Not all rosy now for gold in 2014

Precious metals performed well during the last week. All metals posted strong gains, but while silver rose 7.4% within one week, the focus of many commentators was on gold. The widely followed metal increased 4.1%, but what was more important for gold was the break of the psychological resistance at 1,300$/oz. In order to assess whether gold is now in an upward trend, one has to analyze which factors drove precious metal prices higher.

During the final quarter of 2013 and also in January, gold and other precious metals performed well, when the major stock markets consolidated or traded lower. However, last week, stocks and precious metals moved both higher. In both markets, the statements of Fed chairwoman Yellen at the testimony at the House had been welcomed. The January labor market report and weaker than expected PMIs in the US led to speculation that the Fed might slow the pace of reducing the monthly bond purchases. However, Mrs. Yellen confirmed the FOMC statement made only two weeks before. In the stock market, traders and investors interpreted the statement as an indication the FOMC would still expect a strong US economy. With this respect, the rise of US equity prices is understandable.

However, if the FOMC continues tapering as indicated and the weaker economic data was only due to the severe winter weather in the US, then there would be no reason for the precious metal to be excited about the Fed. Quantitative easing would come to an end rather sooner than later. Even if the Fed keeps the Fed Funds target rate at the extremely low level during this year, the outlook for rate hikes in 2015 remains intact. Thus, it has to be expected that short-term interest rates and yields on US Treasuries would edge up, which implies that the opportunity costs of holding precious metals would increase too.

The outlook for higher interest rates should be supportive for the US dollar. Also the forward guidance of major other central banks points to a continuation of the expansionary monetary policy. However, this appears not as sufficient to strengthen the US dollar against the major currencies. In the case of the Bank of England, the market is skeptical and fears the MPC might raise the base rate sooner than currently indicated. The ECB has been expected to ease monetary policy further already at the February meeting. However, the governing council kept rates unchanged. After declining in January, the 3mth GBP Libor rate edged up again. In the Eurozone, the 3mth Euribor rate also increased slightly after the ECB meeting and is still far above the level prevailing in November. Thus, the development of money market rates contributed to weaker US dollar against the major currencies. Furthermore, the emerging market currencies, which had been under pressure in January, managed to recover slightly as the rate hikes by the central banks in India and Turkey showed some impact. From our point of view, it was the weaker US dollar, which contributed to the rise of precious metals.

However, for the medium-term outlook, it remains questionable whether the US dollar will remain a supportive factor for gold and other precious metals. The GDP growth in the final quarter of 2013 was a bit stronger in the Eurozone than the consensus of economists predicted. The ECB also underlined the outlook towards an economic recovery. Nevertheless, the inflation rate headed lower again and fell to 0.7%, which is far below the ECB’s target rate of close, but below 2%. Of course, the ECB cannot state that the council would expect the Eurozone economy were heading towards deflation. Such a statement could become a self-fulfilling prophecy, which would be counter-productive. But this does not rule out, that the council would have to take further measures to ease monetary policy. Especially, the rise of the money market rates since early December could not be welcomed. Therefore, we still attribute a higher probability to the scenario of further easing. This would be negative for the euro. But higher import prices could be favorable in the present inflation environment. Furthermore, it would be positive in particular for the current accounts of Southern Eurozone member states. Therefore, the positive impact of the US dollar on gold might be short-lived.

Another factor contributing to the recovery of gold and silver has been the behavior of institutional investors. As they reduced their exposure last year, it seems that the pictures is changing. According to the CFTC report on the “Commitment of Traders”, large speculators have changed their attitude towards gold since last Christmas. They have increased on balance their long positions by almost 24K contracts and reduced short positions by around 22K contracts in the Comex gold futures. Thus, the net-long position rose from 25,904 contracts on December 17, 2013 to 71,201 contracts in the week ending Tuesday, February 11. Furthermore, gold holdings at the biggest ETF, the SPDR Gold Trust fell for more than one year from 1,350.82 tons at year-end 2012 to 790.46 tons at the end of January this year. It is well known that institutional investors were massive sellers in this ETF. But know, it appears that also PIMCO is now done with reducing its gold holdings. The gold holdings at SPDR Gold Trust increased over the last two weeks to 801.25 tons. This might be just the one swallow, which does not make a summer. However, it is already sufficient for prices of precious metals to recover that large institutional investors are no longer selling gold.

  

In our forecast for the LBMA annual analyst survey, we penciled in a high of 1,475$/oz for gold in this year. Thus, gold could still increase further and the current upswing might have further potential. However, we would be surprised if the main driver would be a weaker US dollar. As the US economy is expected to be in an almost Goldilocks situation with robust GDP growth and no inflationary pressure in the pipeline, the normalization of Fed monetary policy will continue, which implies terminating bond purchases this year and lifting the Fed Funds target rate next year. In this situation, the US stock market should provide attractive return perspectives. Furthermore, the yield on 10yr US T-notes should have only limited potential for a decline. But a strong rise also appears currently not as the most likely scenario. Thus, government bonds also offer good performance opportunities. In this environment, institutional investors could also switch quickly out of precious metals again. Thus, we still expect more a trading than a trending market for precious metals in 2014.

Fed Quantitative Easing and Emerging Market Currency Weakness

Just a few weeks ago, when some emerging market currencies came under renewed strong pressure and the central bank of Argentina suspended to intervene in the foreign exchange market and the central banks of India and Turkey hiked their key interest rates, many commentators compared the situation with the Asian currency crisis in the late 1990^th. However, in-between, the situation has calmed down a bit and the US stock market posted the first week with a gain in this year. From our point of view, the situation is not comparable to the Asian crisis.

There are several indicators, which could lead to a currency crisis, especially when a country has a fixed exchange rate regime. The first factor is increasing indebtedness in foreign currencies. Often, the interest rate level in an emerging market country is higher than the one in a country, whose currency is regarded as a reserve currency. Thus, it is not surprising, that borrowers try to take advantage of the interest rate spread between two currencies. The amount of outstanding borrowing in foreign currencies increases. Sooner or later, foreign exchange analysts regard the level of foreign debt as unsustainable and write reports with the recommendation to sell this currency. As traders and investors follow those recommendations, the currency weakens and the cost of servicing the debt in a foreign currency increases. These costs are then regarded as unsustainable in foreign exchange markets and the pressure on the currency intensifies.

However, statistics about the debt in a foreign country only state the amount of debt but not whether this debt is hedged against currency fluctuations or fully exposed to the exchange rate risk. Private entities as well as governments could enter swap agreements that transfer the foreign currency loan into one denominated in the domestic currency. The disadvantage of those swaps is the reduction in the borrowing costs is given up to a large extend.

Some central governments from emerging market countries, like for example Turkey, are frequent borrowers in international bond markets. If not explicitly ruled out by law, those governments could reduce the foreign exchange rate risk without sacrificing a large part of the interest rate advantage of borrowing in a foreign currency. They could enter an agreement with the central bank to sell the proceeds from the bond to the central bank for obtaining the corresponding amount in local currency and at the same time agree to reverse this transaction when the bond is due. The central bank would have an increase in foreign reserves and could invest this increase in a bond which expires shortly before the bond of the central government is due. Thus, the central bank would have the necessary liquidity back when the reverse currency swap with the government would be due. In addition, the central bank could earn interest on the bond in foreign currency. As the profit of central banks is usually distributed to the central government, the foreign exchange rate risk would be widely reduced. By and large, only the spread between the interest rate paid by the government on its bond and the interest rate earned by the central bank would be exposed to the risk of exchange rate fluctuations.

Such a transaction would not only reduce the exchange rate risk for the central government, but would also sterilize the impact of government borrowing on the current account. The rise in capital imports is neutralized by the increase of foreign reserves. However, the central bank extends its balance sheet. But also this effect could be sterilized by withdrawing liquidity from the banking sector.

Another indicator often quoted is the rise of capital imports. An increase of capital imports is viewed as a growing dependence on foreign capital inflows. Furthermore, it is argued that those capital imports would increase the debt of the private and government sector in foreign currencies, and thus, would intensify the risk of an unsustainable debt level if the currency depreciates. This could indeed be the case. However, also in this case, a more in-depth analysis is required for avoiding the wrong conclusions. Capital imports are not necessarily the result that a country would have to obtain funds in a foreign currency to finance its imports. The rise of capital imports could also be the result of foreign investors, seeking higher returns, increase their investments in assets of an emerging market country. Investments in equity markets or bonds issued at the domestic primary market are normally denominated in the local currency. In this case, the investor would have to bear the foreign exchange rate risk. The higher capital imports in this scenario do not alter the level of indebtedness in other currencies, and thus, they do not change the risk that exchange rate fluctuations could lead to a default of private or public debtors.

The third indicator for the risk of a currency crisis is the development of the current account. A rising deficit in the current account is regarded as unsustainable if a certain ratio of current account deficit to GDP is exceeded. However, a closer analysis of the factors driving the higher deficit is also needed for this indicator. If, as it is often the case, the widening current account deficit is due to an increased demand for foreign goods and services by the emerging market economy, then this indicator could rightly point to an increased risk of a currency crisis. But if the original impulse comes from foreign investors purchasing more assets of an emerging market economy, then the situation is different. Even if the central bank tries to neutralize the impact of higher capital imports induced by the demand of foreign investors, it normally cannot fully sterilize the impact of foreign investors on the balance of payment. Thus, if capital transactions induced by foreign investors are the main reason that the capital account shows an increased net-import balance, then the current account has to be in a deficit. This is an underlying condition of balance of payment accounting.

The Economist published an interesting chart some weeks ago, which displayed the cumulative purchases of bonds and equities of emerging market economies by institutional investors. The striking point was, that the cumulative purchases started to increase already at the beginning of the new millennium, thus, about one decade before the Fed implemented quantitative easing. The glut of capital flows from two Asian countries with huge current account surpluses into Western capital markets depressed the return on government bonds, especially on US Treasury notes and German Bunds. However, also the spreads of other Eurozone member countries over the benchmark bunds fell considerably. Thus, institutional investors sought to achieve higher returns to meet expectations of funds sponsors by investing in emerging markets.

The financial crisis only shortly led to a decline of the cumulative investments in emerging market equities and bonds. For bonds, they almost fell back to zero. However, already in 2009, the cumulative investments reversed direction again and increased strongly due to the massive stimulus measures taken by China. The quantitative easing measures of the Fed supported this move, but were not the trigger. Therefore, the rise of capital imports by emerging market economies was induced by the decision of investors to allocate more funds for the purchase of emerging market stocks and bonds. By mid-2013 the level of cumulative investments in emerging market stocks as well as in bonds exceeded the pre-financial crisis amount by far. As lined out above, those investors also had to bear the risk of exchange rate fluctuations.

As former Fed chairman Bernanke announced in May at a Congress testimony that the FOMC might decide to taper at one of the next few meetings, institutional investors and fx-traders came to the conclusion that less money would flow into emerging market assets. In addition, rising yields on US Treasury paper had to be expected and the yield on the benchmark 10yr US T-Note indeed rose to 3%. Thus, also the relative advantage of domestic emerging market bonds changed. In this altered environment, institutional investors had to adjust their asset allocations. As a result, they reduced exposure to emerging markets, which already led to currency weakness in the summer of 2013. With the start of tapering in January, another wave of currency weakness set in.

However, as it were institutional investors, which increased their exposure to emerging markets, they were also the driving force behind the rise of capital imports and current account deficits by emerging market countries. They invested in assets denominated in local currencies of the various emerging market economies. The repatriation of funds could have a positive impact on the emerging market countries. With the devaluation of their currencies, their products gain in international competitiveness. The capital account should no longer be the driving force for the current account, which should improve. Thus, the situation is different than it was in the late 1990^th at the Asian currency crisis. That the situation has calmed down might be due that more investors recognized the differences.  

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.   

Metals Markets in 2014

Also at the start of the New Year, we participated at some polls about price forecasts for precious and base metals. Unfortunately, a sick leave prevented us from writing about these forecasts in this blog earlier. In-between, the LBMA has published their analyst polls in the 2014 LBMA Precious Metals Forecast Survey, a 29 page document containing the forecasts of various analysts as well as some short arguments for their predictions. Another poll by ThomsonReuters just published the consensus forecasts for precious and base metals.

There is an old adage at Wall Street that as the first week goes, so goes the year. A similar one is called the January effect and states that the performance of the stock indices in January indicates whether the stock market will be up or down for the whole year. The first few weeks of the year 2014 indicate that the factors having an impact on metals in 2013 will also drive the markets this year.

While the S&P 500 index is down compared with the end of last year, precious metals posted gains with the exception of silver. However, when we refer to the January effect, we don’t predict that the bear market in precious metals would be over and that gold would be in a bull market in 2014. What could have been observed already in the second half of last year was a significant, negative relationship between the returns of gold and the S&P index, while in the period from 2009 until the end of 2012, this relationship was positive. This pattern also prevailed so far this year and we expect it will also persist during the remainder of 2014. The reason of the structural break in the relationship between returns on gold and the US stock market was a change in the behavior of major institutional investors. The Abenomics in Japan as well as the announcement of QE3 by the Fed induced considerable shifts in asset allocations by large investors. Furthermore, the expansionary monetary policy has not led yet to a rise of inflation rates, which many fund managers expected. Nothing currently indicates that this behavior would reverse again this year.

After the strong performance of major stock markets in 2013, it was not surprising that the year started with a consolidation. The US economy is in a good shape, which should be supportive for the stock market. Thus, a severe correction or even a bear market are not the base scenario for the US stock market. Therefore, gold is not out of the woods and could even fall below last year’s low. On the other hand, a consolidation of the US stock market could lead to gains in the price of gold, which could slightly exceed the high reached in August 2013. All in all, we expect a broad sideways trading range around current levels. However, for the average price of gold this implies another negative year.

For the PGMs, we expect a similar trading pattern. However, already last year, they performed better than gold and silver. Based on forecasts of a stronger global GDP growth, the demand for PGMs from the automotive sector should increase. Labor unrests remain the risk factor on the supply side. Based on the statistics from Johnson-Matthey, we expect that the supply/demand balance will support the PGMs further. Thus, they are expected to outperform gold and silver also in 2014.

For the base metals, China and Indonesia will remain the key factors also this year. For tin and nickel, the export ban on unprocessed metal is a supportive factor. Also the stronger global growth should be supportive for these metals. For aluminum and copper, the key factor continues to be the state of the Chinese economy. The central bank, the People’s Bank of China, first led short-term interest rates rise but finally provided liquidity to ease the tensions in the money market. This demonstrates that the PBoC on the one hand will act if rising interest rates endanger the current pace of economic activity. But on the other hand, it would do nothing to spur GDP growth. Thus, we expect that the growth rates will remain in a narrow band around 7.5%. This will translate into fluctuations of the widely followed PMI indices slightly above the crucial 50 threshold, which does not exclude that the HSBC PMI might be in some months below this level. Therefore, we also expect a sideways movement for the base metals in our central case scenario. 

The Hidden Shadow Warehouses and Base Metals

Normally, we do not comment a specific press article. However, after the Christmas holiday, the Wall Street Journal published an article titled “Millions of Tons of Metals Stashed in Shadow Warehouses”. The tenor of this article is that more and more metal would be stored in hidden warehouses not licensed by the LME and that statistics about LME warehouse inventories would be less useful. Furthermore, the article creates the impression that holding inventories outside of LME warehouses would be intended to manipulate the market by banks and hedge funds.

This article contains some errors and inconsistencies. The LME is not the only metal exchange, which has licensed warehouses officially. As long as aluminum futures were traded on the CME, this exchange also had licensed warehouses for that metal and reported inventories daily. Copper inventories continue to be posted daily on the CME website. The Shanghai Futures Exchange has also licensed warehouses and publishes the stocks. Last Friday, these inventories were 186.7 thousand tons of aluminum. Licensing by an exchange means that these warehouses are delivery places for the traded contracts at maturity. If a delivery is due, the seller may deliver the metal by warehouse receipt of an official warehouse. The buyer has no obligation to accept metal, which is not held at one of the official licensed warehouses.

Thus, the statistics about warehouse inventories held on warrant and cancelled warrants provides information about which quantities are available for delivering into the outstanding contracts, counted by the open interest. However, this is only a daily snap-shot. These statistics do not imply that the metal available for meeting delivery obligations in the future are limited as the inventories could increase by delivering metals held outside the official warehouses into the official stocks. Nevertheless, the exchange warehouse inventories provide a good indication about the scarcities of the various base metals.

The author writes correctly that the official warehouses of the metal exchanges are also deposits for non-registered metal stocks. In the industry, the term "crossing the line" is well known and expresses that through easy transport over a certain line of separation, the metal disappears from the statistics, although it has never left the warehouse. But if the metal has left the "official, segregated storage area", then it is no longer directly available for deliveries of exchange-traded contracts. Often, the warehouses providing a financial incentive by lower storage costs to the metal from the official to the unofficial inventory areas.

Unfortunately, the author fails to recognize, why the unofficial stocks have risen so sharply. Here the LME and the warehouses have a significant fault. The LME warehouses function more like a mouse trap. It is easy to get the metal into the warehouse. But, it could sometimes take several months for the holder of a warehouse receipt to receive her metal from the warehouse. For this waiting period, she must bear the storage costs also. Therefore, for consumers of these metals, the pressure has arisen to store more metal outside the warehouses of the exchanges in order to have the necessary flexibility to use the metal for the own production of goods. The LME management would have to solve the problem of long queuing times at their warehouses. Maybe the law suits filed in the US will speed-up this process.

Furthermore, producers and consumers will always hold some inventory outside the official warehouses. Models of inventory holding like the Baumol model also can explain the rise of off-exchange warehouse stocks to some extend by rising global GDP and lower interest rates due to the zero interest rate policy followed by major central banks.

The problem with the so-called shadow storage is an essential one for analysts, who analyze statistics of production and consumption and derive forecasts for price developments from this data. The production figures can be estimated reasonably well. Sometimes this data will be published by national statistical offices. Analysts can also poll mining companies about their production estimates. Nevertheless, also production figures were revised even several years later and thus, have a degree of uncertainty, which should not be neglected. However, for consumption statistics the picture looks completely different. There are no reliable official statistics of metal consumption. Also polling companies using base metals as an input in the production of goods is a mission impossible given the sheer number of companies in the metal processing industry on a global scale.

Therefore, statisticians apply an auxiliary construct that is referred to as apparent consumption. The changes of the inventory holdings are subtracted from the production and the difference is considered as consumption. Therefore the better the actual changes in inventories are recorded, the better consumption could be estimated. If the change of inventories is underestimated, then the consumption is overestimated necessarily and vice versa. Thus, the disadvantage of this approach is a high degree of uncertainty about the effective consumption of base metals. Figures are revised still many years later. Furthermore, it is possible that revisions of data lead to changes in the supply/demand balance by the pen of the statisticians. It had been the case that the market had expected a supply deficit (surplus), but final figures showed a supply surplus (deficit).

This problem of data revisions has considerable implications for quantitative modelling of base metal price developments. Metal prices are based on the information available at the time of trade. If this information is significantly different from ex-post information used in modelling, then the estimates are distorted and could lead to erroneous conclusions. As data about inventories in exchange warehouses is available in a timely manner and is not subject to revisions, it is still preferable compared to estimates of the supply/demand balance.

For some base metals there are international organizations such as the International Aluminum Institute or the International Copper Study Group. These institutions also estimate the total inventory changes, whether held in private storage outside of exchange warehouses or in public strategic reserves. They publish this information on a monthly basis, although the statistics are published with a usual time lag. The stocks in the warehouses of the exchanges, however, are available the next morning.

The author also touches the area of inventory financing. In a number of articles and comments of analysts, the use of existing stocks as collateral for loans is discussed. In some of these articles, the impression is created that the metals are purchased solely to obtain a loan. This is only useful if there are opportunities for arbitrage, which should be exploited without the use of own funds. However for consumers the situation is different. They need to hold stocks for current production as just in-time production is not always possible. This inventory holding ties up capital. And since in many jurisdictions, equity is more expensive than debt financing due to tax treatments, it makes sense to fund the inventory holdings by a bank loan and to use the metal as collateral for the credit. But consumers will only hold higher inventories when they expect also an increase in demand for their products. However, normally consumers would not hold those inventories at exchange warehouses.

For producers, the situation is also different. If a market is in backwardation, they can sell their production of refined aluminum or copper at the spot market. However, if the market is in a contango situation, then it might be a better strategy to deliver the metal into exchange warehouses and to sell the corresponding number of futures contracts. Selling the metal in the spot market would depress prices even further and might lead to a less favorable price for the producer. However, if the producer needs funds, he could obtain a bank loan against the warehouse receipt as collateral.

For many base metals, inventories held in exchange warehouses declined from the peaks reached in 2013. If this metal all went into the “hidden shadow warehouses”, then the exchanges and the LME in particular should be worried and should take measures to reverse this development. The exchanges could also demand from the warehouses to provide figures off metal inventories outside the official zone at those warehouses. However, with respect to the development of global PMI indices, the decline of inventories at exchange warehouse might be more a reflection of a stronger global economy.

Finally, the FOMC did it!

The decision of the FOMC has been long telegraphed and was finally made seven months after outgoing Fed chairman Bernanke made his famous statement during a testimony at Congress. One might assume that the recent US labor market report, which was surprisingly strong, tipped the balance within the FOMC. However, in the first two sentences of the statement, the FOMC writes “Information received since the Federal Open Market Committee met in October indicates that economic activity is expanding at a moderate pace. Labor market conditions have shown further improvement; the unemployment rate has declined but remains elevated.”

This could be interpreted like the committee could have waited also one or two more meetings for making the decision to reduce the volume of monthly bond purchases by $10bn to $75bn. Thus, other considerations might also have played a role. One possible reason might be the looming end of Mr. Bernanke’s term as Fed chairman on January 31, 2014. He was the architect of quantitative easing by the Fed. Thanks to his policy, the US economy performs better than the Eurozone. But his policy is also strongly criticized by Tea Party politicians, who do not understand how monetary policy works. Thus, it would not be surprising if Mr. Bernanke would also like to be the Fed chairman starting to exit quantitative easing.

The fear of tapering had a negative impact on financial markets. Whenever economic data was stronger than expected, markets feared the exit from QE3 and stock as well as bond prices declined. Taking the decision reduces the uncertainty in financial markets. The yield on the 10yr US T-note edged up only slightly compared to the close of Friday, December 6, when the US labor market data was released. Thus, decision was already priced in by the fixed income markets.

The December FOMC meeting is one of the four quarterly meetings, where the committee presents its projections and the Fed chairman explains the monetary policy at a press conference. While various FOMC members already pointed out that tapering would not imply an end of the zero interest rate policy (ZIRP), it was a good occasion to demonstrate that the Fed Funds rate will remain at the extremely low level for quite some time. The majority still expects that the first rate hike would take place in 2015. Also important is that the majority expects that the Fed Fund rate would be at 1% or less by the end of 2015. Furthermore, the FOMC made clear that a fall of the unemployment rate below the level of 6.5% would not be an automatic trigger for a rate hike. Instead, the Fed Funds rate will remain at the current level for some time after this level will have been reached. This assurance was welcome in the bond market and triggered a rally at the stock market.

For forecasting the direction of the 10yr US Treasury yield, the money market rate implied in the Eurodollar Futures at the CME maturing within the next 12 – 15 months provides a good guideline. Thus, we analyze the implied 3M Libor of the March 2015 Eurodollar Future. Currently, this implied 3M Libor rate is at 0.495% while the current 3M Libor rate is at 0.248%. Given the projections of the FOMC that the first hike of the Fed Funds target rate would take place in 2015, the timing of this move would be critical. As long as the FOMC would not increase the first quarter of 2015, the implied 3M Libor per March 2015 could even edge down further, which would limit the upside potential for the yield on the 10yr US T-notes. Only if the market starts to price in rate hikes in the short-term interest rate futures, the long end of the US Treasury curve has to be expected to come under stronger selling pressure.

The spread between the yield on the 10yr US T-note and the 3M Libor is at 239 basis points. The steepness of the yield curve, combined with the limited risk of higher Treasury yields, makes carry-trades interesting for banks and hedge funds. Therefore, the declining demand from the Fed might be easily compensated by other buyers, like banks and hedge funds.

We pointed out that the macroeconomic fundamentals would argue for investments in the US stock market even in the case of tapering. Nevertheless, given how the stock market reacted before the FOMC decision on stronger economic data, a negative reaction on the decision to reduce the volume of monthly bond purchases could not be ruled out. Especially, as many market pundits claimed that the rise of stock indices were only caused by the extension of the Fed balance sheet. However, the precious metals reacted as expected. Gold reached the lowest weekly close of this year. The correlation between gold and the S&P 500 index turned negative in 2013. Thus, the rally in the stock market following the FOMC announcement caused further funds flowing out of the precious metals and into equities. The holdings of the SPDR Gold Trust ETF dropped to 808.7 tons, which is a fall of 40.1% compared to the same day last year. While the FOMC underlined the outlook for stable interest rates, the US dollar gained against other major currencies as dealers bought the dollar on less liquidity provisions by the Fed. Thus, the increase of the US dollar index was another factor, which weighed on the precious metals. As long as the US stock market remains strong and the US dollar appreciates against the major other currencies, gold might not have reached the bottom. Thus, the low of the downswing starting earlier this year is probably still ahead.   

No reason to fear tapering

The US labor market report was stronger than the consensus of Wall Street economists predicted or whisper numbers among traders indicated. Before the release of the report, markets feared a stronger report would signal the Fed would taper at the next meeting. However, financial and commodity markets only briefly traded lower but after a few minutes reversed direction and traded higher. Thus, many markets traded like it was selling the rumors and buying the facts. Nevertheless, neither the S&P 500 Index nor most precious metals managed to end the week higher than the Friday before.

In a market report published by ThomsonReuters, one trader was quoted that US stock markets trade higher because the market now knows that the economy would be able to absorb the negative impact of tapering by the Fed. This statement just underlines that financial markets are not always information efficient as academic theory postulates. For more than six months now, the Fed emphasized that the decision to reduce the volume of monthly bond purchases would be data dependent. This implies, that the FOMC would only decide to taper if the majority of the voting members were convinced the economy were on a sustainable growth pace, which implies that tapering would not hurt the economy.

Some analysts and asset managers argued that the rally in stock and commodity markets were driven only by the liquidity provided by the Fed. If this argument were correct, then stock markets were in a bubble. Precious and industrial metals as well as the markets for agricultural commodities corrected this year. Thus, the liquidity of the bond purchases did not flow into most commodities any longer. For gold and silver, we pointed out in this blog that the shift in Japan’s economic policy to overcome the deflation was the crucial factor for the correction. For industrial metals it was high stockpiles and fears about Chinese GDP growth, which dominated the market developments. Thus, for the commodity markets, the argument that only the Fed liquidity injection by QE3 drove prices higher was obviously wrong. But is it also wrong for US stock markets?

We developed some macroeconomic indicators for various stock market indices, which are all based on the macroeconomic portfolio theory of Prof. James Tobin, which he created to study the economic impacts of fiscal and monetary policy measures. This indicator does not include any monetary aggregate like money supply or the size of a central bank’s balance sheet. The indicator is based on monthly macroeconomic variables which are highly correlated with GDP growth. Also short- and long-term interest rates are included.

As the chart shows, the macro-indicator only had a brief decline in the second quarter this year. The shaded area indicate when a moving average of the indicator is increasing and thus provides a set-up for a buy signal. It is worth to note, that the macro-indicator rose in the second half despite the yield on 10yr US Treasury notes provided a negative contribution on balance. The major moves higher of the S&P 500 index took place when also the macro-indicator signaled a bullish environment for the stock market. Thus, we have to come to the conclusion, that QE3 was helpful for the stock market rally, but the rise of equity prices was not driven solely by the Fed buying bonds but also by favorable macroeconomic fundamentals.

Furthermore, we have to conclude that the fear in some financial markets about the impact of tapering are overdone. They were only justified, if tapering would lead to a deterioration of economic fundamentals. However, the FOMC also emphasized that the volume of bond purchases could be increased again if the economic development worsens after the committee decided to taper. Therefore, the downside risk for the US economy appears to be rather limited as the FOMC remains ready to act when needed.

After the release of the US labor market report, the question is now, whether this report would now tip the balance among the FOMC voting members already at the December meeting. The decline of the unemployment rate to 7.0%, which was accompanied by people returning back to the workforce is certainly a strong argument. Also the number of job creation is more robust than economists predicted. However, in the Beige Book, which serves as a basis for the FOMC decisions, the regional Reserve Banks preparing the report, paint a picture of modest economic development. Thus, from our point of view, a tapering decision at the next meeting appears still not as the most likely scenario. However, the probability for reducing the volume of monthly bond purchases in Q1 next year has clearly risen. 

Nevertheless, there is no reason to fear tapering. The rise of the US stock market was well supported by economic fundamentals. The Fed will keep the short-term interest rate, the Fed Funds target rate unchanged well into 2015. The yield on 10yr US Treasuries has risen further to 2.88%. Thus, the yield curve is rather steep and attractive for carry trades, which should limit the upside risk in the US Treasury market. But tapering might be positive for the US dollar, which might appreciate against major currencies as the ECB and the Bank of Japan will continue to stick to a very expansionary monetary policy. For the metals markets, the risk of a firmer US dollar is the major risk of tapering by the Fed. But as the FOMC heralded this move for more than six months, it should now be priced in.