Gold reached new record highs, but what’s after a compromise to lift the US debt ceiling?

Last week we wrote, there were indications that gold might consolidate. However, this was not the case. Gold already rose to a new record high on Monday. The reason was that both parties in the US congress failed to reach a compromise over the weekend. There was not only a disagreement between the parties but also within the Republican Party. Members of the Tea Party wing in the House did not support the bill of House majority leader Boehner. A vote in the House had to be postponed to Friday, which strained nerves of already jittery investors further. After the House passed the bill, it was immediately rejected in the Senate with the majority of the Democratic Party. Gold reached a new record high on Friday at 1,631$/oz but closed below the high of the day.

At the time of writing this blog article, ABC has reported that both have reached a last minute compromise. The fundamental opposition of the Tea Party supporters has indeed elevated the risk that no compromise might be found to lift the debt ceiling right in time. However, on the other hand, financial and commodity markets also appear not to understand the rules of political bargaining. If a subject is treated rather emotional and less rational, like the public debt, then agreeing on a compromise too early could backfire. Political leaders could be criticized by there own supporters as being too soft to the other side. And given the deep rift within the Republican Party, Mr. Boehner, could not accept a compromise before the last minute.

According to the unconfirmed ABC report, the debt ceiling would be lifted beyond the presidential election in 2012 and more than 1 trillion US dollar budget cuts should be implemented over the next 10 years. Lifting the debt ceiling beyond the 2012 presidential election as demanded by president Obahma should be a time span long enough to calm financial markets. The stock market might rebound after suffering last week on fears of a possible default of the US Treasury. If economic data released during the coming week is not preventing a recovery of the stock markets, then money might flow back into risky assets. However, this time gold is probably not profiting from flows into risky assets. Investors might take profit on some of the gold bought since the start of July.

However, gold had not only been bought as a safe haven because investors feared a possible default of the US Treasury. A main reason was also the debt crisis in the eurozone and the threat of a contagion to Italy. After the EU leaders agreed on a rescue package at the summit on July 21, it lasted less than one week that the crisis is back on the radar screens of investors and traders. If there would be a reward for stupid comments and demands, German politicians would lead the nomination lists. First, Germany’s demands pushed up the yields on bonds of the peripheral countries. After finding a compromise that also the European Financial Stability Facility should be allowed to buy Greek debt in the secondary market, which is essentially a participation of private investors to fund the rescheduling of Greek debt, German finance minister Schaeuble wrote in a letter that the EFSF should be allowed to buy bonds only if the ECB approves the purchases in the case of financial turmoil. This comment pushed yields of Spanish and Italian bonds higher. Thus, a debt auction of Italy the same day disappointed the markets and the yield on 10yr Italian BTPs rose over the 6% level. The rise of yields on peripheral government bonds was another factor that gold reached another high last Wednesday.

As Germany’s government is sabotaging a solution of the eurozone debt crisis, the downside risk for gold appears to be limited.

Economic data released in the US last Friday disappointed. The US GDP growth in the second quarter was only 1.3% annualized while the consensus was looking for a growth rate of 1.8%. However, even worse was the downward revision of GDP growth in Q1 from 1.9% to a mere 0.4% annualized. The US Treasury market rallied and the yield on 10yr US T-Notes fell to 2.80%. The bond market speculates that the Fed might embark on QE3. However, the GDP deflator rose stronger than expected at 2.3% and the rise for the previous quarter was revised up from 1.9 to 2.5%. Also the PCE deflator increased. Data for the core PCE, the Fed’s favored inflation gauge, had not been released last Friday. However, it looks that QE2 was successful in pushing the core inflation rate towards the target. Thus, another round of buying US Treasury paper by the Fed might not be at the agenda of the FOMC. Therefore, another push for gold by QE3 appears less likely at present 

Gold can not hold above 1,600$/oz, consolidation likely

At the beginning of last week, gold had surpassed the psychological resistance at 1,600%/oz and reached a new record high at 1,606$/oz on July 18. However, gold could not defend the gains and ended the week at 1,598$/oz, only a slight gain compared to the close of the preceding week. Fundamental as well as technical factors suggest that gold might be in for a consolidation. It could not be ruled out that gold retraces one third to one half of the gains made since the start of July.

The US is still facing the risk that the US Treasury might default on its outstanding debt. The tea party fundamentalists are not moving even one inch and insist on their demands. However, reaching a compromise requires that both sides make some concessions. As part of the Republican Party is opposing a compromise, a failure to increase the debt ceiling before August 2 is a rather likely scenario. While many bond market investors are still optimistic that a default of the US Treasury would be avoided by an 11^th hour compromise, the probability for such a scenario is not negligible. The rating agencies already announced that in this case, they would immediately rate US Treasury paper down to default status. This is providing gold some support and argues more for a consolidation then for a stronger correction.

In Europe, the situation has eased considerably over the week. Finally, stubborn German chancellor Merkel recognized that her demands were not acceptable. France president Sarkozy convinced her to give up resistance, which paved the way for a compromise at the EU summit. The agreement on a second bail-out package for Greece might not be the first best solution. However, it removes some uncertainty from the market, especially the risk Greece might not have sufficient funds to meet its obligations is September has diminished considerably. Thus, the euro strengthened against the US dollar. We pointed out already earlier that the debt crisis in the eurozone has two opposing effects on gold and other precious metals. On the one hand, the demand for gold as a safe haven increased. At the same time the weaker euro had a negative impact on gold. In the first half of this month, the safe haven aspect dominated. Now we might see the opposite move that the firmer euro provides some support for gold but that profit taking by investors seeking the safe haven might push gold lower again.

The large speculators have increased their exposure in gold further. According the latest CFTC report on the “Commitment of Traders”, the non-commercial increased their net long positions in gold futures in the week ending July 18 by 21,700 to 219,297 contracts, the highest level since mid-December 2010. The deadline for this report was the day gold hit its new all-time high. As gold consolidated afterwards, the large speculators might not have increased their net-long position further. Thus, it would not come as a surprise if the next report shows a small decline of the net-long position held by the hedge funds and CTAs.

The technical situation is not yet bearish for gold, but the indications for a consolidation or correction are increasing. Gold rose along the upper Bollinger band line until it reached the new record high last week. However, gold did not close above the upper band line. A close back inside the band would have been a sell signal. Nevertheless, gold did not rise further along the upper band line, which indicates that gold bulls are exhausted and need a breather. Furthermore, the MACD is increasing now at a slower pace than its signal line. Therefore, the difference between these two lines gets smaller and might turn negative, which would be a signal that the upward trend is likely to reverse. Also the stochastic indicator has crossed in the overbought zone. As the faster line is falling, it is likely that this line might return back into the neutral zone. This event would trigger a sell signal for gold.

Thus, while there is no sell signal triggered yet, the fundamental and technical perspectives spell some danger for gold bulls. It might be too early to reverse positions and to go outright short. However, taking some profits in gold might be worth a consideration.  

Gold at a new record high

A two week rally pushed gold to a new record high. Last week, gold gained another 50$/oz to close the week at 1593$/oz. Silver performed even better by gaining almost 10% on the week, but despite coming close to the 40$/oz level, silver clearly remained far below the record high. During the first half of last week, both precious metals advanced strongly while the US dollar firmed against the major 5 currencies at the same time. However, during the second half of the week, the US dollar pared its gains, which was another positive factor for gold and silver. However, we still recommend to keep an eye on the US dollar as its influence on the price development of precious metals could strengthen again.

One of the major factors pushing gold and silver higher is the ongoing debt crisis in the eurozone. At the start of last week, European bond markets panicked. Italian government bonds got under massive selling pressure after the Italian PM Berlusconi made a comment about the saving package of his finance minister Tremonti, which the market understood that the finance minister would be at risk of being sacked. However, the Italian parliament passed the Tremonti austerity measures to balance the budget by 2014 in record time of only one week last Friday. Also an auction of Italian government bonds went well, which calmed the strained nerves of investors. Nevertheless, the market is still jittery. A debt crisis in Italy would certainly be beyond the means of the EMSF.

However, for the time being, the debt crisis in Europe is probably to stay a supporting factor for gold. The market is still waiting for an agreement of European finance ministers on a second bail-out of Greece. The major obstacle is again the German government. The Merkel cabinet is opposing smart solutions, which would not trigger a downgrade of Greek government bonds by the rating agencies, but insists on the demand that private investors should bear a major share of a restructuring of Greek debt. As long as the ideology of the German chancellor prevents a pragmatic solution, precious metals have further upside potential.

The market also waited for the results of the stress test of 91 major Banks in Europe. There were many reports about leaks from officials about the results of these tests as well as some unfounded rumors, which also gave the precious metals a push higher. However, the actual number of only 8 banks needing to increase their capital to satisfy the required capital ratios was far less than the whisper numbers indicated (up to 20). As the results of the stress tests were released after the markets were already closed in Europe, it might have an impact on the precious metals with the start of trading at the new week. Last year, the marked was relieved about the results of the stress tests. This might be the case again this year. However, it might easily be overshadowed by the pending solution of a second bail-out of Greece.

A second factor supporting the precious metals last week had been the semi-annual testimony of Fed chairman Bernanke at the Congress. Obviously, some investors and traders have difficulties to understand a sentence in the conditional form. A statement, the Fed could act with QE3 or other measures of expansionary monetary policy if needed, does not imply that the condition for embarking on QE3 is given. The written statement of Mr. Bernanke as well as the recent FOMC statement and the minutes made it quite clear that the majority of the FOMC does not regard a further monetary stimulus being necessary to prevent the US economy slipping into a double dip recession. Nevertheless, the market interpreted Bernanke’s testimony as a preparation for implementing the next round of quantitative easing. This has pushed gold to the new record high. However, the crucial question is now, can gold and silver defend the gains even without the support of a further monetary stimulus in the US?

After large speculators reduced their net long position in gold futures during the preceding two weeks from 203,227 to 157,775 contracts, they strongly increased the net long position by almost 40K contracts in the week ending July 12 to 197,597 contracts. Also in the silver market, large speculators increased their net long position since the start of July. At 20,503 contracts it is at the highest level since the May crash in commodities.

After a two week rally, gold is overbought. Thus, a correction can not be ruled out. However, the fundamentals are still positive. Furthermore, while still some weeks away, the best season for precious metals is approaching. Thus, we would use a correction in precious metals to increase positions as long as the debt crisis in Europe is not calming down.

The US dollar is not the only driver of gold prices

Last week, the US dollar firmed against the euro and other major currencies but nevertheless, gold rallied. While the US dollar is a major factor for the development of the gold price, it is not the only one. In our quantitative fair value models for gold, also the price of crude oil, the S&P 500 index as well as the yield on 10yr US Treasuries play a crucial role in explaining the price development of gold. Furthermore, there are factors, which play a role for a certain period of time, but which could not be included in a quantitative model. One such factor is the current debt crisis in the eurozone.

On Tuesday, when markets were already closed in Europe, Moody’s announced that it downgraded Portugal government debt to junk status because the rating agency does not believe the new government would be able to implement the austerity measure and would be able to borrow in capital markets again in two years time. Thus judgment is not well founded because the new government is just a few days in office and this is too short to make a sound assessment. Also the new government in Portugal has a broad majority in the parliament to push through necessary reforms. Furthermore, Moody’s forecast could become a self-fulfilling prophecy. Again a rating agency poured oil in the fire. Nevertheless, financial markets reacted on the downgrade by selling the Portuguese government bonds, driving CDS higher and selling the euro. Gold was sought as a safe haven.

Rumors about European banks failing to pass the stress test were spread around. However, on Friday a report about an EU draft that governments should recapitalize banks pushed spreads over German government bond benchmarks higher and set the euro under further pressure. This increased the attractiveness of gold even more.

The ECB increased the refinancing rate at its policy setting council meeting as expected. At the press conference, ECB president Trichet indicated that another rate hike later this year is likely by using the key words “monitoring very closely” the development of the inflation rate. However, this supported the euro only briefly.

Supportive for gold had been that crude oil prices and the S&P 500 Index ended the week higher, despite the losses both suffered on Friday. Thus, both factors were on balance supportive for gold and compensated the negative impact of a firmer US dollar.

Gold got a stronger push to the upside last Friday after the release of the US labor market data. The ADP estimate of private sector payrolls released the day before surprised to the upside. Thus, the market revised its expectations for the non-farm payroll figure even higher. However, with only 18 thousand new jobs created, the non-farm pay roll figure came in even below the downward revision for May. Also the unemployment rate edged higher again to 9.2%. The 10yr US T-Note future rallied by more than a full point from the previous close and more than 1.5 points from the low of the day. Gold also jumped higher after the release of the US labor market data. This indicates clearly, that the markets expect not only that the Fed will keep interest rates at the low level for an extended period of time, but also speculates the Fed would embark on QE3.

However, there are a few points to keep in mind when drawing conclusions about the labor market report and the further Fed policy. First, one reason for the weak non-farm payroll figure was the government sector. US states have to reduce staff to keep the budget balanced. The state of Minnesota is practically bankrupt despite still being rated AAA by the agencies. The Federal government faces the deadline for an increase of the debt ceiling approaching quickly without a compromise being in sight. Thus, it should not come as a surprise that the public sector is reducing its workforce. The US economy has worked through the impact of the catastrophe, which hit Japan in March. This is reflected in the slow increase of new jobs in the private sector. The summer vacation season is period, where companies are a bit hesitant to hire new staff. This might also have played a role for the June labor market data. Seasonal adjustments can even aggravate the problem if there are slight deviations from the seasonal pattern.  In addition, the labor market is not a leading indicator of economic activity but a lagging one. The leading economic figures all indicated lately, that the US economy is recovering from the negative impact of the catastrophe hitting Japan. Thus, it is far more likely that the Fed is just waiting to get a clearer picture of the state of the US economy. Talk about QE3 might prevail for some time. However, the recent labor market report is not a reliable indication that the Fed would resume buying Treasury paper. Thus, the rally of gold might continue in the short-run, but if the US economy continues recovering, it might not be on a sound foundation.  

Improved outlook for base metals in H2

Two factors are probably the catalyst for a strong recovery of base metals last week. And both factors are repeating the history. Like in the summer of 2010, base metals suffered also this year under the debt crisis in Greece and the impact on the euro as well as on talk of a double-dip recession in the US. Developments last week indicate an improvement in both countries. For the base metals, it might set the stage for a trend of higher prices in the second half of this year.

After the Greek PM Papandreou survived a confidence vote in the parliament already the week before, investors were still cautious. Rumors were spread around that the austerity package would not find a majority in the Greek parliament. However, even before the final vote on the austerity package took place, sentiment improved. Strikes and unrests at the Syntagma Place in front of the parliament building could not prevent that lawmakers approved the austerity package. The eurozone finance ministers also agreed in a telephone conference on Saturday to transfer the next installment to the Greek government. Thus, a default is avoided, at least for the time being. The euro rallied above 1.45 versus the US dollar after trading down to 1.41 at the start of last week. The firmer euro and preventing a collapse of Greece, which could send even stronger shock-waves through financial markets than the bankruptcy of Lehman Brothers in 2008, also send base metals prices higher.

The second factor contributing to the strong recovery of base metals was US economic data. We have pointed out in the past, that readings of the purchasing manager indices for the manufacturing sector above 60 are not sustainable for a longer period and that indices retrace back to the mid-50 level. We also stated before that expectations of economists in the City or on Wall Street are not rational in the sense of academic theory but are adaptive. The consensus remains sticky if economic data comes in below consensus for some time but then adjusts after about 3 months and then tends to underestimate the economic figures. This has been also the case this year. However, the economic impact of the earthquake, which caused a tsunami and the nuclear catastrophe in Japan, made forecasting of short-term economic data more difficult then it is already in normal times. This uncertainty had also been expressed by the Fed in the recent FOMC statement and by Fed chairman Bernanke during the press conference.

While the media criticized the Fed for this more cautious stance, the economic data released during the past week indicates that the Fed is still smarter than many journalists and academic scribblers’ comments in news-papers. At the beginning of the week, the Richmond Fed index rebounded from -6 to +3. The pending home sales also posted a far stronger gain than the consensus had expected. However, more important had been the ISM purchasing index for the manufacturing sector in Chicago and the nationwide index. The Chicago PMI rose again above the 60-level and come in at a surprisingly strong reading of 61.1. The consensus expected for the nationwide ISM manufacturing PMI a further decline to 51.9 but the index rose contrary to the forecasts to 55.3. This level is still compatible with strong economic growth. The talk about a possible double dip recession appears to be exaggerated. Also Prof. Doom, Nouriel Roubini, does not always get it right.

Furthermore, the HSBC PMI for China remained unchanged at 50.1. This index has the tendency to be somewhat lower than the official PMI for China. Thus, the central bank was successful in reducing the speed of economic expansion but managed to avoid a too sharp slowdown.

From our point of view, the lower than initially expected US GDP growth was influenced to a large extend in the first quarter by the adverse weather conditions. In the second quarter, the impact of the earthquake in Japan in March played a crucial role by interrupting supply chains. However, both factors have not derailed the US economy as the recent PMI data indicates. Beside the monetary policy of the PBoC, the Chinese economic expansion was also influenced by the events in Japan. It seems that these negative impacts are now digested. We expect a stronger GDP growth in H2 in the two major commodity consuming countries. This should also have a supporting impact on base metal prices. Consumers might be well advised to hedge their exposure.   

“In Gold We Trust”

This is the headline at the title page of a German business weekly this weekend. It is an old market adage that it is time to exit a market if magazines report about this market on its title page. Given the price development of gold over the last two trading days of the previous week, the old wisdom seems to get it right again.

However, it is certainly not the reason gold dropped by 3.7% from the high reached on Wednesday to the close on Friday that a German business magazine devoted the title page to gold. The two factors causing this decline had been the FOMC meeting and the second press conference by Fed chairman Bernanke as well as the debt crisis in Greece and how the eurozone handles it.

Greece’s PM Papandreou reshuffled his cabinet the week before and faced a confidence vote in parliament last week. He survived this confidence vote. This week, the Greek parliament will vote on his austerity package. If markets were forming expectations rationally, as academic theory postulates, then markets should price in that with expressing the confidence to PM Papandreou, the majority of the lawmakers would also vote for his austerity package. However, financial markets still fear that the austerity measures demanded by the EU to support Greece would fail to pass the approval of parliament in Athens. As a result, the credit default swaps for Greek government bonds are still surging and the spread over benchmark German bonds and notes are rising. However, also the yield on German government bonds are falling due to safe haven flows into Bunds. The yield of 10yr Bunds dropped to 2.83% and is only 13bp above the eurozone inflation rate. Institutional asset managers taking their fiduciary duties seriously should not invest in bonds yielding less than the inflation rate. Nevertheless, they buy German government bonds along the curve and thus, harm their clients by holding bonds with a negative real yield.

Therefore, the Greek debt crisis has a negative impact on the euro directly and indirectly. The direct impact is the flight of capital out of the eurozone based on the fear of a Greek default. The indirect negative impact is via the yield and interest rate spreads, despite the ECB is going to hike the refi rate at the rate setting council meeting in July.

However, also the FOMC meeting had a negative impact on gold. The Fed revised its forecast for GDP growth down to 2.7 – 2.9% compared with 3.1 – 3.3% in April. The unemployment rate is now expected slightly higher at 8.6 – 8.9%. But unlike some market commentators and bank economists predicted, the FOMC decided to terminate QE2 as scheduled by the end of this month. In addition, as Fed chairman Bernanke pointed out, the Fed does not consider the implementation of QE3. However, it will reinvest proceeds from interest payments as well as maturing notes. Thus, the Fed will remain its current stance, but will not become more expansionary. As the market priced in further easing measures to support the economy, the US dollar recovered and this is a negative factor for gold.

We were never convinced by the argument that QE2 would be inflationary. The rise of headline CPI is the result of the supply shocks in the agricultural and crude oil markets. Both shocks are not the result of the Fed monetary policy. Nevertheless, those investors believing that QE would be inflationary had to revise their expectations about inflation after the Fed announce that they are not considering QE3, which is also a negative factor for gold and other precious metals.

All in all, we still expect the precious metal markets to consolidate over the summer month. The low reached in early May at 1,463$/oz should be a stronger support level.  

Gold torn between euro weakness and the Greek debt crisis

The ECB prepared the markets for a rate hike in July at its monthly press conference and the euro lost about six cents versus the US dollar to 1.41 within a few days. If the sell-off were triggered by profit taking according to the old market adage to buy the rumors and to sell the facts, the impact of the stronger US dollar on Gold should have been negative. One would have expected that gold would give back a bigger part of the gains made before. However, this was not the case. The weakness of the euro against the US dollar was not triggered by profit taking, but by renewed fears of a Greek default on its national debt.

Partly, the drop of the euro could be blamed on the continuing protests in Greece against the austerity policy. The Greek government is trying to push the sixth saving package through parliament. However, the Greek government is in an uphill struggle like Sisyphus. The more they try to save, the more the GDP contracts and the debt to GDP ratio increases, which leads to further downgrades by the rating agencies. The agencies are part of the problem as they pour gasoline in the fire and prevent the fire-brigades from EU, ECB and IMF to extinguish the fire.

However, also the German government is more part of the problem then the solution. German academics have demanded to let Greece default and restructure its debt. The finance minister resisted this siren calls and rightly pointed out that it could lead to collapse of the financial system like the bankruptcy of Lehman Brothers. But suddenly, he changed his course and demanded that the private sector would have to make voluntarily a considerable contribution to a second bail-out package for Greece as it is rather unlikely that Greece would be able to obtain funding in the capital markets next year given the high interest rates in secondary markets and poor ratings by the agencies, which keep the outlook still on negative.

The ECB fears that the demand from Germany could trigger the credit event clause as the rating agencies already threatened. In this case, all Greek debt outstanding could be demanded to be redeemed immediately. In addition, the ECB would no longer be able to accept Greek government debt as collateral in the repo operations. This could trigger the default of banks in Greece. Fortunately, Germany has softened its stance after a meeting between German chancellor Merkel and French president Sarkozy in Berlin last Friday. This gave the euro a push higher and gold also profited from this move.

Also the politicians in Greece play a crucial role. The troika of IMF, EU and ECB demanded that also the opposition would back the agreement between Greece and the troika. However, the opposition party, which was responsible for the ballooning budget deficit between 2004 and 2009, is not willing to cooperate. They demand tax cuts, a measure the troika will not accept. Furthermore, the conservative opposition creates the illusion among the population that the austerity policy would not be necessary to avoid a default on the national debt and a collapse of the financial system. Thus, the support for the policy of the PM is decreasing. After a government reshuffle, the PM faces a confidence vote after this blog is published.

In the case that the PM of Greece will survive the confidence vote, the flight to the save haven of gold might ease somewhat. But in this case, the euro should strengthen versus the US dollar, which would be a positive factor for gold, especially as the diverging monetary policy in the eurozone and the US point to further dollar weakness. In the case that the development concerning Greece get worse, the euro might come under renewed pressure, but the impact on gold might be compensated by safe haven buying. In the short run, it looks like gold remains torn between these two opposing forces.