A False Break-out of Gold

The break-out of gold above the resistance at 1,355$/oz turned out to be just a false break-out. Gold did not only fall back below this resistance level, but also finished the week below the close of two weeks ago. Normally, technical analysts expect a stronger move in the opposite direction after a false break-out. In the case of gold, this would imply further weakness. However, in the short run, gold might be torn between geo-political developments and negative medium-term economic fundamental factors.

The rise of gold above the resistance at around 1,355$/oz, corresponding to the high made in October last year, was driven mainly by geo-political developments. Financial and commodity markets feared that the referendum held at the Crimea peninsula about whether to become an independent republic or to join the Russian Federation would lead to increased political and military tensions. However, after votes were counted, financial markets already in Asian trading shrugged off the result of a vast majority for joining Russia. Many analysts predicted that this result would lead to further turmoil in financial markets, with gold being a beneficiary due to its safe haven status. However, traders acted according the old market adage to buy the rumor and to sell the fact. Also the statement of Russian president Putin, which he made on Tuesday, that the rest of the Ukraine should remain intact and that Russia would not be interested in other territory than the Crimea contributed to further selling of gold as well as other precious metals and recovery of stock markets.

But does this imply that the political tensions would subside? While one would hope that they ease indeed, unfortunately the risk remains that they might flare up again. The USA and the EU reacted with sanctions, which were partly retaliated by Russia. There are more and more demonstrations in the Eastern part of the Ukraine also demanding a referendum about joining Russia. Transnistria is another autonomous region in Moldova and along the border to Ukraine, which has a Russian majority of its population. NATO now fears that tensions in this region would lead to another military intervention by Russia. Also demands by some politicians to deploy more NATO troops in member states being neighbors of Russia would increase the tensions. Thus, it could not be ruled out that any escalation of geo-political tensions in the Black Sea region lead to a renewed flight into the safe haven of gold and other precious metals.

The second factor, which drove gold lower last week was the first press conference of the new Fed chair, Mrs. Yellen. The FOMC kept the Fed Funds target rate unchanged at 0.25% or less and also continued to reduce the volume of monthly bond purchases by a total of $10bn. This had been widely expected. However, the markets were surprised by a half-sentence of Mrs. Yellen during the press conference that the first hike of the Fed Funds target rate might occur about 6 months after the termination of the bond buying program, which is also known as QE3. Stock and bond markets sold off and the US dollar firmed against the major currencies, which then also send precious metals lower.

But this market reaction on a so-called “surprising statement” demonstrates again that the academic theory about efficient and rational financial markets is flawed. Even under Fed chairman Bernanke, the FOMC told for more than one year that the first rate hike is expected to take place in the middle of 2015. So far, the FOMC has reduced the volume of bond purchases by $5bn for the US Treasury paper and mortgage bonds respectively at each FOMC meeting starting in December. This decision became effective with the start of the month following the meeting. Thus, for the month of April, the volume of Treasury purchases has been reduced from $35bn to $30bn and of mortgage bond purchases to $25bn. If the FOMC keeps that pace of cutting the buying volume, which appears to be a plausible assumption given the current FOMC projections for US economic growth, inflation and unemployment development, then there would remain six more FOMC meetings until the purchases of US Treasury paper will be terminated. Given the calendar of FOMC meetings in 2014, this implies that the final cut of US Treasury buying will be made at the December FOMC meeting. And six months later will be well in the middle of 2015, which is exactly what the FOMC indicated for quite some time as the most likely time for the first rate hike.

Furthermore, starting to hike the Fed Funds target rate in the middle of next year does not imply that the FOMC would then embark on an aggressive restrictive monetary policy. The majority of the FOMC members still expect that the Fed Funds rate would be at 1.0% or lower by the end of 2015. Given the projection of the core PCE inflation, this would still imply that the real Fed Funds target rate is negative between -0.7 and -1.0%. However, this could hardly be called a tightening. As long as the nominal Fed Funds target rate remains below the core PCE inflation rate, the monetary policy of the Fed is accommodative. This should be supportive for stock markets. While the short-term interest rate could remain at the current level for some time, the forward rates would have to price in rate hikes in 2015 and beyond. The close the first rate hike gets, the more it will have an impact on money market rates and on yields of US Treasury notes. Thus, opportunity costs of holding gold are poised to rise and this will have eventually a negative impact on gold.

Therefore, the medium-term outlook for the major fundamental factors of the gold price indicates that gold is likely to weaken. However, gold has profited so far this year from an increased uncertainty about the development of stock markets and geo-political tensions. This uncertainty could even lead to a new rise of gold towards 1,400$/oz or even above. But once the uncertainty subsides and investors have again stronger convictions about the outlook for other asset returns, then flows out of the safe haven could send gold to new lows. 

Political and Economic Uncertainty Drives Gold to New 2014 High

Last week’s analysis that gold might have reached a peak at 1,355$/oz was premature. On Wednesday, March 12, spot gold broke through the resistance at this level and rallied further to 1,387$/oz.

One of the arguments for a peak was the divergence between gold and silver the week before. However, silver also rallied and pared the loss of the first week in March. But silver did not manage to rally stronger than gold, thus, it performed worse than gold. The PGMs even declined last week, which is a clear indication that it was not a broad flow of funds, which lifted gold above the resistance at 1,355$/oz.

The euro strengthened further against the US dollar, which was another factor for the positive performance of gold. Some members of the ECB council dampened further hopes for more monetary stimulus. This lifted the euro to almost 1.40 against the US dollar. The ECB expects growth to pick up, nevertheless, it revised its inflation forecast lower. However, the risk for GDP growth in the Eurozone is more biased to the downside than for positive growth surprises. Thus, also the risk for the ECB inflation forecast is higher for further falling inflation rates, which implies that the deflation risk would increase. The ECB might be at the brink of repeating the policy mistakes made by the Bank of Japan by waiting too long. Therefore, over the medium-term horizon, a further step to ease monetary policy remains still the most likely scenario.

In mid-January, the gold holdings of the SPDR Gold Trust ETF had reached a low 789.6 tons and recovered slowly towards the level at the end of last year. Since then, the gold holdings hovered around the 800 tons level. However, last week, gold holdings jumped by 1.4% to 816.6 tons. After having bottomed out at 22,691 contracts in early December last year, the net long position in gold futures held by large speculators rose to 118,890 contract on Tuesday, March 11, according to the recent CFTC report on the “Commitment of Traders”. This development clearly indicates that institutional investors increase again their exposure in gold. But what is the reason behind this move?

First, it is the geo-political development in the Ukraine and in particular at the Crimea peninsula. Since the start of this year, tensions in this region had an impact on stock markets. Initially, it was only on some days depending on the news flow. However, since the revolt on February 21/22 leading to the installation of a new administration, the situation escalated. Announcing sanctions by the US and the EU against Russia increased the nervousness among stock market investors. In each stock market report this week, the geo-political tensions between the West and Russia concerning the Ukraine were mentioned for the weakness of international stock markets.

The second factor, but probably more important, was the economic data released in China,  which revived fears that the Chinese GDP growth might fall below the 7.5% targeted by the government. It already started over the weekend, when the Chinese Custom Office released the data for the trade balance in February. Instead of an export surplus of $13.2bn as expected by economists, the trade balance swung to a deficit of $23.0bn as imports rose far stronger than exports. While the trade data is still reported on a monthly basis, China’s National Bureau of Statistics changed the procedure for industrial production figures. The output data for the first two month of the “Western” calendar year are reported together for February, which is due to the variable Chinese Lunar New Year holidays. For the first two months, industrial production increased by 8.6% over the same period in 2013, while the consensus predicted only a small decline of the annual rate of change from 9.7% in December to 9.5%. The weaker than expected economic data out of China weighed on stock markets as investors fear a slow-down of global economic activity.

Therefore, we come to the conclusion that it is the uncertainty about political and economic developments, which led to a new risk assessment of international stock markets. In 2013, institutional investors shifted funds out of precious metals into stock markets due to higher expected returns in equities, while the risk for a set-back in precious metals increased. Now, investors estimated that the risk for a correction in stock markets has risen and expected returns declined after the rally in many stock markets last year. Thus, gold is currently profiting as one of the safe havens in times of increases uncertainty.

But this fear among investors might not be justified. We have developed a set of macroeconomic indicators for various stock market indices, including the S&P 500 index, the Japanese Nikkei 225 index and various European countries. All these indicators still favor long positions in the corresponding stock markets based on the national economic data.

Gold and silver currently profit from uncertainty and a re-assessment of the risk-return relationships of international stock markets. Thus, gold cold rise to the 1,450$/oz mark, which we predicted as the high of gold in 2014 (see for example in the LBMA analyst forecast survey). However, for a push higher, the economic fundamentals would have to deteriorate and stock markets would have to correct further.   

Higher Probability for Gold at the Peak

For forecasting the development of financial and commodity markets, not only quantitative but also technical analysis could be a valuable tool. Two weeks ago, we saw an analysis with the forecast that gold would reach a cyclical high at around 1,355$/oz in early March. This analysis was based on a study of price cycles and Elliott-Waves. On Monday, March 3, gold reached a high of 1,354$/oz and did not trade above this price during the remainder of the week. Also our further analysis, which is not based on technical analysis, comes to the conclusion that gold might have reached a peak.

The first argument is the divergence between gold and silver. Usually, silver is the more volatile of the two precious metals, but trades in the same direction as gold. But if silver moves in the same direction as gold and then reverses the trend, then it is a good harbinger that also gold might reverse the trend with a higher likelihood. While gold still managed to close above the last price of the week before, silver ended the week with a loss of 1.4%.

If a market does not rally on good news, then it is often a reliable indication that the rally has run its course. In the case of gold, the news was the development in the Ukraine, especially at the Crimea peninsula. The decision by the Russian parliament to permit a military intervention at the Crimea as well as the call of a referendum about the future of the autonomous region by the local government triggered sanctions by the USA and the EU. Russia announced that it might also reply with retaliations. It seems that Cold War is back after almost 25 years after the fall of the Berlin Wall. In such a situation, one would expect gold to be bought as a safe haven. However, gold showed only a modest reaction on Monday as equity markets around the globe fell and funds moved into commodities.

The ECB kept interest rates unchanged and also did not provide more liquidity at the ECB council meeting, while some analysts and traders expected further monetary easing. At the same time, the ECB lowered its forecast for the inflation rate in the Eurozone. In addition, ECB president Draghi declined to provide any guidance about the outlook for possible rate cuts. The euro strengthened against the US dollar, but this had hardly an impact on gold. A good news, which failed to push gold to a new high. A reason that gold could not rally on a firmer euro might be the expectation that ECB might just keep the powder try but take further easing measures rather sooner than later. The surprisingly strong drop of Eurozone producer prices points to downward risk for consumer prices.

It is not only the current development of producer and consumer prices, which point to further easing. The ECB might have to react also on political developments, which are out of her control and influence. Of course, this political factor is the crisis in the Ukraine and Crimea peninsula. Further sanctions by the EU and Russian retaliations could have a negative impact on the Eurozone economy and especially could push the Southern Eurozone economies back into recession. Thus, it appears only as a question of time until the ECB eases monetary policy again.

In the US, the Fed Beige Book provides further confirmation that the FOMC is very likely to stick to the path of reducing the volume of bond purchases at the next meeting. The weaker than expected economic data is regarded as the result of adverse weather conditions. Without any doubt, the weather played a role. The seasonal adjustment procedure (Census X-11 or X-12) are pure time series (ARIMA) techniques, which do not take into account external factors. Thus, one would have to wait until weather conditions are again back to normal for assessing whether the weakness of Q1 economic data was only driven by the weather or also reflect a weaker economy. Unfortunately, this might only be seen by summer. However, the February purchasing manager indices point to a still growing US economy. Therefore, the FOMC might have almost completed tapering until they have a clear picture about the strength of the US economy. Thus the US dollar might not provide much support for gold bulls.

Beside the technical analysis based on gold’s cyclical price behavior, also fundamental considerations indicate that gold might have reached a peak. But the big risk factor is the political risk. An escalation of the situation in Ukraine and the Crimea peninsula could lead to a sudden flight to the safe haven. Thus, it might be a bit too early to sell or go short in gold. However, investors holding gold might be well advised to tighten their stops.

Is there a Decade of London PM Gold Fixing Manipulation?

Last Friday, on February 28, Bloomberg reported about a study co-authored by NY University Stern School of Business Professor Rosa Abrantes-Metz and Albert Metz, a managing director at the rating agency Moody’s Investors Service. In their not yet published draft research paper, the two authors claim that “The structure of the benchmark is certainly conducive to collusion and manipulation, and the empirical data are consistent with price artificiality” and that “It is likely that co-operation between participants may be occurring.” We come to the conclusion that their findings could be well explained and are not a valid proof for manipulation of the PM London gold fixing.

The authors of the study refer to unusual price activity around 3 p.m. in London when the afternoon fixing of the gold price is taking place. They have not observed these trading patterns during the morning fixing. Furthermore, large price moves during the afternoon fixing were overwhelmingly to the downside. Screening intraday data from 2001 to 2013 they found those patterns from 2004 until the end of the data sample. In a telephone interview, Mrs. Abrantes-Metz said “There’s no obvious explanation as to why the patterns began in 2004, why they were more prevalent in the afternoon fixing, and why price moves tended to be downwards”. Thus, the two authors concluded in their research paper that unexplained moves may indicate illegal behavior by the five banks of the gold fixing working actively together to manipulate the benchmark.

Mainstream academic theory is that financial markets, and gold could be included in this group, were efficient. Anomalies were only temporary and as soon as the market had discovered them, they were exploited and disappear. Nevertheless, many academic studies also found that anomalies in stock markets persist even many years after their discovery. One of those anomalies is the year-end effect that stocks, which already performed well during the year tend to rally further towards the year-end. The reason behind this move is that institutional investors who had been not invested or underinvested in those equities buy the stock for reasons of window dressing for showing in the reports that they had also held the top performers in their portfolios. This behavior is absolutely legal and is not regarded as market manipulation. This leads to our first objection against the conclusion of Abrantes-Metz and Metz. Detecting anomalies in price behavior might be an indication for illegal behavior but it is by no means evidence that prices had been manipulated.

Furthermore, that Professor Abrantes-Metz could not explain the unusual price patterns is more an indication for a lack of familiarity with the gold market than an indication for price manipulation.

In a comment, Ross Norman, the CEO of Sharps Pixley, provided already a good explanation why the unusual price behavior had been detected only for the pm fixing but not for the one in the morning. The afternoon fixing covers trading in both financial centers, London and New York and thus provides commercial participants in the gold market a higher liquidity and thus, the chance to get a better price. In addition, many producers are located in North America and the afternoon fixing is more convenient for their time zone. While gold at the Comex division of the CME trades electronically also during the London morning hours, the liquidity is higher at the futures exchange during the afternoon fixing. This is another reason for commercial participants to prefer buying or selling of gold at the p.m. fixing.

However, one might argue that with higher liquidity the occurrence of price spikes should be reduced and not increased. What might sound compelling at first quickly turns out as a flawed argument by closer inspection for several reasons:

First, if a larger order has to be executed the price impact would be greater in a less liquid market situation. Thus, a buyer or seller still obtains the better price if it is executed in the afternoon fixing despite moving the price considerably from the level prevailing shortly before 3 p.m. in London.

Second, the development of the price of gold could be explained by prices of some financial instruments and other commodities. In our quantitative fair value model, the weekly or monthly price development of gold is well explained by the S&P 500 index, the US dollar index and crude oil. Also GARCH-X models show that these factors have an impact on the daily return and volatility of gold. Thus, we are not surprised that intraday spikes in the gold price occur during the afternoon gold fixing.

When the afternoon fixing starts in London, then it is 10 a.m. in New York (except for a couple of days as shifts to daylight saving time and back take place at different dates in spring and fall). Some of the market moving US economic data is released at this time. If this economic data deviates from the consensus forecast then the stock and forex market react strongly. Sometimes also data releases confirming the consensus can trigger stronger price moves in the stock and/or forex market. Thus, it should not be surprising that also participants at the gold fixing react on those moves if a new price is called at the fixing and bids and offers could be adjusted.

Also the behavior of institutional investors in the US stock market could provide an explanation for the price spikes at the London afternoon fixing. Trading at the NYSE starts at 9:30 a.m. in New York. However, some studies have found out that institutional investors just enter the stock market at around 10 a.m. – exactly at around the time the fixing in London starts. Often the US stock market reverses direction around this time. Furthermore, a popular strategy among intraday traders is to trade breakouts of the trading range during the first 30 minutes. Price reversals and increased volatility of the US stock market then could also have an impact on the price of gold during the fixing period.

Abrantes-Metz and Metz also point out that the spikes are more to the downside than to the upside. As Bloomberg wrote “on days when the authors identified large price moves during the fix, they were downwards at least two-thirds of the time in six different years between 2004 and 2013. In 2010, large moves during the fix were negative 92 percent of the time”. But also this is not really surprising if one just considers who participates in the London fixing on the commercial side. During the period under investigation, many central banks had been sellers of gold. For this group, the fixing is one mean to sell larger quantities and to obtain an “official price” for the audits. But also mining companies sell their production in larger quantities at the fixing as hedging and financing operations are often tied to the fixing price. The typical buyers like jewelries or ETFs are less reliant on an objective price set during the fixing and could also be active in unreported spot market transactions.

Another argument often used in articles and blog contributions is the movement of the gold price during the period of the fixing. But again, this is not an indication of price manipulation but reflects more a lack of understanding. In a few articles, we even found statements that the LBMA would be an exchange. However, this is not true. The London Bullion Market Association is just an industry association and not an exchange. It is also not responsible for the gold and silver fixing.

This misunderstanding might result that some exchanges hold auctions at certain times and call the price of this auction the fixing price. However, the London gold fixing is not an auction. At an auction, the participants submit the quantities, which they buy or sell at a certain price. These bids and offers have to be submitted at a certain time and then the price is determined that leads to the highest quantities traded. Usually all orders are settled at the same price. This procedure is for example applied at the Xetra trading platform of Deutsche Boerse. There, prices of the closing auction deviate often considerably from the last price of the official trading session and in some cases are even outside of the trading range of the day. Nevertheless, the German watchdog BaFin, who critized fiercely the London gold fixing, has not yet the slightest suspicion or even started any investigations that this practice might be a manipulation.

The London gold fixing is a process of price finding. The chairman is calling a price close to the actual spot quotations when the fixing starts. Then the five member banks submit the quantities they would buy and sell based on the orders of their clients or for their own accounts. For fixing the price of gold, the difference between supply and demand has to be less than 50 bars – around 620kg. This is usually not immediately the case. In the case of excess demand a higher price is called and a lower price is called if supply exceeds demand. The five banks involved in the fixing then contact their clients with the new price called and collect again bids and offers, which are then submitted to the chairman. This process of adjustment to find the fixing price takes some time. Usually, the gold price is fixed within 10 minutes, but could also last up to one hour depending on the market situation. This procedure had also been applied by official exchanges. For example, the Frankfurt Stock Exchange used this procedure for the official fixing of the Deutsch Mark exchange rates until the introduction of the euro.

However, markets are not standing still during this process. Especially, trading in the gold future continuous and prices are disseminated within milliseconds. But this information is also available to the clients of the five banks conducting the fixing. Also banks active in spot gold trading display indicative bid and ask prices. Thus, when a new price is called, the clients of the banks are also well informed about the current market situation and can adjust the quantities they want to buy or sell at the new price called accordingly. Usually, the banks don’t know the exact quantities their clients want to buy or sell in total when a new price is called.

If one defines market manipulation as an attempt to move the price to a certain level, the five banks would have to agree on this price before the fixing starts. For pushing prices artificially lower, this would also require that they were willing to sell an unknown quantity of gold, which would expose them to significant price risk. At best, they might know the total quantity supplied and demand at the first price called. That gold is not fixed at the first call and that prices move and more calls of a new price are made is not an indication of price manipulation. Just the opposite, it is an indication of no wrong doing by the fixing group!

All in all, we come to the conclusion that the findings of Professor Abrantes-Metz and Metz could be well explained and are not a valid proof of manipulations at the PM London gold fixing. Normally, a flawed academic research paper is not a problem. However, Professor Abrantes-Metz advises the European Union on financial benchmarks. But if such a flawed research paper leads to accusations against the five Banks of the London gold fixing and the EU imposing considerable fines, then it is a scandal.  

Base metals gain despite weaker PMIs

All base metals closed the week higher than on the Friday before. Nevertheless, the market came under stronger pressure on Thursday after the release of various PMIs, with especially the HSBC manufacturing PMI for China weighing on the market.

The flash estimate of the HSBC PMI for China declined further from 49.5 in January to 48.3, while the consensus of economists predicted only a marginal decrease to 49.4. Thus, not only the market for base metals but also stock markets came under pressure. However, one should keep in mind that there is also an official manufacturing PMI for China. The HSBC index is a survey under medium-sized, privately owned companies whereas the official survey comprises for large companies, which are mostly owned by the state. This official manufacturing PMI will be released on Saturday, March 1. In January, the official manufacturing PMI was at 50.5, and thus, unlike the HSBC index pointed to a still expanding manufacturing sector. For the February index, the consensus is looking for a slight decline to 50.3. While the official index is expected to point still to an increase in economic activity, the HSBC index shows an accelerating contraction of the manufacturing sector. But only one manufacturing PMI could get it right. As the companies surveyed in the official PMI have a greater contribution to GDP than those in the HSBC index, we would put more emphasis on the official PMI. Nevertheless, the financial and commodity markets rely more on the HSBC index.

Also in the Eurozone, the flash estimates of the manufacturing PMIs disappointed expectations among economists. The flash estimate of the German manufacturing PMI showed a surprising decline from 56.5 to 54.7, which is still indicating an expansion of the manufacturing sector, albeit at a slower pace. More worrisome is the further fall of the French manufacturing PMI from 49.3 to 48.5 while the consensus expected a slight increase. For France, also the service-sector PMI posted a surprisingly strong drop. Thus, fears about the French GDP growth re-surfaced after France grew in the final quarter of 2013. For the Eurozone, the flash estimate showed a decline of the manufacturing PMI from 54.0 to 53.0, which would still point to a further recovery of the manufacturing sector in the Eurozone, but with regional divergences. As the automotive sector reported increasing new car sales even in those countries being hit especially hard after the financial crisis, this development indicates that the demand for base metals should increase in the Eurozone.

In the US, the ISM manufacturing PMI will be released only at the first working day of the following month. Nevertheless, there are several surveys conducted by the regional Federal Reserve Banks, which usually provide a good indication for the nationwide PMI. The Empire State manufacturing index, published by the NY Fed, fell in February to 4.5 down from 12.5 in January. The Philly Fed manufacturing index plunged from 9.4 in January to -6.3 in February. Both indices point to another fall of the nationwide ISM index. A relatively new index is the Markit manufacturing PMI. Data is only available from May 2012 onwards. This index moved against the direction of the other indices and rose by 3 points to 56.7 in February. However, financial and commodity markets focus solely on this index, which triggered a rebound of stock indices and metal prices.

But one should be careful with the Markit manufacturing PMI for the US. This is just the result of a flash estimate. Thus, this estimate might be biased by responses from companies located in regions, which were less impacted by the severe winter season in the US. During the short history of the Markit PMI, it showed partly considerable revisions. Thus, the Markit flash estimate is not necessarily a reliable indication that also the nationwide ISM manufacturing PMI will increase in February. A disappointing index reading might turn out to be negative for stocks and base metal prices. However, a negative reaction at the US stock market might be positive for precious metals. 

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.