Better perspectives for base metals

The compromise in aid to Greece, the EU leaders have made at their summit in Brussels last Thursday, might lead to a short-term recovery in the euro exchange rate against the US dollar only and thus also the precious metals might profit merely in the short run. However, a permanent shift towards a stronger euro will appear as doubtful in the light of the compromise found. Since the precious metals react more strongly to the US dollar as the industrial metals, this indicates a better performance of non-ferrous metals over the medium-term. In addition, the recent economic data are a further indication of better prospects for industrial metals.

The German press, especially the mass tabloids, celebrated the relentless attitude of Chancellor Merkel in the question of EU assistance to Greece. But the refusing stance of the federal government, determined by internal politics, has proved as a disservice the euro. In particular, it is negative that Greece has to ask for an IMF-loan first. This means that the EU is not able to resolve its own problems without help from the outside (ie, primarily by the US and China). This does not create confidence in a currency some EU politicians have believed that it could replace the US dollar as a global investment and reserve currency. Not unduly, the ECB is concerned that an intervention of the IMF might interfere with its independence, which is also a negative factor for the confidence in the euro. It also appears doubtful whether the IMF under its statutes is allowed to grant Greece a loan as the problem in Greece is not one of balance of payments, but one of financing of the budget deficit. The third point to add is that the States of the euro area have to establish unanimously that Greece receives no credit in the financial markets any more before bilateral loans can be granted. Given the position of Chancellor Merkel, the stance of "no money from German taxpayers for Greece" could again become a stumbling block for a unanimous decision. The recovery of the euro from 1.327 up to 1.341 against the US dollar is likely to be primarily based on short-term profit-taking and replacement purchases of euro short positions and no medium-term trend reversal signal.

The industrial metals react less strongly to the development of the US dollar than the precious metals. In particular, gold is seen as a protection against a weak US dollar. Although base metals benefit from a weak US dollar, the fundamental factors of supply and demand play a greater role. The economic data, released during the preceding week, were better in the US than expected. It is true that GDP growth for the 4th Quarter of 2009 was revised down slightly, but the data for the current quarter indicate a further recovery of the US economy, which is after all the second-largest consumer of industrial metals. The Richmond Fed index rose from 2 to 6 points, while the consensus expected only a rise to 5 points. The orders for durable goods increased by +0.9% in the core rate, more than the consensus of economists had forecasted. In the euro zone purchasing managers' indices could also increase strongly from 54.1 to 56.3. In Germany, the Ifo index rose from 95.2 to 98.1 and thus has not only recouped the slight decline of the previous month again, but still achieved the highest level since June 2008. Overall, therefore, the economic data point to a further recovery in the economy and thus increasing demand for more raw materials. Therefore, even a less expansionary monetary policy in China would change little of this perspective.

Another important indicator of the economic outlook is the trend in the equity markets. In Europe, key indices reached a new annual high in the previous week and the US indices continued to rise. This suggests all in all that the economic outlook will be judged positively on the stock markets. This should also positively impact on the base metals. They should therefore perform better than the precious metals in the coming weeks.

Greece's problems continue to weigh on Precious Metals

As already stated in this blog, problems of Greece and the fear of state bankruptcy remain a burden on the metals markets for the foreseeable future, particularly for precious metals. The connecting link in this chain is the exchange rate of the euro on foreign exchange markets against the US dollar. But it was less the Greeks or even the infamous hedge fund that put the credit default swaps (CDS) markets under pressure, but politicians in Berlin. Most German officials can not cope with the requirements of solid government and are unable to solve problems adequately. The failure of the Berlin policy has put the euro and therefore the metals markets under pressure again. Also, this problem should not be resolved so quickly.

At the start of last week it looked as if the EU put together a package of measures to assist Greece after Greece took the additional savings measures, which were demanded by the EU and the ECB. At the recent press conference, ECB president Trichet praised Greece for the new budget explicitly. But the markets were disappointed by the EU finance ministers, after the chairman of the Eco-Fin Juncker told the press that there had been agreement on the technical aspects of assistance to Greece. It had been leaked, however, hereafter by EU sources that Germany had blocked more concrete statements on which the markets had been waiting. But then by mid-week, Chancellor Merkel shocked the markets with a u-turn of the German policy. She turned to stubborn and recommends Greece to take a loan assistance of the IMF. Germany would not agree to EU package of measures for Greece at the forthcoming summit of EU heads of state under any circumstances.

What are the reasons for the sea change in German politics? Ultimately, it is likely that the state election in North Rhine-Westphalia and the lack of political leadership by Chancellor Merkel as well as the crash of the FDP in the polls, after Foreign Minister Westerwelle rapidly losing popularity, which resulted in the Berlin chancellery to this u-turn. The CDU/FDP coalition in Berlin has in the few months since taking office lost so rapidly in approval that the Merkel-led CDU is threatened with the loss of power in North Rhine-Westphalia. This would also mean that the majority would be lost for the Berlin government coalition in the Bundesrat, the upper house. Aid for Greece is not popular in Germany and the mass media stir up negative sentiment strongly. For the party strategists it is the easiest way to float on this wave of sentiment, and thus, to alienate the voters, even if the unpopular support for Greece is the overall better alternative. While Greece's government under Prime Minister Papandreou explains to its own population the necessity of saving and convince them, so the government can count on broad support, Chancellor Merkel as so often lacks political leadership.

A support package for Greece does not necessarily imply or require that the money of foreign taxpayers, including the German citizens, has to flow to Greece. After all, the Papandreou government has not asked for any financial support from EU. For the financial markets, it is however important to know that Greece still has funding alternatives and is not facing bankruptcy. Requested from the EU are measures, which illustrate that EU countries support Greece, after the Government would implement the required fiscal restraint. Greece would certainly get an IMF loan, without additional restrictive fiscal measures being required. But the German Finance Minister Schaeuble has far quicker worked into the matter of his new resort than the physicist Merkel understands the laws of financial markets. As Schaeuble pointed out, the course of Greece to Washington for the IMF would send the wrong signal. It would show the world that Europe were not in a position to solve its own problems without the cooperation of the USA and China. Confidence in Europe and the euro could take longer-term damage. It would also signal to hedge funds that they had a free hand to attack the next victim. Once the sharks have tasted blood, they attacked the victims. The Asian crisis in 1997, originated in one country, but other countries were infected by the Asian contagion. Even Hong Kong, which operated a sound policy and its currency was firmly tied to the U.S. dollar in a "currency board" system, came under attack. If the EU can not agree on an aid for Greece and the country must take an IMF loan then Portugal and Spain could be the next victims. The euro is likely to remain under pressure against the U.S. dollar, and the speculation about an end to the monetary union could mount again. For the precious metals that would be first a negative scenario. Only once a flight of investors from the euro zone into gold sets-in, the price of gold in dollars might rise again despite continued euro weakness.

Precious metals might face a correction

The markets for precious metals could face a more significant correction. Although the fundamental factors influencing precious metals were positive in the weekly comparison, the precious metal prices, with the exception of platinum, traded lower. Experience teaches that when a market is not rising on positive news any more, but even declines, a severe correction is usually looming around the corner. In this case, even platinum can not escape the downward pressure.

Striking in the development of the gold price in the previous week was that the price came under strong pressure from the futures markets, when pit trading was opened in the U.S. In the econometric models of QCR Commodity Research Quantitative for gold and silver, the respective net positions of large speculators are one of the explanatory variables. But in the case of gold, the net long position increased by 822 to 208,194 contracts, according to the latest report from the CFTC. In silver, the net-long position even rose sharply by 4107 to 35,165 contracts. Overall, this is seen as positive. However, the CFTC data refer to the preceding Tuesday, thus, a reduction in net long position during the previous week is possible. In the largest gold ETF, the SPDR Gold Trust, a slight decline in the gold holdings took place on Wednesday of last week, but they remained constant in the following days.

In the weekly comparison, the U.S. dollar has depreciated against both the euro and also the trade-weighted index of the 5 most important currencies. The S & P 500 Index has improved slightly. The yield on 10yr U.S. Treasury notes rose as a result of positive U.S. economic data to 3.75%, but that overall, should be favorable for the metal. Only oil prices suffered a slight loss during the week. Overall, however, the fundamental factors were positive for precious metals.

The reason given by dealers for the decline of gold prices was technical factors. In fact, the spot price of gold has found resistance at the upper Bollinger Band already in the preceding week. At the beginning of the previous week, gold then dropped below support at 1130 $/oz and the short-term uptrend line has also been broken to the downside. An attempt to get back above this uptrend line has failed on Friday. Therefore, it seems very doubtful whether the support at the lower Bollinger band and the recent pivot low at 1088$/oz will hold.

Metal markets suffer from economic uncertainty

The metals markets have had to withstand considerable stress by economic data leased around the middle of last week. But these are likely to be distorted vigorously through the hard and long winter in the northern hemisphere. In the coming months, there should be a correction, which would positive for the metals markets. The example of Greece has shown in the previous week, how little the information-efficient markets are, contrary to the theory of rational expectations. It would take some considerable time before the crisis has endured. Hence the fear of a Greek state bankruptcy remains in the spotlight and contagion to other countries in the euro zone stays on the agenda. For the metals markets, this means that a weaker euro could further weigh on prices.

The metals markets have already turned into the red at the beginning of the trading week. But they came under huge pressure with the publication of two economic figures before they could recover towards the weekend. In Germany, the ifo index of business climate fell surprisingly from 95.8 to 95.2, while the consensus among economists was looking for a slight increase to 96.2. This decrease was caused by a marked deterioration in current business conditions from 91.2 to 89.8. The key here was the retail sector, which suffered strongly due to weather conditions. However, for the further development of business activities, the business expectations are more likely to be of importance. These have continued to improve and have increased from 100.6 to 100.9. With the start of the spring, thus, the situation should improve in the retail sector and should also improve further in other sectors of the economy. In addition, the weaker euro is helping the German export industry, which also does not argue for an economic downturn, even if the GDP growth in 1st Quarter could well again stagnate.

The second negative factor for the metals markets came just hours after the publication of the Ifo index with the release of U.S. consumer confidence. Although even the consensus had expected a slight decrease, but did not calculate with a massive drop from 56.5 to 46.0. Consumer confidence suffered from the development of the labor market in particular. But even here, the weather plays a role, as was also acknowledged by Fed Chairman Bernanke in testimony before the U.S. Congress. With the end of the winter season, the situation could improve again. In addition, it must be remembered that the plunge of consumer confidence needs not necessarily lead to a massive drop in consumer spending. Even for the significantly lower than expected sales figures of the housing market, the weather played a role. But it remains to be seen, whether the situation improves again. For the copper demand, however, building permits and housing starts should be the more significant factors.

These economic data have not only led to falling prices in the stock markets, but also to declining prices for crude oil and declining yields 10yr. U.S. Treasury Notes. These figures were negative for the metals markets. In the gold market, it is often argued that lower yields reduce the opportunity cost. However, they also reflect a worsening of economic assessment, and thus diminishing inflation risks. Therefore, this is negative for gold. Thus also the precious metals could not escape the influence of the worse-than-expected economic data.

Greece came under renewed pressure and the CDS rates and the yield spreads on government bonds have once again widened. This was triggered by the rating agencies. But have only affirmed old positions and thus repeated long familiar-looking statements. The markets are not information-efficient, but behave like somebody watching repeatedly a scary move and gets again shocked every time. The market initially waits for Greece to launch a 10yr. government bond. But even with a successful placement, Greece remains on the agenda. Only when the government shows highly visible successes, reducing the budget deficit to GDP ratio in line with promises made, the situation might ease. Until then, however, the euro versus the U.S. dollar stays vulnerable. Therefore, the euro could remain a burden on the metals markets.

Fed interest rate policy is not negative for metals markets

The increase in the discount rate by the U.S. Federal Reserve is not negative for metals markets. In the current environment, it has even to be seen as a positive sign. Although there are first voices to delete the phrase in the statement of the FOMC that the interest rates would remain low for an extended period of time, a shift in interest rate policy, not on the agenda. Thus, the U.S. interest rate policy remains positive for the metals markets.

The financial and commodity markets reacted in the previous week already nervous that the voices in the Fed increase, which argue to drop at least in the FOMC statement any hint about how long Fed interest rates would prevail on the extremely low levels. It is therefore understandable that the markets, especially in Asian trading, followed the increase in the U.S. discount rate by 0.25% points to 0.75% with a Pavlov reaction of falling prices.

But this move by the Fed is not a change in interest rate policy. After the bankruptcy of investment bank Lehman Brothers, the Fed has massively reduced its interest rates. The discount rate is not the main interest rate of the Fed policy. Over the "discount window", the U.S. banks get emergency liquidity from the Fed. Hence the discount rate was generally well above the Fed Fund rate. During the financial crisis, the Fed has massively reduced the spread between discount rate and the Fed Fund target rate.

In hearings, Fed Chairman Bernanke has made it always clear that the U.S. economy is recovering, but still faces significant headwinds. This assessment has been reflected in the statements of the FOMC after the meetings. To interpret the increase in the discount rate as a signal of an imminent reversal of monetary policy is therefore a mistake. Moreover, this measure reflects the contrary that the situation has sufficiently stabilized on the U.S. money market, and thus, the Fed can gradually return from an emergency to a normal situation.

This view has gained dominance in the stock markets in Europe at first. After a weak opening, equity markets stabilized and recovered further during the trading session. This has pulled the metals markets higher, too. In addition, the euro could recover against the U.S. dollar from the lows and turned into the plus. The normalization of the U.S. money market underscores the fact the Fed's optimism about the further development of the U.S. economy. The economic data released the previous week had been largely better than expected. The recovery in equity markets is likely to continue in this light. Rising stock markets are in the current environment also positive for the metals markets, which should also have more upside potential.

China's monetary policy - no drop in copper demand

The two hikes of the minimum reserve ratio by the Chinese central bank (the Peoples Bank of China) by 0.5%-points each in mid-January and in the past week, and the brakes on lending by commercial banks does not mean the demand for copper at the largest consumer is going to collapse. Overall, despite a tightening of credit policy, copper consumption in China should develop better than the International Copper Study Group estimated in its forecast from early October 2009. The supply surplus could be lower in our view. This does not mean, however, that the price of copper will not suffer under greater burdens in the year 2010. These possible pressures, however, are more likely to come from those factors that have driven the price of copper strongly higher in 2009, although the LME inventories had increased significantly.

The net-lending of Chinese banks in the first 20 days of 2010 was around 151 billion euro. Given the objective of China's central bank, to limit the volume of new loans to around 781 billion euro, it comes as no surprise that the PBoC has twice raised the minimum reserve requirement ratio by 0.5% points and the commercial banks put on hold the granting of new loans during the last third of January. Even as the target of the PBoC is to reduce volume of new loans in this year to the equivalent of 999 billion euro, this volume would still be well above the amount of new loans in 2008. Therefore, China is far away from pursuing a restrictive monetary and credit policy, but it will not be as expansionary as in the previous year. However this is not surprising, given the recent growth figures for GDP of 10.7% in the 4th Quarter of 2009. The development of inflation in China suggests that China's central bank takes his foot off the accelerator, too. Although the inflation rate for consumer prices in January, after a surprise fall to 1.6%, is at a moderate level, but it has accelerated considerably for producer prices, which rather sooner than later would spill over to consumer prices.

The fears in the markets, not only for copper, seem to be based on the fact that some analysts and traders confuse acceleration and speed. In the 1st Quarter of 2009, the growth of China's GDP was still at 6.1% yoy. It has steadily accelerated to 10.7% in the last quarter. While one could still argue that the basis for comparison in the 2nd and 3 Quarter was distorted by the prescribed production stoppage with respect to the Olympic Games in Beijing, but this applies no longer to the 4th Quarter. The accelerated GDP growth has been due to the expansionary monetary and credit policy. In China, as the central bank takes the foot off the accelerator, the monetary and credit policy as a whole is less expansionary, but is still far from acting restrictively. For the growth rates, this means that they will not rise much further. But the Chinese economy is likely to be far away from a drop in growth rates. In yoy-comparison China's GDP could still grow by a double-digit rate this year.

For the demand for copper, this implies it should grow strongly again. The International Copper Study Group estimates that much of the Chinese consumption would be satisfied by supplies from the strategic reserve, which was strongly increased in 2009. We do not share this assumption. On the one hand, a strategic reserve is not used to compensate for short-term fluctuations. Secondly, the copper stocks in the warehouses of the metal exchanges have increased and copper is not scarce. In order to provide copper to the market from China’s strategic reserve, probably a significant plunge of the copper stocks in LME, SFE and CME warehouses would be required.

Overall, we consider the impact of actions by the Chinese central bank on the recent development of the copper price is far overdone. This does not imply that the price of copper is unlikely to suffer under various burdens this year. Many analysts and traders expressed surprise that the price of copper has risen almost to $ 7,800 per tonne, although the stocks in warehouses have steadily risen. Our econometric model for the fair value of copper shows other factors, which also have a significant impact on copper prices, have more than offset the negative impact of rising stocks. But in the course of 2010 these factors are likely to lose more and more their positive influence and could even become a burden. The OECD leading indicator could still rise further, but the further increase is likely to lose momentum, which is negative for copper. Also in the equity markets, the gains over the previous year are expected to decline. The Fed is likely to begin in the second half to adopt a less expansionary monetary policy. This would then also lead to rising yields of 10yr. US Treasury bonds and thus also impact on the price of copper negatively. Also we do not expect oil prices - as an indicator of expected inflation risks – to drop significantly, which would then also draw copper prices down. But a robust rally as in 2009 is not expected as well. The US dollar is already having a negative impact on the price of copper. After the weakness of the US dollar in 2009, when it served as the funding currency for carry trades, the greenback has gained strength in the foreign exchange markets, as the fear of state bankruptcy of Greece and breakup of the euro dominated sentiment. This scenario is absurd, as ECB President Trichet has rightly observed, but the irrationality leads to a flight into the safe-haven of US dollar denominated assets. Not only the precious, but also the base metals suffer under the flight into the US dollar.

After the strong upward trend in the previous year, copper could trade this year in a wide sideways range. In this scenario, Copper is for buy-and-hold investors not interesting, but should offer still attractive trading opportunities for more flexible investors.

The tail wagging the dog and metal prices fall thereafter

The correction in precious metals prices might be approaching its end, because in the previous week panic has engulfed the financial markets and this is often a sign of a speedy turnaround. The trigger for this panic is the development of credit default swaps (CDS) with which investors can hedge against a possible insolvency of an issuer. The 5yr CDS rate for Greek government bonds climbed in the previous week, according to data from Markit to 425.18 bp, which is 20.84 bp higher than the level of the previous week and this, although, the EU imposed tight controlling measures on the budget of the Hellenic Republic, to reduce the deficit in relation to GDP and to push it back under the limit of 3% by 2012. Also the CDS rates on government bonds have increased significantly in Spain and Portugal, after Portugal at an auction, has not accepted the buyer demands and reduced the volume of emissions below the level intended originally.

Rising CDS rates on government bonds are supposed to be positive for precious metals as a safe haven, because they reflect that the financial markets priced in a higher probability of failure of a sovereign debtor. But things are not so simple, unfortunately. The yield spreads between government bonds of different countries in the euro zone and German Bunds as a benchmark are based on the development of CDS rates. If the CDS rates for Greece, Spain and Portugal desend, it also widens the corresponding yield spread over Bunds. This relationship is now providing for hedge funds and proprietary trading desks of investment banks, a very attractive playground. The market for CDS is in fact much narrower and less liquid than that for government bonds. Hedge funds can therefore already pushing CDS rates upwards with a low risk. At the same time they sell their bonds, so for example, from Greece, and buy in return German Bunds with approximately the same maturity. Rising CDS rates can therefore lead other investors to the assessment that the affected country really is heading for bankruptcy. These investors will be compelled either to sell their holdings in these bonds, or secure the holdings by buying CDS. They will, however, reinforce moves in the CDS induced by hedge funds, which in turn has an impact on the yield spread. The tail wags so successfully with the dog.



On the foreign exchange markets, the interest rate difference plays a major role. For the exchange rate of the euro against the U.S. Dollar, this is at the short end of the term curve, the difference between the 3M or 12M USD Libor and the Euribor. At the long end of the curve, the foreign exchange market has so far mostly focused on the yield spread between the 10yr U.S. Treasury and the 10yr German Bunds. With the outbreak of the crisis over the deficit in the Greek state budget late last year, this is pushed into the background and focus on the foreign exchange market is also directed to the CDS rates. Quite a few foreign exchange strategist and professor of Doom, Nouriel Roubini, predicted an end to the euro. With rising CDS rates for Greece, Spain and Portugal, the euro exchange rate against the U.S. dollar got more and more under pressure. Since the high of 1.514 at the beginning of December 2009, the euro has fallen by over 10% until 1.358 against the U.S. dollar.

Rising CDS rates for southern European countries in the euro area not only lead to an exodus of investors from the euro, but because of the stronger U.S. dollar also out of gold. But as pointed out above, a market panic indicates often that a movement is nearing an end. The technical picture of EUR/USD and gold indicates that the sell-off could be petering out. The recommendation might be, then, buyer beware, because unlike in the opera and theatre, there will not be a bell ringing for the entry.