stimuli. Thus, US economy is improving after the weak second quarter and this labor market report provides further evidence. However, it requires a miracle that the US economy would produce so many new jobs that the Fed would terminate QE3 anytime soon. Nevertheless, it is a widespread misperception that precious metals would require further liquidity injections to move higher.

We pointed out several times that precious metals trade in line with other risky assets and therefore, the risk aversion of investors is crucial for the price movements. The reaction in markets for risky assets following the release of the US labor market report was very strange. Initially, stock index futures rallied. But only shortly after Wall Street opened, the market turned direction and closed down around 1% lower on the day. Position liquidations were not limited to stocks, but spread also to other commodities. Crude oil, another major fundamental factor for the price of precious metals, plunged by more than 2.6% on the day. As the labor market surprised strongly on the upside, the selling pressure across the markets for risky assets could not be attributed to the buy the rumor and sell the fact behavior of some traders and investors.

Some commentators argued that financial markets would now price in a victory of incumbent US president Obama at the election next Tuesday. Furthermore, they stated that Wall Street would regard a victory of president Obama as positive for safe haven Treasury paper while a victory of Mr. Romney would be positive for stocks. However, the weakness of this argument is that opinion polls showed for some time already that president Obama would win at least the Electoral College votes, even before hurricane Sandy hit the northern parts of the US East coast. Thus, it appears as really strange that investors start to price in a re-election of US president Obama just a bit more than one hour after the release of the US labor market report, which normally should have lifted stocks and commodities higher.

The sentiment of large speculators for commodities has definitively changed during the month of October. We pointed out that the sentiment worsened with the earnings reporting season as many companies provided a very cautious economic outlook. Some commentators also pointed to window dressing operations by hedge funds as for many managers the business year ends with the October ultimo. The recent CFTC report on the commitment of traders shows that the net-long position of non-commercials dropped further in the week ending October 30 to 170,222 from 182,043 in the preceding week. This would be fully compatible with window dressing operations. However, the massive position liquidations on Friday and the flight into safe haven assets can not be explained any longer as window dressing.

So far, we regarded the correction of precious metals more as a buying opportunity as the fundamental economic data surprised on the upside. Economic data of the two major economies is still better than economists predicted. However, the reaction of various markets for risky assets last Friday indicates that something is wrong when markets do not react positive on good news. Maybe markets react again normally after the Presidential Election next Tuesday. Until the markets show again normal reaction, we would keep the powder try.