Quantitative Commodity Research

US Bonds – helpful for precious metals short-term but medium-term risk

2014-07-13T15:15:00.000+01:00

The major fundamental factors in our fair value models for the weekly metal prices were mixed this week. The major role played the outlook for US interest rates and stock markets for the precious metals.

Base metals were mixed but digested well the Chinese trade data, which showed a slower than expected increased of Chinese exports of 7.2% yoy compared with a 10% rise predicted by the consensus. Thus, the export surplus came in lower than expected at $31.6bn. Analysts reported that the import of metal was already affected by the probe of Qindao warehouses as banks are now more cautious with providing letters of credit to metal importers.

As far as US interest rates are concerned, two reports had an impact on markets. The first was a forecast revision by the chief US economist at Goldman Sachs. It took Mr. Hatzius a long time to wake up and to understand the messages, which the FOMC sent out with the quarterly short-term projections and dot charts. The message of the Fed was for quite some time that the first rate hike will take place most likely in mid-2015. But Goldman Sachs predicted against all odds that the first hike would not occur before Q1 2016. Now, also Goldman Sachs forecasts the first increase of the Fed Funds target rate for 2015. As the Fed prepared the markets for quite some time, this forecast revision should not have had any impact on markets. However, traders and analysts argued that the US stock market traded lower after the longer weekend due to the Goldman Sachs forecast revision. Another hint that the Chicago school theory financial markets are not information efficient is not worth a cent, neither an economics noble laureate.

The second report had been the minutes of the recent FOMC meeting, which were released on Wednesday. The interesting news of the minutes is that the majority intends to terminate the bond purchasing program with the October FOMC meeting. This implies that the purchases of US Treasury paper will be reduced not at the current speed of $5bn in October but by $10bn. However, ending QE3 by the end of October 2014 has also implications for the timing of the first rate hike by the Fed. Chair Mrs. Yellen stated several times that the first hike might take place about 6 month after terminating the bond purchase program. Therefore, the FOMC might decide already at the April 28 -29, 2015 FOMC meeting instead at the on at the end of June next year to increase the Fed Funds rate.

If the FOMC decides in April 2015 to hike the Fed Funds rate, then there are five more meetings scheduled were the committee could lift the key interest rate to a more normal level. Thus, also the level for the Fed Funds indicated by the dot charts of 1.25% by the end of 2015 gets more likely. However, the Fed Funds futures only price in a rate of 0.75%. From our point of view, fixed income markets are currently too optimistic for the outlook of Fed Funds by the end of next year. But adjusting expectations for the short-end will usually also have an impact on the long end of the US Treasury curve. Thus, 10yr US Treasury notes appear to be expensive at the current yield of 2.52%.

It might still take some time until the fixed income markets realize that the implied rate for the Fed Funds by the futures traded at the CME are too low compared with the signals send out by the Fed. However, once the market starts to correct its expectations, the potential impact on metal prices will be negative. On the one hand, rising US interest rates and yields increase the opportunity costs of holding metals. On the other hand, this development could reduce the attractiveness of commodity financing trades in China and thus, reduce the Chinese demand for metals used in commodity financing, which is not only limited to aluminum and copper, but also includes precious metals.

But that precious metals rose further during the past week, is the result of the “shoot first and ask later” mentality among traders and investors. On Thursday, Espirito Santo Financial Group (ESFG), which holds a stake of 25% in Portugal’s largest bank Banco Espirito Santo (BES), decided to suspend trading in its shares and bonds due to “material difficulties” at its largest shareholder Espirito Santo International (ESI), which is controlled by the Espirito Santo family. After BES shares fell by 19%, Portugal’s stock market regulator halted also trading in BES shares. Rumors swirled through markets that BES were in financial difficulties. As a result, not only the shares of BES and ESFG plunged, but it dragged also the Portuguese stock market and also other markets in Europe and the US lower. Furthermore, contagion spread also to the market for government bonds of the Eurozone. Yields on peripheral bonds jumped and Greece was only able to sell have the amount intended at an auction. The plunge of stock markets and soaring yields on peripheral Eurozone government bonds triggered a flight into save havens, which included also precious metals beside US Treasuries and German Bunds. During Thursday night, BES declared that its exposure to ESI would not put the bank at risk of running short of capital to assure investors about its financial stability.

This declaration led to a stabilization. However, according to reports published on Thursday, it should have been clear, that the problems of ESI are institution specific and not a general problem of the Portuguese banking sector in total. The flight to safe havens might support these assets for some time as investors might prefer to get more evidence that the Portuguese banking sector is not in troubles. Thus, in the short-run, the precious metals might be well supported by the safe haven status and as a mean to diversify the risk of holding equities. But the outlook for the US bond market in the medium-term indicates that the all-time high is far out of sight for gold and silver.

Against the Fundamentals, but not the Flows of Funds

2014-07-06T15:56:00.003+01:00

Last week, precious metals closed higher than the Friday before. However, all fundamental drivers included in our fair value models were negative. But investors have rediscovered commodities and the rise of some base metals also supports the precious metals.

Among the economic data, the focus was on the purchasing manager indices for many countries. The Markit flash estimates prepared the markets already for weaker PMIs for many countries in the Eurozone. Thus, it was not a surprise for the market that the final index confirmed the trend, especially as also the EU data on business confidence come in lower. In the US, the ISM manufacturing PMI also edged lower while the consensus of Wall Street economists expected a small increase. However, the lower ISM did not harm the recovery of the US stock market as some components of the ISM manufacturing PMI pointed to better index readings next month.

But not each decrease of a purchasing manager index translates into weaker economic activity. The first misunderstanding is the threshold level of 50. The PMIs are so-called diffusion indices based on surveys. The percentage of negative responses is subtracted from the positive ones. If the number of positive and negative replies is the same, the raw index is zero and the value of 50 is added to obtain an index oscillating around a positive number. However, the responses are not weighted by the size of the company. Regression analysis between economic activity and manufacturing PMIs show that the critical value is in most cases below the 50 threshold.

Furthermore, the time series properties of the PMI are different from those of financial assets. The vast majority of assets in financial markets follow a random walk, which could be described by a geometric Brownian motion. However, oscillating indicators like the PMIs are mean-reverting and their behavior could be described by an Ornstein-Uhlenbeck process. Even with a slow speed of adjustment to the mean, declines during the phase of economic expansion occur and are not necessarily already a harbinger of a slowdown.

In China, the official manufacturing PMI remained above the 50 threshold. However, the more widely followed HSBC manufacturing PMI fell below the 50 threshold in January and now rose again above 50 in June. This surprise already provided support for copper after the release of the flash estimate and lifted copper further up this week.

The US labor market data came in far stronger than predicted by even many optimistic forecasters. The number of new jobs created rose to 288,000 and also the figure for the preceding month was revised higher by 7K to 224,000. The unemployment rate was expected to remain unchanged at 6.3% but dropped to 6.1%. And average hourly earnings increased again by 0.2% on the month. Thus, the labor market report points to an acceleration of the US recovery after the GDP drop due to the weather in the first quarter. This has lifted the US stock market to new highs for the S&P and Dow Jones indices. Also the US dollar appreciated against the major currencies and the US dollar index rose. Furthermore, the US bond market declined and yields on the 10yr US Treasury note rose by to 2.64%. All these factors are usually negative for precious metals.

Stronger economic data is normally supportive for the price of crude oil as it indicates a rising demand. However, demand is only one side of the equation. It was developments at the supply side, which lead to falling oil prices. In particular the news that the Libyan government reached an agreement with rebels, who handed over ports with oil terminals, send the price of crude oil lower.

In 2013 and also in some parts of this year, a stronger US stock market was negative for precious metals. The rise of the PGMs could be well explained with a stronger economy, translating into higher demand from car makers, and the supply loss due to the strike in South Africa. But why does gold and silver now rise when the major fundamental drivers are negative?

First, correlations are not causations and many factors can have an impact on the relationship between two variables. This explains well, why correlations fluctuate widely if correlation is measured over a shorter time period like 20 or 30 days. There were also periods when the stock markets and gold moved in the same direction before.

Second, the behavior of investors is not constant. Their assessment of future performance perspectives changes. Also the perception of risk is variable. In 2013, investors were convinced that stock markets offer a better return outlook and they shifted funds massively out of commodities into stock markets. The precious and base metal prices declined from the levels prevailing at the start of last year. However, now, two developments have changed the outlook. Many investors get more cautious towards equities. The valuations do not look as attractive compared to last year. Volatility has dropped. This is often regarded as a sign of complacency by investors. However, fund managers are now aware that low volatility spells danger.

Analysts at the end of last year were predicting that supply of many metals would rise and would shift the supply-demand balance towards lower prices on average in 2014. In this blog, we pointed out for copper that the development of warehouse inventories were not compatible with the narrative told by analysts but also official organizations. Indonesia impost export regulations, which had a strong impact on the supply of some metals. Nickel was the first base metal reacting with rising prices. But also lead and zinc prices recovered during the first half. Now also copper recovered and is trading again above the 7,000$/t level.

Therefore, we conclude that an increasing risk-awareness towards equities and the improved outlook for commodities has induced investors to allocate again more funds into commodity markets. Unfortunately, the LME has delayed further the publication of data comparable to the “Commitment of Traders” report compiled for US exchanges by the CFTC. Thus, there is only data for copper traded at the CME available for base metals. At the start of the year, speculative investors were net long 10,363 futures contracts and by the end of the first quarter, this turned into a net short position of 32,975 contracts. But during the second quarter, the net short position was reduced significantly to 1,764 contracts as of July 1^st. In gold, the non-commercials were net long just 766 Comex gold futures at the start of June. Within one month, the net long position rose to 40,299 contracts, the highest level since early December 2012. Also the gold holdings of the SPDR Gold Trust ETF rose by almost 20 tons after hitting a low of 776 tons in late May.

If our conclusion about the behavior of large investors is correct, it has two implications for precious metals. First, firmer equities are not a reason to sell gold as some investors also buy gold as a hedge against the case that equities might reverse direction. Second, the improved economic outlook for the US and China leads to more funds flowing back into commodities. This is the kind of tight that lifts all boats. But as piano player Sam sung in the famous movie Casablanca: “Those fundamental things apply, as time goes by”. Thus, the stronger US recovery should lead to the first Fed rate hike in the middle of 2015 and rising yields will support the US dollar and weaken US Treasury paper. Both should weigh on precious metals and other commodities in the medium-term.

Loans backed by falsified gold transactions

2014-06-29T15:34:00.002+01:00

What started in the copper market with the probe of alleged fraud at Qindao warehouses in China now spreads to the gold market. Bloomberg reported on Thursday that China’s chief auditor discovered 94.4 bn yuan ($15.2bn) were collateralized by falsified gold transactions. Although already widely suspected by many people, this was the first official confirmation that also gold is used in Chinese commodity financing deals. Goldman Sachs reports according to the media that up to $80bn false-loans may involve gold. Thus, the question is: how do these false-loans influence the spot gold market?

To answer this question, it is first necessary to analyze how commodity financing deals work. There are two possibilities. In the first kind of commodity financing transactions, the owner of the commodity uses warehouse receipts to get credit from banks. The proceeds from this collateralized loans can be invested in higher yielding assets before redeeming the debt. This transaction is only economical if the return on the investment is higher than the interest rate on the loan. Due to restrictions, this is currently the case for investments in the Chinese shadow banking system.

The second transaction involves the import of the commodity. The Chinese buyer places an order with a foreign company to buy the commodity. Then the buyer applies for a letter of credit from a lender, which is used to import the commodity. With opening the letter of credit, the buyer obtains the consignment, which he can sell in the domestic market. Again, the importer of the commodity can use the proceeds for investing onshore before paying back the original loan. As many commodities are traded internationally in US dollars, this type of financial deal involves cross-currency transactions. Funding costs in US dollars are quite low and the foreign exchange rate risk is limited due to the yuan exchange rate regime, which allows only limited daily fluctuations. In addition, as long as the yuan strengthens against the US dollar, the yuan appreciation even contributes to the return in local currency for the Chinese importer.

In the first type, if the loan is based on a falsified gold transaction, then the warehouse receipt is a fake. This implies that the lender has made a loan but the collateral is worthless. The lender could demand from the borrower to provide the promised collateral. Alternatively, the creditor could cancel the loan agreement and demand the repayment of the credit. For the borrower, it might be probably easier and cheaper to liquidate the domestic higher-yielding investment and to redeem the loan. Buying the gold in the spot market requires to have the funds available to pay the seller. Obtaining a loan in this situation is probably far more expensive. In addition, interest payments on the original loan are still due.

Therefore, the direct impact on the spot price of gold should be rather limited. Those who obtained a loan based on false-gold transaction are more likely to liquidate the investment and redeem the loan than purchase gold to provide the collateral. However, the process of selling the higher yielding investments probably leads to price pressures for those investments, which might induce other investors to purchase gold as a safe haven.

In the case of the second type of commodity financing transaction, there should be a discrepancy between the gold import statistics and the volume of consignments. In international trade finance, after a letter of credit was opened, the bank of the exporter sends the documents to the bank of the importer. The importer’s bank examines the documents, makes the payment to the bank of the exporter and hands the documents to the importer. If the consignment is faked, the buyer of the consignment will notice the fraud with a delay of only a few months if the commodity never arrives at the port of destination. Furthermore, ships can be tracked easily nowadays. Thus, the chances of discovering a falsified gold transaction involving gold imports are higher. Therefore, it is more likely that a faked gold transaction occurs with warehouse receipts instead of consignments.

In the case of a falsified consignment, it is also rather unlikely that it will lead to a higher demand for gold in the spot market. The buyer of the consignment would have to prove who faked the consignment. This could be either the exporter or the importer. Identifying the party who faked the documents is a time consuming process. But even if the buyer succeeds to obtain a legal title against the criminal party, it might be worthless in the case this counterparty went bankrupt in-between.

While the amount of commodity financing based on falsified gold transactions is impressive, the impact on gold prices should be rather limited. Unwinding the financing deals does not involve buying or selling gold as a necessary condition. However, other assets, i.e. those purchased with the proceeds from commodity financing might come under pressure. This is especially the case if lenders demand more and secure collateral or terminate the loan agreement.

Precious Metals rally after FOMC Meeting

2014-06-22T16:02:00.002+01:00

While precious metals traded sideways ahead of the FOMC meeting, the four metals rallied as the US dollar weakened against the major currencies after the meeting. Gold jumped above 1,300$/oz. and silver above 20$/oz. However, we regard the reaction in the precious metals and foreign exchange markets as overdone.

The FOMC kept the Fed Funds target rate unchanged at 0.25% or lower and reduced the total volume of bond purchases by another $10bn. This should not come as a surprise. The Fed did not provide any hint that the majority of FOMC voting members would accelerate the speed of tapering. Even with the committee recognizing “that growth in economic activity has rebounded in recent months”, the stronger growth compared with the first quarter is not a convincing argument to change track in monetary policy. Also the improvement in the labor market is not sufficiently strong enough to justify a faster termination of bond purchases. The FOMC still regards the unemployment rate as elevated. Furthermore, the committee states “inflation has been running below the Committee’s longer-run objective, but long-term inflation expectations have remained stable”. Thus, also the second target of the Fed does not provide a justification for reaching the end of bond purchases faster than previously indicated.

The FOMC also presented its economic projections. It lowered the projection for GDP growth in this year from 2.8 – 3.3% to 2.1 -2.3%. At a first glance, this might look like a major revision in expectations for the current quarter and the second half of 2014. However, for the GDP in the final quarter of 2014 to be 3% higher than in the same quarter of the previous year, GDP has to grow at an average quarterly rate of around 0.75%. But due to the negative weather, US GDP declined by 0.25% quarter-on-quarter, which translates into a drop of 1.0% annualized. Taking this decline into account, the revised projection still implies an average quarterly GDP growth of around 0.75% for the other 3 quarters in 2014. Thus the new projection neither reflects a more pessimistic nor more optimistic view of the FOMC members on the underlying expansion of US economic activity. Also the revisions for the unemployment and inflation rate are only minor.

There was criticism that the decision to taper further by $10bn was inconsistent with the revision of GDP projections. However, as shown, the FOMC has not changed the projection for average quarterly growth for the remaining 3 quarters. Furthermore, the revision of the GDP projection has led to accusations that the Fed would always overestimate GDP growth. The FOMC presents a range of GDP growth, nevertheless, there remains an imponderability in any forecast of a random time series. And in the case of the Q1 GDP growth, the weather had a stronger impact on economic activity than on average during the winter months. Even meteorologists did not predict such a long cold period before the start of the winter season. Therefore, the FOMC is not to blame for overestimating the GDP growth in Q1.

But also the expectation of faster end of bond purchases are not rational based on the expectation of a recovering US economy. The projections of the FOMC for the dual mandate variable are only modified slightly. Also the underlying expectation for average quarterly GDP growth remains almost unchanged. However, for terminating bond purchases faster the FOMC would have to expect stronger economic activity than previously assumed. Just forecasting a recovering after the decline of GDP in Q1 is not sufficient.

The dot charts are sometimes misinterpreted. But they give a good indication about the direction of monetary policy and the possible Fed Funds target rate at the end of the corresponding year. There is still no majority expecting a rate increase in 2014. Thus, the middle of 2015 remains currently the most likely date for the first rate hike. However, there appears to be no majority for increasing the Fed Funds target rate beyond 1.25% by the end of 2015. The dot chart from the March FOMC meeting showed that the majority did expect the Fed Funds rate to be only lifted to 1.0%. Thus, the FOMC got a bit more hawkish as far as the outlook for interest rates is concerned. But the Fed Funds December 2015 future just prices in a hike to 0.75%.

From our point of view, the risk is clearly that the FOMC might hike the key interest rate more than the market prices in during the second half of 2015. This should be supportive for the US dollar against the euro and the Japanese yen. However, the Bank of England might increase the base rate earlier. But overall, the indications provided by the FOMC do not support arguments for a weaker US dollar. Thus, the FOMC policy outlook is also not positive for the precious metals.

But there is not only a danger for precious metals of the Fed monetary policy outlook for 2015 via the influence of the US dollar on precious metals. At the current yield of 2.62% on 10yr US Treasury notes, there is hardly any downside potential left unless economic conditions weaken surprisingly and would derail the FOMC policy projections. A rise of the Fed Funds target rate to 1.25% within the next 18 months should also lift yields higher at the medium- to long-term maturity range. Given the outlook provided by the FOMC, 10yr US Treasury yields in the range between 2.75 – 3.0% appear more appropriate and 2.62% looks as expensive. A rise of US Treasury yields also increase the opportunity costs for holding precious metals. Thus, also the medium-term outlook for the US Treasury market is a negative factor for gold and silver.

Therefore, we come to the conclusion that the outlook for precious metals is not as positive as the market believes after the FOMC meeting. As long as the US economy develops as the FOMC expects, the risk for precious metals remains more biased to the downside. Only negative surprises, which would lead to a change in the outlook for the Fed policy, could make gold more attractive in the medium-term. However, geo-political developments could lead to demand for gold and silver as safe havens. How the situation in Iraq develops is hard to predict.

Roller-Coaster for the PGMs

2014-06-15T16:16:00.001+01:00

It was a roller-coaster week for the PGMs. After a government mediation failed to reach an agreement between the unions and mining companies to end the longest mining strike in South Africa, palladium rose further to 862.5$/oz. Thus palladium traded higher than in late February 2011 and reached the highest level since February 2001. Also platinum rose, but remained below the high of the year, which was reached at 1,493.90$/oz on May 22.

However, after reports emerged that a wage deal might be in reach, both PGMs came under pressure and posted strong losses. It was a bit of buying the rumor and selling the fact, but it is at the time of writing just a hope that the mining strike will be over soon.

According to GFMS, the demand for palladium exceeded supply in 2013 by more than one million ounces. South Africa contributed 2.35 mil ounces to the total mine production of 6.4 mil. Ounces. Scrap recycling added another 1.9 mil ounces to the total palladium supply. With the long lasting strike, the mine production in South Africa is expected to fall significantly short of last year’s level. Thus, overall palladium supply should be lower in 2014 than in 2013. In late April, GFMS estimated that 0.6 mil ounces were lost due to the strike. Thus, when workers return back to work, the total loss could come close to 1 mil ounces. At the same time, the recovery in the European automotive sector points to an increased industrial demand. Therefore, the supply deficit might rise to 2 mil ounces or above.

From the high reached last Wednesday, palladium lost more than 50$/oz. In the short run, the price of palladium might retreat further. However, with the outlook for a higher excess demand, palladium should be well supported.

One question often asked was about the size of the price increase since the start of the year. Many commentators had expected a stronger rally given the duration of the strike. One possible answer is that palladium consumers hedged their demand right in time with options. In this case, the short seller of the option only needs to buy incremental amounts of palladium according to the change in the option delta to remain hedged. Another possibility is that consumers expected that prices would decline again after a wage deal is reached. They can secure physical palladium by lending from holders of palladium inventories, which do not need the metal for immediate consumption. These are mainly financial institutions and investors.

The rise of palladium to a new multi-year high had also a positive impact on gold and silver. All four precious metal have a common usage in the jewelry industry. Thus, they are to some degree substitutes. A rise of the price of one metal relative to the others is increasing the attractiveness to use one of the other metals as a substitute. Thus, the rise of the PGMs increased the attractiveness of gold in the jewelry industry. This explains that the rally of the PGMs at the middle of the week also pulled gold and silver higher. Also quantitative models (VAR) show that there is a stronger link between gold and platinum prices and a stronger link between silver and palladium.

Then the question arises, why did gold and silver prices increased further while platinum and palladium plunged? From our point of view, the answer is the recent geo-political developments in the Middle-East region. With the ISIS terror group gaining control over Mosul and moving towards Bagdad, the markets got surprised. Oil markets fear that the rebels gain control over Iraqi oil exports. Stock markets fear a negative impact on global growth and turned lower, with weaker than expected US economic data being another reason for taking profits. Thus, gold and silver remained in demand as a safe haven, while the PGMs sold off.

Where Is the Copper Supply Surplus Gone?

2014-05-25T18:20:00.003+01:00

Only less than two months ago, the International Copper Study Group forecasted at its semi-annual meeting in Lisbon that after four years of supply deficit, the copper market would swing into a surplus. While the ICSG estimates that the apparent refined copper consumption exceeded supply in 2013 by 282 thousand tons. For this year, the ICSG forecasts a supply surplus of 405 thousand tons. This swing in the supply/demand-balance by 687 thousand tons is due to an increase in mine production, which leads also to a rise of refined copper output. For this year, global mine production is expected to increase by 4.7% to 18,904 thousand tons. Refined copper production is forecast to rise faster than mine production by 6.5% to 22,362 thousand tons. The global copper consumption is predicted to increase by only 3%, which is less than global GDP growth, to 21,957 thousand tons.

A swing in the supply/demand balance of the magnitude predicted by the ICSG should be reflected in the development of copper stocks. According to the recent figures published on May 22, 2014, by the ICSG in the press release for the Monthly Copper Bulletin, global copper stocks increased by a total of 102 thousand tons in the first two months of 2014. Inventories held in the warehouses of the three major exchanges (LME, Shanghai and CME) dropped by 25.2 thousand tons in the same period, which is in a clear contrast to the estimate of the ICSG for the first two month. Since March, the fall of inventories accelerated. Despite some temporary inventory builds at some exchanges, copper stocks are currently down 228 thousand tons YTD. This plunge of copper inventories at exchange warehouses since the beginning of March is in such an obvious contrast to what one would expect given the forecast of a 405 thousand tons supply surplus.

Certainly, copper inventories are not only held in exchange warehouses. Producers and consumers of copper also hold inventories, but one would expect that these holdings are more determined by economic activity and opportunity costs. If we take this into account, it appears rather unlikely that producers and consumers have increased their inventory holding by the amount to explain the difference between the change in the supply/demand-balance and exchange warehouse inventories.

Furthermore, if producers hold more inventories, then one would expect that they also want to hedge the inventories, especially when the majority of forecasters predict a change in the supply/demand balance. This should lead to a considerable increase of open interest and falling copper prices. However, when copper reached its low of the year so far in March, the LME copper futures open interest was up only 7 thousand contracts compared to the end of 2013. In addition, copper at the LME remained in a slight backwardation in mid-March. But copper prices were in contango at the Shanghai Futures Exchange. LME open interest in copper futures rose far stronger since mid-March to more than 340 thousand contracts at the start of this past week. This rise in open interest was accompanied by a recovery of the copper price. This argues that not producers are hedging against further falling prices due to a supply glut but consumers hedge future demand. However, this behavior would be only rational if consumers doubt that forecasts of a supply surplus depressing prices are correct.

The other explanation is that the copper supply surplus is held in bonded warehouses in China and had been used for financing deals. In April, we analyzed the development of the copper price in Shanghai and the inventories held at SHFE warehouses. In 2012 and 2013, a structural break took place and inventories at SHFE warehouses rose stronger as a model based on the development between 2009 and 2011 would have predicted. However, this development had not a major impact on the price of copper. Other factors explained the price development far better. It could not be ruled out, that the higher SHFE warehouse inventories were the result of stocks moved out of bonded warehouses.

Thus, doubts remain that the excess production of refined copper was absorbed by stocks held in bonded warehouses in China for serving as collateral in financing deals. Furthermore, it could not explain the decline of stock held in exchange warehouse inventories

While total exchange warehouse inventories decayed since the start of this year, stock held in LME warehouses declined by 195 thousand tons and remained almost unchanged in CME warehouses. At SHFE warehouses, inventories rose until the plunge of copper prices, and then also sunk from 213.3 to 92.7 thousand tons, which translates to a fall of 33.2 thousand tons since the end of 2013. It had been reported at the end of April that China’s State Reserve Bureau bought copper. However, according to the sources of the reports, the SRB bought from bonded warehouses. But this does not explain the fall of copper stocks at SHFE warehouses, unless the SRB also bought silently since mid-March copper in huge amounts held in bonded and exchange warehouses.

We have data for cancelled warrants only for LME warehouses. At the LME, the free available copper stocks plunged to a mere 92,650 tons at the end of this week. This is the lowest level since early April 2008. Copper is in a backwardation at the LME and the SHFE, which indicates that copper is tight and not abundantly available as estimates about a supply surplus would suggest. Our quantitative model for global total refined copper supply and consumption indicates that consumption would further exceed supply in this year. Structural changes can have a significant impact, which quantitative models do not incorporate immediately. Thus, we would not rely solely on quantitative forecasting models. However, the development of copper inventories in exchange warehouses, the backwardation and the results of the quantitative model increase our skepticism that the copper market will swing to a supply surplus in the magnitude forecasted by the ICSG.

The End of the Silver Fixing

2014-05-18T17:37:00.001+01:00

The announcement of London Silver Market Fixing Limited that it will terminate to administer the London silver fixing with the close of business on August 14, 2014, should not come really as a surprise. After Deutsche Bank already declared to withdraw from the fixings of gold and silver, only two bullion banks remained in the group conducting the silver fixing. When this decision was made public by Deutsche Bank, FCA board member, Mrs. Tracey McDermott, stated that the UK regulator could intervene if there were too few participants left in the London silver fixing.

In the media reports about the announcement, no reason was stated why London Silver Market Fixing made this decision. However, it is quite easy to guess what the major reason behind this move is. The risk of financial penalties by regulators or pending lawsuits – especially outside the UK - just got too high. In the USA, CFTC commissioner Bart Chilton called for investigations into the London fixings for some time already without having provided any evidence for manipulation of the London fixings or for misconduct by the bullion banks involved. Also the head of the German watchdog BaFin, Mrs. Koenig, accused Deutsche Bank of wrongdoing without presenting facts. The London fixing was discredited by foreign regulators. But now, they made a disfavor to many producers and consumers of silver.

In this blog, we have pointed out a few times, that the fixings of gold and silver are not comparable with the setting of the Libor benchmark rates. The London fixings are a price discovery procedure, which is based on real trading activities and not on estimates of what the market price might be. Furthermore, the bullion banks do not know how their clients might change the quantities they commit to buy or sell if a new price will be called in the fixing process. In addition, the procedure applied in the London fixings had also been used in the past at regulated exchanges.

The LBMA issued the following statement: “As part of our role as the trade association for the London Bullion Market, the LBMA has launched a consultation in order to ensure the best way forward for a London silver daily price mechanism. The LBMA will work with market participants, regulators and potential administrators to ensure the London Silver Market continues to serve efficiently the needs of market users around the world. As part of the consultation process, the LBMA will be actively approaching market participants requesting feedback.” Furthermore, the LBMA conducts a survey in the process of market consultations. Thus, the current system of price fixing in the silver market is coming to an end, but the search for an alternative system is taking place already.

What might be possible alternatives to the current London silver fixing? Silver is also quoted by many financial institutions on quote screens at Bloomberg or ThomsonReuters terminals or electronic foreign exchange trading platforms. One possibility would be to use those quotes sampled at a random time within a specified time span. Thus, traders would only know the time span, but not the exact time stamp. Then the quotes in the lower and the upper 25% percentile could be discarded and from the remaining quotes the average would be published as the new benchmark indication. However, such an approach would have the same weaknesses as the Libor benchmark procedure.

From our point of view, any substitute for the current London fixings should be based on real trades and not on quotes. Liquidity in the market is not the same at every point in time but varies during the day. Thus, a new reference price should be found when the liquidity is usually high in the market and this is the case in the afternoon London time. Furthermore, a new benchmark price should be found by trading taking place at one central location. In addition, the price should be set in an auction style procedure.

Spot trading in precious metals is usually OTC trading, but for the fixings, it is concentrated at one place where the price is discovered in an auction style procedure. If the current system has to be replaced without abandoning the advantages of high market liquidity, supply and demand concentrated at one location and auction for price setting, then moving the fixing to a regulated exchange is probably the best solution. This could be an electronic exchange but also an open outcry system. The LME is already fulfilling the requirements for a fair and transparent price setting for cash and forward transactions in base metals. There are ring sessions with settlement prices for transactions in the morning and afternoon. Moving the London fixings of precious metals to the LME ring trading might be the best alternative. Producers and consumers would be able to obtain the best price for larger quantities in trades at a regulated exchange. The procedure would be transparent and the precious metals market would still have benchmarks satisfying the requirements for reflecting the true market price.

ECB gets ready for easing, negative for precious metals

2014-05-11T17:56:00.000+01:00

All precious metals ended the week lower than the Friday before. Among the major fundamental factors of our fair value model, the slight increase of the US dollar index and the marginally lower S&P 500 index were negative for the precious metals, while the modest increase of the crude oil price should have been supportive. However, the major fall of the precious metals occurred last Wednesday after the speech of Mrs. Yellen at her testimony before the Joint Economic Committee of the Congress had been released.

The initial reaction in the stock market was negative, but also the precious metals headed lower. But as Mrs. Yellen stated that the US economy would need further accommodative monetary policy, the stock market recovered. Also the statement by Russian president Putin that military forces had been ordered to return back to their home bases supported the stock market and weighed on precious metals.

From our point of view, the major risk for gold and silver is biased to the downside. And the recent events and economic data in the Eurozone strengthen our assessment. The EU Commission presented the spring forecasts. The inflation rate in the Eurozone is expected to be only 0.8% this year and 1.2% in 2015, which is a slight downward revision. GDP growth is predicted to be 1.2% in the Eurozone in 2014 and should accelerate to 1.7% next year. The German economy is expected to be the locomotive for the Eurozone with a GDP growth of 1.8% this year. Slovakia and the Baltic member states are expected to post stronger growth, but these countries have only a smaller share at Eurozone GDP.

However, also the growth engine in Germany sputters. The volume of new orders in March was expected to increase by 0.3%, however, it dropped by 2.8% on the month according to the preliminary figures. Industrial production figures also disappointed with a decline of 0.5% on the month, whereas the consensus among economists predicted an increase of 0.2%. One could rightly argue that the monthly data is volatile and that a 3mth moving average would provide a better picture. However, looking at the chart below, there is a worrying development. The German manufacturing production reached the highest level since the start of the financial crisis in 2007 in July 2011. Since then, the index of manufacturing production hovered sideways. The industrial production including the construction sector exceeded the high from 2011 marginally in February, but this was mainly due to construction activity, which was up as the winter season was unusually warm. The volume of total new orders (excluding construction orders) did not even come close to the pre-crisis level when it peaked in early 2011.

But two others points are striking analyzing the chart. First, Germany pushed through that other Eurozone member states suffering under the fall-out of the financial crisis had to impose austerity measures when the debt crisis hit the Eurozone. But the austerity measures did not only lead to a fall of economic activity in the Southern European countries, they also fired back on Germany, which is depending heavily. Second, the flow of new orders and industrial production only recovered after ECB president Draghi gave the pledge that the ECB would do whatever is needed to keep the single currency intact in July 2012. Also the decision to introduce the OMT program was helpful to restore confidence. But it was again Germany, which opposed this policy of the ECB.

However, restoring investors’ confidence that the euro would not fall apart and mitigating the financial stress of Southern Europe came at a cost. The euro recovered against the US dollar and some other major currencies. While this was initially welcome and also attracted foreign investors buying government bonds of the crisis countries again, the euro has now reached a level, which is negative for two reasons.

First, the strong euro hurts the competitiveness of many countries, especially of those countries, which compete with Chinese exporters. Many German exporters will be hurt less by the current level of the euro as their goods are not easily substituted by products of Chinese manufacturers, like luxury cars for example. But in Southern Europe, the benefit of lower wages could easily be lost by the foreign exchange rate movements.

The second reason is the impact of a stronger euro on the inflation rate. About 10 years ago, the ECB welcomed a stronger euro as it helped to keep the inflation rate close to the target rate. However, now, the situation is completely different. In many countries, the austerity policy and a negative output gap weigh on the development of consumer prices. In some Eurozone member states, the inflation rate is already negative. A stronger euro exercises further pressure on import prices, which will feed through to consumer prices. Thus, a further strengthening of the euro would increase the risk of outright deflation in the whole Eurozone and not only in some parts of the currency area.

The finance minister of France called for measures to weaken the euro. In a typical Pavlov reflex, a spokesperson of German chancellor Merkel already rebuffed this call. However, ECB president Draghi shared the concerns of the French finance minister. While the council did not take any measures at the rate setting meeting this month, Mr. Draghi prepared the market for some policy measures at the next meeting. Another reduction of the repo rate might not be enough to weaken the euro sufficiently. We are still convinced that only some measures of quantitative easing could lead to a desired depreciation of the euro.

But it is again Germany, which voices criticism about further rate cuts or QE. The main argument against further monetary measures is that it would lead to rising real estate prices and thus causing a bubble. However, the situation in Germany is currently not comparable with the US or Eurozone member countries at the start of this millennium. For a bubble in the real estate market, two developments have to coincide: the house prices have to rise and this rise must be accompanied by a surge in construction activity. As the chart shows, the index of house prices in Germany meandered along a slightly declining trend for the first ten years of this century. But with the debt crisis, the flight of many investors into tangible assets led to a rise of house prices. However, this price increase was concentrated on a few urban regions. Nevertheless, more important is that higher house prices did not lead to a strong rise of housing permits. The rise of house prices reflects the scarcity of housing units in the favored cities, which cannot be easily increased by construction activity. Furthermore, for a bubble, house prices would have to exceed the discounted net rent income. This is not everywhere the case even in suburbs of major cities. As long as the rise of house prices is mainly driven by demand from tenants wanting to become the owner of their home, there is hardly a bubble to build.

Therefore, we come to the conclusion that the ECB will act to prevent the euro form firmer further. Just a rate cut would not be sufficient to achieve this target. Thus, even if the council decides not to embark on QE at the June meeting, the foreign exchange market will force the council to take QE measures rather sooner than later. But with the ECB easing and the Fed on hold, the economic outlook remains positive for risky assets like equities. Funds are therefore expected to prefer stocks over precious metals. This outlook would not be positive for gold and silver. However, the best friends for gold investors might be politicians taking the wrong measures endangering the still fragile economic recovery in the Eurozone.

Risk for gold and silver remains biased to the downside

2014-05-04T14:38:00.000+01:00

Gold and silver ended the week again slightly lower. However, the PGMs rose once more as hopes for an end of the strike in South Africa were disappointed and the labor unrest continues. The two major economic events for the precious metals were the FOMC meeting and the US labor market report. But also the geo-political development in Eastern Europe played a role.

The decision of the FOMC to reduce the volume of monthly purchases of US Treasury notes and bonds as well of mortgage bonds by $5bn each should not come as a surprise. However, some market participants had feared the committee might express a less optimistic view about the US economy. This was not a rational assumption as the FOMC always stressed that the weaker economic data earlier this year was caused by the severe winter conditions in many parts of the country. According to the first estimate, the US real GDP grew at an annualized rate of 0.1% in Q1. This is still a remarkable achievement. The ISM manufacturing PMI increased further and came in at 54.9 after 53.7 the month before. Thus, the PMI rose stronger than the consensus of Wall Street economists predicted. It also indicates that the US economy expands again at a solid pace in the current quarter.

The FOMC decision and the economic data was well received in the stock market. Thus, it was not surprising that gold and silver headed lower for most of the week. But both metals pared most of the loss on Friday. One reason for the rebound was surprisingly the US labor market report. The number of new jobs created in April was far higher as expected. Instead of 215K additions to the payrolls in the non-farm sector, 288K persons found a new job. Also the figures of the two preceding months had been revised higher. Therefore, the pay-roll was about 100K higher than the consensus expected.

In addition, the unemployment rate dropped to 6.3% while the market expected only a decline by 0.1 percentage points to 6.6%. This decline was due to a lower labor force participation rate. However, we have pointed out several times that the baby boomers start to leave the work force as they retire. The negative part of the labor market report was the unchanged average hourly earnings. Some economists argued that this would limit the increase of private consumption. But the recent figures on personal spending released earlier in the week showed a strong increase of 0.9% on the month. The average hourly earnings of production workers increased by 0.2% on the month, which indicates that a broad part of the total workforce earned more and thus, could increase consumption accordingly.

Nevertheless, the labor market report was not well received in the stock market. However, it was not only the labor market report weighing on stocks and thus, helping gold and silver to recover. Also the developments in the Ukraine, especially in the City of Odessa, played a role. Safe haven government bonds pared the loss following after the release of the labor market report. German Bunds even returned back into the black. Also the precious metals profited from the flow into safe havens.

As long as economic data plays the major role, it seems that the risk for gold and silver are biased to the downside. This is also reflected by the development of gold holdings at the biggest ETF, the SPDR Gold Trust, which fell again in this past week by more than 9 tons to 782.85 tons. The release of the OSCE observers over the weekend might reduce fears of an escalating conflict in the Ukraine. This could be positive for stock markets and thus, weigh on gold and silver. However, as long as no peaceful solution is found, the geo-political developments could also lead to a (brief) rally in both precious metals.

Gold’s support at 1270$/oz fundamentally not sustainable

2014-04-27T16:33:00.000+01:00

Gold managed to close around 10$/oz higher this week compared with the close on Thursday before the major trading centers closed for the Easter Holiday weekend. Also other precious metals posted gains in the weekly comparison. However, we have some doubts that these gains are sustainable.

On Thursday, gold fell to a low of 1268$/oz shortly after noon GMT. From this level, gold slightly recovered and rocketed to 1291.5$/oz at the London PM fixing. There were no complaints that gold had been manipulated higher from the usual conspiracy theorists this time. Technical analysts argue that gold had found support and this triggered a short-covering rally. In-deed, there are several reaction highs and lows located around the 1270$/oz level. And according to the chart theory, those previous highs or lows often serve as support or resistance and lead to market reversals.

However, we are not convinced that it was a technical reaction, which led to the strong rebound, and that gold has a solid basis at around 1270$/oz. Often, when those support or resistance levels are approached, one sees attempts by professional traders to fish stop orders and causing false break-outs with a strong and rapid countermove. This was not the case in the gold market. After hitting the low, gold remained in a consolidation mode for an hour. The strong rise later seems to have taken the market by surprise.

Furthermore, the US durable goods orders data had just been released and it came in much better than Wall Street economists had predicted. Core durable goods orders in March rose 2.0% on the month, while the consensus predicted an increase of only 0.6%. Stronger US economic data is currently not positive for the gold market. Also the reaction in stock markets was positive, which also argues against a technical driven short-covering rally only because gold hit a support level.

The recovery of gold only gained momentum and the price rocketed after stock markets pared gains and turned negative. The reason for this reversal in equity markets had been the recent developments in the geo-political tensions about the Ukraine. Russia’s defense minister announced that he ordered a military drill of forces near the border to Ukraine. Furthermore, the compromise reached before the Easter Holiday did not lead to the agreed results. Ukraine’s acting interim president ordered again troops to move to the eastern parts of the country and to disarm the separatists as well as to regain control over occupied government buildings.

Thus, it is the currently negative correlation between the price of gold and US or other major stock indices, which helped gold to rebound from a technical support level. Our quantitative model for the S&P 500 index, based on macroeconomic indicators, is still long positioned. Furthermore, the recovery of gold was not accompanied by an inflow of fresh capital to gold ETFs. While the holdings of the biggest ETF, the SPDR Gold Trust remained unchanged at 792.14 tons on Thursday and Friday (after falling by 3 tons at the start of the week), gold holdings of all ETFs declined on Thursday according to data compiled by Thomson Reuters.

Therefore, the fundamental factors still indicate that the risks for gold are biased to the downside. The support at 1270$/oz might not be as strong as expected by some technical analysts. However, in the short-run, the geo-political tensions about the Ukraine could remain a dominating factor.

On the ECB Plans for QE

2014-04-20T16:39:00.002+01:00

The development of the US dollar against the major currencies remains one of the crucial factors for the price trends of precious and also base metals. Of course, the policy of the Fed is one decisive determinants of exchange rate fluctuations. However, the monetary policy of other major central banks is also an important component in the price discovery process in foreign exchange rate markets. In this past week, ECB president Draghi stepped up verbal interventions which failed to drive the euro weaker against the US dollar. However, the ECB prepares the blueprint for implementing quantitative easing. Once the ECB embarks on QE, the US dollar could strengthen, which would have a negative impact on metal prices.

As the ECB is the central bank of 18 independent countries, implementing a common quantitative easing policy is not as easy as it was for the Fed or the Bank of England. The ECB has to decide, how to split the amount of quantitative easing among its member countries. According to the online edition of a German weekly magazine, the ECB staff considers currently two proposals. The first one is to allocate the funds for asset purchases based on the share, which each national central banks hold of the ECB capital. This would imply that the ECB would purchase for 26% of the QE volume German bonds, for 20% French and for 18% Italian bonds. When the ECB introduced the outright monetary transaction (OMT) program, which was not used so far, the Deutsche Bundesbank complaint that this program would be a transfer program. This argument also played a role in the decision of the German constitutional court. However, the argument of transfers could now also be applied to this proposal. As the ECB earns interest on the bonds purchased, the profit resulting from QE will be distributed to the national central banks. But German bonds bear the lowest yields. Thus, countries with higher yields could rightly complain that they would subsidize Germany, which would profit from interest earned by the ECB on buying bonds of countries with a higher yield level.

Furthermore, allocating the highest share of QE funds for buying German assets does not make much economic sense. One should keep in mind, what the reason for QE is: namely to prevent deflation. Germany profited from the financial crisis in the Eurozone already by having the lowest yields in the Eurozone and by growing relatively strong compared to the rest of the Eurozone. The deflation risk in the Eurozone is the result of the wrong economic policy, which Germany pushed through at EU summits. If the ECB will decide to allocate funds for QE according to the share on its capital, then Germany would be the biggest winner again. Another argument against the highest share for Germany is that German companies already have lower funding costs compared with companies located in other Eurozone member states. They need less support from the ECB than others.

The second proposal is to allocate the funds according to the size of national government bond markets. In this case, the ECB would allocate 25% for buying Italian bonds and about 22% for French and German bonds respectively. This would make more sense because some countries with higher borrowing costs for companies compared with German entities would receive a bigger slice of the cake. However, from our point of view, this is still not an optimal solution.

The two proposals do not take into account the reason for QE. To prevent deflation, countries where the deflation risk is high should receive relatively more funds than countries with less deflation risk. Thus, one criteria could be the difference between the ECB target inflation rate and the actual inflation rate. As the ECB’s target is an inflation rate close, but below 2%, a good starting point might be the difference to 1.9% inflation rate. According the Eurostat, the statistical office of the EU, the harmonized CPI inflation in Germany is 0.9% in March 2014. Thus, Germany is 1.0% below target. However, in Greece, the inflation rate is the lowest with -1.9%, which implies that Greece is 2.8 percentage points below the target. In Cyprus, harmonized consumer prices dropped 0.9% from the same month one year earlier and in Spain the inflation rate was -0.2%. At the other end of the spectrum are Finland with +1.3% and Austria with 1.4%, which would need less monetary stimulus.

Another indicator of deflation risk would be the output gap. The risk of deflation is increasing, the more the actual output is below the potential output. Thus, countries with a bigger negative output gap should receive relatively more monetary stimulus than countries with a small negative output gap. Given the GDP development over the last few years, it is also not difficult to guess that the Southern European countries would need a relatively higher monetary stimulus than Germany.

It should be clear, that neither the difference between actual and target inflation rate nor the size of the output gap alone are a good weighting factor for the allocation of QE funds by the ECB. The size of the bond markets should also play a role because the financial markets have to absorb the volume of QE measures. What we would propose is a two-step process to calculate the allocation weights. In a first step, weighting factors would be calculated based on the inflation gap. In the second step, the size of bond markets would be multiplied with this inflation based weighting factor. The volume of QE would then be allocated according to the share of the weighted bond market size in relation to the sum of weighted bond market size over all member countries.

Precious metals rise, but less than fundamentals sugges

2014-04-13T16:20:00.000+01:00

This week, all four precious metals posted gains compared with the close of the Friday before. However, given the development of the major fundamental drivers, the performance was a bit disappointing. The only exception was palladium, which rose 1.75%. Gold came in second with an increase of 1.2% over the week. However, after rising again above the psychological resistance of 1,300$/oz, a stronger rebound had to be expected against the backdrop of the fundamentals. Silver and platinum did not even manage to increase by 0.5%.

Not only the fundamentals, but also geo-political factors would have argued for a stronger increase of gold as the metal is usually regarded as a safe haven. Russians are a strong part of the population in the eastern parts of the Ukraine. The occupation of government buildings in some cities in the eastern Ukraine increased the tensions instead of deescalating it. NATO warns that Russian forces might invade the Ukraine and US President Obama already announced there would be further sanctions against Russia. In such a situation, there is usually a stronger demand for safe haven assets.

Some members of the FOMC feared, according to the minutes of the recent meeting, that financial markets might not understand the dot charts with the forecasts for the Fed Funds target rate. Obviously, they were right as the reactions after the FOMC meeting, Mrs. Yellen’s speech on March 31, and now after the release of the minutes showed. The messages is again that the first rate hike has to be expected only as early as mid-2015. We have pointed out several times that the FOMC has not changed its course. Even under the chairmanship of Mr. Bernanke, the Fed always indicated during 2013 that until mid-2015 the Fed Funds target rate would remain at the exceptional low level of less that 0.25%.

After the release of the FOMC minutes, the US stock market rallied. However, this rally was very short lived. Already the next day, the market gave the gains back. Profit-taking and the earnings season had a stronger impact. Especially technology stocks suffered most. But also the broader S&P 500 index lost 2.6% in the week over week comparison.

Over the recent couple of months, there was a negative correlation between the US stock market and gold. Given the decline of the US stock market, one would have expected a stronger flow into gold. However, investors have reduced their exposure to gold. The large speculators have reduced their net-long position in gold futures from 100,145 to 88,599 contracts in the week ending April 8, according to the recent CFTC report on the “Commitment of Traders”. Compared to the high, the non-commercials have reduced their net-long position by more than one third. Also the holdings of the biggest gold ETF, the SPDR Gold Trust, fell by almost 5 tons during last week.

But not only should the stock market have contributed to a stronger flow into gold. Also other fundamentals were positive for gold. The US dollar rebounded as markets have now understood that the first rate hike by the Fed will not take place earlier as some economists and market strategists suggested. The US dollar index fell by almost one full point to 79.45 and the euro rose to 1.3905, a gain of 2ct compared to the close of the Friday before. The head of the Deutsche Bundesbank, Mr. Weidmann, played down the risk of deflation in the Eurozone earlier this past week. However, one should not make the mistake to interpret this statement as an indication that the ECB would not embark on QE. A central bank cannot warn of deflation risks for psychological reasons. Such a warning could just increase the risk of deflation, which is clearly unwelcome as the experience of Japan demonstrates. However, as the Eurozone is just a currency union of independent states, implementing QE is far more complicated than it had been for the Fed or the Bank of England. Thus, we still expect that the ECB staff is working on the technical details of QE. From our point of view, the most likely scenario is still that the ECB will vote for QE before the summer recess. This should have a weakening impact on the euro against major currencies, which would be negative for gold and other precious metals.

Also the US Treasury market reacted positively on the FOMC minutes. The yield on the 10yr US T-Note fell by 11bp to 2.62%. This reduction of opportunity costs of holding precious metals should have a positive impact on the demand for all four metals. However, the crucial question is how far the yields on the 10yr benchmark Treasury note could fall. As long as the expansion of the US economy keeps on track, we regard US T-Notes at a yield below 2.5% as expensive. Thus, the most likely scenario remains that the US bond market will not provide much more support for gold. In the medium-term, rising yields are likely, which would be negative for gold.

Another fundamental driver of gold is the price of crude oil, which rose by 2.6$/bbl to 103.74$/bbl for the front-month WTI future at Nymex. Brent increased by only 0.6$/bbl for the front month future. However, also for this factor, the medium-term outlook remains not favorable for gold and other precious metals. In the short-run, the re-opening of ports in eastern parts of Libya remains a crucial factor. OPEC released its monthly report recently and also has reduced the forecast for crude oil demand. Thus, the risk for crude oil appears currently to be more on the downside.

Despite all fundamental drivers were positive, gold rose just 1.2% over the week. A stronger reaction had to be expected. Furthermore, it seems that major investors have reduced their exposure in gold by selling into the rallies. The outlook for the fundamental drivers of precious metals over the medium-term horizon remains negative for precious metals. At best they remain neutral but will not provide much support for a further rally. Only the supply situation for the PGMs remains supportive and should lead to an outperformance, especially of palladium. But for gold and silver, the risks are more biased to the downside in the medium-term. But this does not rule out that the markets edge up further in the short-run.

Precious metals re-bounced but danger is ahead

2014-04-06T15:46:00.002+01:00

It was a trading week with two different halves for precious metals. All four precious metals ended the week higher compared to the Friday before. However, at the start of the week, especially gold was weaker and fell to 1.277$/oz, the lowest level since February 11, 2014. Thus, gold corrected more than 50% of the rise from the low of this year. While silver traded sideways at the start of the week, the PGMs already continued to recover.

On the one hand, the weakness of gold at the start of the week could be explained by the fall below the 1,300$/oz level, which triggered further selling and physical demand in Asia was not sufficient to prevent the slide. However, it was also the development of stock markets, which weighed on gold as investors switched funds from gold into equities. This could be seen by the gold holdings of the SPDR Gold Trust ETF, which declined by 6 tons in total on Monday and Tuesday to 800.9 tons.

What has driven US stocks higher and gold lower on Monday was a speech given by Fed chair, Mrs. Yellen. She stated that the US economy would still need support by a monetary stimulus. Some analysts and traders interpreted this statement as an indication that the Fed might not hike the Fed Funds target rate as soon as the market expected after the recent FOMC meeting. However, the FOMC remained on track, and neither the remark of Mrs. Yellen at the press conference nor the statement made last Monday are a hint of a policy change. The sentence, which excited traders on Monday, is just underlining what is obvious for those with some understanding of monetary policy. If the FOMC were not thinking that the US economy still need the monetary stimulus, the committee would have terminated QE3 already completely. That the Fed pumps $55bn into the US bond market this month could not be justified if the FOMC were convinced that this stimulus would not be needed!

Furthermore, this statement also does not alter the outlook for the first hike of the Fed Funds target rate. The most likely scenario is still that the first increase will take place in mid-2015. Currently, the FOMC reduces the volume of bond purchases by $5bn for the US Treasuries and the mortgage bonds respectively. Maintaining this pace implies, that the FOMC would decide at the October meeting to end buying mortgage bonds and at the December meeting to terminate purchases of US Treasury paper. Thus, six month after the December 2014 meeting is right in the middle of 2015. And this date had been mentioned by Mr. Bernanke already about one year ago. Thus, the words might be different, but the message remains the same. However, that the Fed Funds target rate will be positive again in real terms could only be expected to take place in 2016 given the FOMC projections for the Fed Funds rate and the inflation rate. Thus, the Fed monetary policy will remain expansionary for two more years.

The turn-around for gold came on Wednesday when the market shifted its focus on the forthcoming US labor market report. The ADP estimate already provided an indication that the non-farm payroll figure would be solid. With an increase of 191,000 jobs created, the actual figure was very close to the consensus among Wall Street economists. However, the figures for the first two months of 2014 had been revised considerably higher. The unemployment rate remained unchanged at 6.7%. The FOMC already takes into account that further improvements of the unemployment rate might be harder to achieve as persons who left the labor force might return with a better outlook for finding a job. The average hourly earnings remained unchanged in March. All in all, this labor market report provides just confirmation that the FOMC is likely to maintain its current policy.

The labor market report triggered the rise of gold above the 1,300$/oz level. However, we don’t regard this move as justified by the fundamentals. The ECB kept rates unchanged. However, ECB president Draghi talked about measures of quantitative easing during the press conference. The ECB council has not yet made a decision. But it looks like that the ECB staff is working on a blue print for QE. Some of the details have to be finalized. Overall, it appears to be only a question of time. According to a report in a German paper, the ECB would simulate the impact of QE in the volume of 1,000bn Euro. If such a package would be implemented, gold might get on the same path as after the announcement of Abenomics in Japan. The Euro would probably weaken against the US dollar, which is likely to send gold lower.

Shanghai Copper Price and the Inventories Puzzle

2014-04-01T16:29:00.000+01:00

After the financial crisis in 2008, there had been a structural break in the copper market. Until this break, the development of the copper price could be well explained by economic and financial market data of industrialized countries, like LME warehouse inventories, total OECD leading indicator, the US dollar index and the S&P 500 stock index. Although China had already risen to the world’s top copper consumer, this data provided a better fit for the LME copper price than the OECD leading indicator for China or the Shanghai Stock Exchange Composite index. After the financial crisis, Chinese data explained the copper price development better.

However, focusing on Chinese data had led to another problem, especially for the analysis of refined copper supply and demand. The identity equation that production plus net imports have to equal consumption plus change of inventories is the basis for the supply and demand analysis. The left hand side of this equation can be estimated with sufficient reliability. The Chinese Customs Office records exports and imports. Also the copper production could be estimated by China’s National Bureau of Statistics as companies have to report their production figures. The problems are on the right hand side of the equation as copper consumption is not directly observable.

Therefore, a concept of estimating apparent consumption is applied. Consumption is estimated by subtracting the change of inventories from the sum of copper production plus net imports. But the problem with this approach is that data on inventories is available for the state reserves and inventories in SHFE warehouses. However, private inventories – mostly held in bonded warehouses in the Shanghai region – are hidden. Thus, apparent consumption would be overestimated if the change of hidden inventories is underestimated and vice versa. Therefore, having a reliable estimate of the change in hidden inventories is essential for an analysis of supply and demand (consumption).

Since the report for global copper supply and demand in November 2013, the International Copper Study Group (ICSG) provides an estimate for adjusting apparent consumption in China. The ICSG applies the estimates of three consulting companies for this adjustment. If there is a significant change in the relationship of hidden inventories to official SHFE warehouse copper stocks then there should be a structural break in the link between SHFE copper price and inventories.

The chart above shows the development of the 3^rd month copper price at the Shanghai Futures Exchange and the inventories held in warehouses licensed by the SHFE. Already a visual inspection shows that there was a close relationship between the development of the copper price and the inventories in the period from the beginning of 2009 until the end of 2011. Since 2012, there appears to be a structural break. This could be verified empirically by an econometric test.

For a quantitative analysis, it is not sufficient to estimate just a linear relationship between the copper price and the inventories. If other factors have an influence on the copper price, then the regression coefficient would be overestimated in the case those other factors were excluded. Therefore, econometric models are usually formed to explain the price development by some more explanatory variables than merely the copper inventories. As the chart below shows, there is also a close relationship between the Shanghai Stock Exchange Composite index and the copper price. What is important for the analysis is that this relationship is also staple in the period after the start of 2012. This is also confirmed by econometric test for a structural break. The same applies for the SHFE 3^rd month copper price and the US dollar index. If a trend variable is included also in the model for the copper price, then there is also a structural break at the start of 2012.

Thus, in a typical model, the price of copper would be a function of inventories, the Shanghai Stock Exchange index and the US dollar index. It is well known from basic algebra, that this function could be rearranged that the inventories are a function of the other variables. Under the assumption that the relationship, which held in the period between the start of 2009 and the end of 2011, also held after 2011 if the development of the hidden inventories were taken into account in the inventory variable, one might derive an estimate for the change of hidden inventories. First, the regression coefficients for the period from 2009 until 2011 are estimated. Second, based on these parameters for the period from 2012 on, the copper inventories are estimated. Finally, the difference between the estimated inventories and the actual SHFE warehouse inventories provide an estimate of the development of hidden inventories since 2012. However, it should be noted that this figures would only be an estimate of the change in hidden inventories and not an estimate of the absolute level.

The empirical results of those estimates provide some surprises. First, there is a positive regression coefficient for the relationship between the price of copper and the SHFE warehouse inventories. This is in clear contrast to the theory of inventories, which postulates that prices should rise if inventories are falling and vice versa. This theory is also widely used to explain the development of the convenience yield of commodities.

Therefore, the question arises: “What could explain the positive relationship between inventories and copper prices at the SHFE during the period from 2009 to 2011”? One possible explanation would be that speculation did not only take place in the futures market but also in the cash market. After the collapse of Lehman Brothers, China was very quick to announce measures to stimulate the economy and to prevent a major crisis. Also the state reserve bureau bought copper. Thus, speculators might also have bought copper and stored it in SHFE warehouses. This procedure gave them more flexibility in managing the trade by having the opportunity to sell a future and to deliver into this future at expiration if the market turns against their positions.

Another possible explanation is arbitrage. If the copper market in Shanghai is in a contango, then there could be an incentive to buy copper in the cash market, store the copper in an exchange licensed warehouse and sell short a copper future with a more distant maturity. If the market is in backwardation, then there is an incentive to take out inventory.

Thus, we included another variable in the regression equation for the SHFE inventories, the spread between the 3^rd and the 1^st month copper price. The regression coefficient for the curve spread is highly significant and it also has the right sign. If the difference between the 3^rd and the 1^st month copper price widens then the inventories tend to increase, just as the theory suggests. In addition, including the curve spread as an explanatory variable for the SHFE warehouse inventories leads to a reduction of the regression coefficient of the copper price, but there is still a positive relationship. Therefore, another factor might explain this unusual correlation between the copper price and the inventories during this period.

It has often been reported that copper is used as a collateral for funding. Given the lower interest rates in the US dollar money market and the trend of the Chinese Yuan appreciating against the US dollar, it makes sense to fund in US dollars and to invest the proceeds in Yuan. Thus, the spread of the 3mth Shanghai interbank rate and the 3mth US Dollar Libor has been added as a further independent variable in the regression equation. But this procedure leads to the problem of multicolinearity as the interest rate spread is highly correlated with the copper price development. However, this is exactly what had been sought as the copper price could be dropped out of the equation explaining the development of the inventories. Thus, the four variables – copper curve spread, interest rate spread, Shanghai Stock Exchange Index and US dollar index explain quite well the movements of copper inventories held at the SHFE warehouses. The regression coefficients are all highly significant different from zero.

The second surprise is the comparison between the actual and estimated inventories since the start of 2012. The chart above shows the development of the SHFE inventories and the estimate according to the multiple regression model. Already from visual inspection, it is quite obvious that the model failed to predict the development of inventories, but this had been expected given the discussion about a rather strong build of hidden inventories. The surprise is the sign of the average forecast error.

For the period from 2009 until the end of 2011, over which the regression coefficients have been estimated, the average of the deviations between the actual inventories and the fitted values is zero by definition. However, for the period from January 2012 until the end of March 2014, the average of the difference between actual and estimated inventories is 82,340 tons. The t-test shows that this average is significantly different from zero at less than the 1% (error) level. During the last 2 and a quarter years, the average of inventories held in SHFE warehouses was 180,268 tons. This indicates that the inventories were on average 84.1% higher than what the model predicted based on the relationships prevailing from the start of 2009 until the end of 2011. If the assumption of constant regression coefficients and a stronger build of hidden inventories in bonded warehouses were correct, one would expect that actual inventories since 2012 were lower and not higher than the model estimate.

Thus, there had been a structural break in the model, which is also confirmed by an empirical test. The Chow test also allows to test, which variable caused the structural break. For the stock index, the US dollar index and the curve spread, the hypothesis of no structural break cannot be rejected. However, for the constant term and the interest rate spread, the hypothesis of no structural break can be rejected at the 1% significance level. The constant term alone explains around 62,000 tons of the higher inventories during the out-of-sample period. For the interest rate spread, the sign changed to negative during the period beginning in January 2012.

The model failed to provide an estimate of the change of hidden copper inventories held in bonded warehouses, which would confirm the prevailing narrative. However, the structural break of the constant term indicates that also a shift of inventories from bonded into registered warehouses is a distinct possibility.

A False Break-out of Gold

2014-03-23T15:34:00.001+00:00

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

2014-03-16T16:24:00.000+00:00

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

2014-03-09T18:11:00.001+00:00

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?

2014-03-02T19:13:00.000+00:00

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

2014-02-23T21:57:00.000+00:00

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

2014-02-16T18:19:00.000+00:00

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

2014-02-10T05:58:00.000+00:00

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

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

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

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

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

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

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

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

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

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

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

Fed Tapering, Emerging Market Currency Crisis and Precious Metals

2014-02-02T17:16:00.000+00:00

During the past week, we received some questions from journalists about Fed tapering, the currency crisis in some emerging markets and their impact on precious metals. Therefore, this blog article will deal with those questions and the corresponding answers.

The decision of the Fed to reduce the volume of monthly bond purchases by another $10bn to a total of $65bn should not come as a surprise. It has been well communicated by the Fed and the US labor market report with a further drop of the unemployment rate to 6.7% indicated that the FOMC would stick to the exit strategy. Furthermore, several new voting members in 2014 also stated that they would even prefer a quicker reduction of the monetary stimulus.

Some analysts quoted in the media expressed the view that the FOMC might pause due to the currency crisis in some emerging markets. However, this was only wishful thinking and not based on a proper analysis of the Fed policy. The US central bank is responsible for the monetary policy in the USA and has to take the measures in order to achieve its two targets. It is not the task of the Fed to correct policy mistakes by other central banks or governments. The Fed implemented quantitative easing despite some criticism from other G20 members. Therefore, one had to assume that the FOMC would stick to the statement of the December meeting. Thus, the decision should have been already discounted in the precious metals market. But this does not rule out that precious metals might react on indirect effects.

One of those effects is the reaction in the US stock market. While the S&P 500 index rallied in December after the FOMC, the US stock market extended losses this time. Thus, unlike after the last FOMC meeting in 2013, precious metals advanced after the FOMC decision was announced. However, this did not prevent that all precious metals ended the week significantly lower compared with the close of the preceding Friday.

The currency crisis in some emerging markets should increase the appeal of gold and other precious metals as a safe haven. Thus, it is not a surprise that some emerging market gurus like Mr. Faber recommended to buy physical gold. However, the return of holding gold comes from two sources, the currency and the gold price, which is quoted internationally in US dollars. The return of investing in the US dollar in the case of a currency crisis is positive as long as the crisis prevails. But the correlation between the US dollar and the price of gold is often negative. Therefore, a potential buyer located in a country with a currency crisis would have to expect that the return of gold would be diminished by a decline in the price of gold. The expected return for such an investor is higher if she buys a short-term US Treasury note. Also the expected volatility of a short-term US Treasury note is lower than the one of holding gold. Thus, there are better alternatives as a safe haven than precious metals.

However, the considerations above do not take into account the possibility that the government might impose measures of capital controls. If an investor has to fear that those measures could be taken by the authorities then buying physical gold might be the better choice even if the risk and return is less favorable compared to short-term US government paper.

Among the countries suffering under a currency crisis currently, only India and Turkey are major gold consumers. However, in India the central bank already took measures to curb the import of gold in order to improve the current account deficit. There was some speculation that this measures might be lifted, but this was very likely only wishful thinking. The Reserve Bank of India would risk that the deficit widens again. Thus, India’s gold imports are unlikely to recovery considerably anytime soon. It could not be ruled out that Turkey might take similar steps to curb gold imports in order to improve the current account deficit quickly. Therefore, on balance the currency crisis could even have the impact that demand for physical gold declines instead of rising due to safe haven buying.

The currency crisis could also have a negative impact on precious metals prices via indirect effects. Despite the IMF revised its forecast for global GDP growth in 2014 up to 3.7% just a couple of days ago, equity investors fear that the currency crisis would lead to slower growth. The hike of interest rates during this past week by the central banks in India and in Turkey increased this fear. Thus, weakness of stock markets could be supportive for gold. That gold declined this week on balance, despite weaker equity markets, is due to the biggest gold consumer. As China celebrates the lunar New Year, markets are closed there and seasonal effects point to slower demand after returning from the holiday week. But all in all, we continue to expect that stock markets will be the major factor for the further direction of precious metals and that the recent negative correlation prevails further.

Metals Markets in 2014

2014-01-26T15:40:00.000+00:00

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

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

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

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

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

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

The Hidden Shadow Warehouses and Base Metals

2014-01-05T15:45:00.001+00:00

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

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

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

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

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

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

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

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

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

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

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

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

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

Finally, the FOMC did it!

2013-12-22T16:49:00.002+00:00

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

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

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

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

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

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

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