Download PDF

Gold has not closed outside the range of 1,282 to 1,311 US per oz. since April 14, 2014. It has made the market action over the last six weeks decisively boring. That being said, the low level of volatility in the metals market has been accompanied by seesawing equities. Fridays close on the S&P500 above 1900, despite sitting on record levels, marks the fourth time since March the benchmark US index has attempted to breakout past that physiological barrier. Nonetheless, the one market that has made a significant move in one direction has been US treasuries. While it remains difficult to draw conclusions from passive metal prices or volatile stock markets, it’s the bond market that highlights the perplexities of the western economies stalling economic recoveries. Additionally, it questions whether the outlook for increasing long term interest rates is still intact.

The prospect of the US economic recovery yet again losing pace seems to be what has brought investors back into the US bond market. This too is what has prompted many analysts and money managers to suggest the equity markets are long overdue for a correction; however, the inflation story is what is retarding the earlier notion of an all but certain rise in interest rates. Minutes from the US Federal Reserve’s most recent April meeting even revealed that inflation expectations still remain relatively low for the remainder of 2014, and markets were left indecisive as to whether policy will return to normal perhaps sooner than later.

To make matters even more complex, New York Fed District President William Dudley (who may be one of the more recognized voting members amongst the FOMC) suggested this past week that the Fed keeps their 4.3 trillion dollar balance sheet status quo (see chart below). Quantitative easing was accomplished by expanding the Fed’s balance sheet to purchase Mortgage backed securities and treasury bonds. As these debt instruments mature, instead of removing the proceeds from the Fed’s balance sheet, Dudley suggests they reinvest in what is still a struggling mortgage market. Thus, the question of the long term implications or consequences of an inflated Federal Reserve balance sheet hangs over financial markets.

Famed bond investors have grabbed headlines over the last year for the comments on the end of the bull market in bonds. Most memorable was a tweet from Bill Gross of PIMCO, which read, “The secular 30-yr bull market in bonds likely ended 4/29/2013…” The misconception might have been that bonds were now entering a bear market as the economy springs back to life, but this leaves out another scenario, and perhaps the one currently playing out. And that is that interest rates are at historical lows, but they will remain at historical lows for some time. There is no question that is what a country like Canada has seen, when our 10 year yields recently touched a level not seen since June of last year. Furthermore, maybe some of the forecasts for 2014 like an 85 cent Canadian dollar, 3 percent GDP growth in the US, or US investment banks calling for $1,000 gold prices have to be rethought.

Download PDF

Equity markets on Friday provided no indication that the April jobs report exhibited the best growth in payrolls since January of 2012, or second best since the US escaped recession in mid-2009. With payroll numbers as strong as reported, which showed a net 288 thousand American’s finding work, the expectation would be for swift gains in the equity markets, and given the negative correlation witnessed between gold and equities in the last 12 months, gold to sell off. Even though some negatives can be found with Friday’s report, the broad based strength would expect for a rally in risk assets to ensue. And given that was not the case, it begs the question of whether equities remain in correction territory.

It’s important to highlight the positives in Friday’s numbers because there is without question evidence that the US labour market is strengthening, and it is at a result of the efforts of the US Federal Reserve. Of the 288 thousand payroll positions added, 273 thousand came from a strengthening private sector. The remaining 15 thousand came from a government that has somewhat consolidated following the forced sequester and budget cuts. Therefore, it continues to suggest that those that have the skills to move back into the labour force and will be able find work. That, however, is not so much the concern.

The concern remains that the US Federal Reserve won’t be able to find a solution for the record 92 million Americans who are not represented in these upbeat job numbers. The labour force participation rate is at its lowest level since February of 1978. That translates to the largest share of the American population not to participate in the job market in 26 years. And there is a continuing debate and contribution of academic research that attempts to pinpoint why the participation rate is dropping, particularly when policy goals would be for it to move in the other direction. But there is not a concise explanation of whether it is at the result of an aging population seeing more retirees, or discouraged workers who are fed up looking for work and lose hope.

This begs the question of whether this dichotomy in the American economy between those who are able to find work and those who are not can only continue, and perhaps worsen. Job creation through the first four months of this years has averaged well over 200 thousand positions a month, which are strong numbers even accounting for the extreme winter conditions expected to stall the economy. Even initial estimates for Q1 GDP (reported last Tuesday) are being forgotten as expectations are for them to be revised higher as a plethora of evidence shows the strength of American corporations and consumers. But then looking at the markets, why aren’t they once again taking out their all-time highs?

Download PDF

Does Greece returning to the sovereign debt markets indicate the worst of the euro crisis is now behind us? That question cannot be answered with any certainty. But does the fact that this country was unable to go to the public debt markets since 2010, and now has auctioned 5 year notes below 5 per cent bear any long-term implications? The answer is a resounding no.

To start with background, Greece had their first public debt auction since March of 2010 last week. Only a meager 3 billion euros were auctioned, but demand was so strong the Greek Treasury was able to do fill the orders at a lower than anticipated yield. Some sources had demand at more than 20 billion euros. As interest rates in North America continue to see upward momentum, it might still be safe to suggest that the bull market in bonds isn’t over in Europe.

The Eurozone has advanced significantly from the dark period referred to as the Euro Crises. So much of this is attributed to those oft-quoted words of the European Central Bank President Mario Draghi, insisting to do whatever it takes to save the euro. And to the dismay of many pundits, confidence has been restored in the Eurozone without any market intervention or extraordinary monetary stimulus.

What is also astonishing about the relatively low yields (compared to 4 years prior) of peripheral euro nations’ debt is the unpriced risk in depreciation of the euro measured against the US dollar. The debate still continues as to whether a monetary union of that size and cultural divergence is actually sustainable in the long term. And given a forecasted dire outcome by many that would be associated with a collapse of the currency, the euro continues to defy forecasts and even appreciate in this tepid economic growth environment.

Beyond a low growth environment, there are a myriad of additional factors why Greek debt is attracting such high demand. Foremost, it’s because interest rates will more likely see downward pressure in the Eurozone. The euro denominated countries still sees disinflationary characteristics in many of its markets, and bizarrely it is in tandem with an appreciating euro currency. Both factors contribute to or are associated with downward moves in interest rates.

Importantly, investors are convinced that Mario Draghi and the European Central Bank stand ready, and potentially will act in the near future to unleash their own version of Quantitative Easing. Should this be the case, a weaker euro will ultimately prevail and create the sudden selloff many are anticipating, but the mere fact that investors are still convinced the ECB will act and be effective means there is already some level of assistance being provided to the markets through instilled confidence.

The final factor is all about austerity. The euro crises was about debt, and governments are all implementing policy with the focus of fiscal rebalancing and restraining public spending. This is not a bullish call on Europe, but highlighting that EU member governments are relatively sounder from a fiscal standpoint (thus, this is damning with faint praise given recent history).

Greece’s return to the bond market was extremely well welcomed, but for the investment opportunity in an environment that will continue to see downward pressure in European interest rates. This is not to minimize that Greece still has a painful road ahead. Following six straight years of recession, the Greek economy now produces 25 per cent less output. Public debt is still 175 per cent of GDP, which essentially requires Greece to seek outside funding should their economy hit another speed bump. And not forgetting a tragic scene of unemployed youth, there’s no reason to believe they’re close to being back to normal just yet.

Download PDF

The Federal Reserve used their policy announcement and the press conference following the announcement to alter their method of forward guidance. Previously, it had been the hard line 6.5 per cent unemployment target that would lead to a culmination of the third round of quantitative easing. Unfortunately, as the employment rate has fallen, and the overall labour market hasn’t improved accordingly, there has been a realization that the employment rate is not a sufficient stand-alone measure for the labour market. Thus, the Fed has had to abandon this with a more qualitative approach. This creates a problem for those invested in these markets, for it has been Fed policy providing direction. With a more qualitative approach to guidance, the result will be more ambiguous policy statements from the Federal Reserve’s Federal Open Market Committee (FOMC), and it will potentially lead to greater market volatility from the Fed as their guidance is open to misinterpretation.

One of the touted accomplishments of Janet Yellen’s predecessor, Ben Bernanke, was that he played a role in making the Federal Reserve a more transparent institution. One action in particular was lengthening the FOMC statement that was released after each meeting giving investors and analysts a more detailed approach to how policy is conducted. This was a stark difference to much briefer statements from the Greenspan era that left much to speculation. The importance of this measure though was to eliminate potential shocks to the market. This is why the US Federal Reserve finds themselves between a rock and hard place, and potentially risk reverting back to their old ways with a less definitive approach.

A qualitative guidance approach allows the US Central Bank to act in a more discretionary manner as they do not run the risk of failing to meet predetermined objectives. The consequence will be less clarity from the Fed, which implies the possibility of bigger shocks or surprises for the markets. Former PIMCO CEO Mohammed El-Erian suggests equities sold off following the Fed statement due to an uncertainty premium, which can be thought of as the market pricing a discount for a much vaguer policy outlook. But the uncertainty looks beyond the termination of QE as there are questions surrounding the overall efficacy associated with the Fed’s past course, and this is given QE could be terminated before the labour market is fully repaired.

It is difficult to refute that quantitative easing provided some form of benefit to the US economy; one in particular was supressing the longer end of the yield curve, which was of particular benefit to a troubled mortgage market. But with the Fed’s dual mandate of stable inflation of 2 per cent as well as maintaining full employment, the abandonment of QE before achieving success in that regard is an admission of the Fed’s shortcomings. And part of the problems is inherent in the American labour market. Long-term unemployed are structural issues, and unfortunately record low policy rates will not provide a solution to this problem. That’s part of the reason the FOMC is forced to take this path of paring back QE.

Janet Yellen’s key task will be to conventionalize the role of the US Fed. Her greatest risk is that as long as these markets continue to be driven by the guidance her institution provides as a more ambiguous approach will lead to much greater volatility. The only hope is that markets can move off the life support provided by central bank easing, and back towards being driven by fundamentals. In this case, central bankers can go back to operating in the shadows.

Download PDF

Bloomberg reported on a study this past week that points to decades of manipulation in the gold market. Whether there is credence to this study is something that is yet to be proven, but it highlights periods of suspicious trading activity around the time when the London Bullion Market Association fixes the price of gold every day. It also ads support to the notion that the way the price of gold is fixed is archaic in nature.

We have to begin with a bit of background. The London Bullion Market is not the one we commonly think of in North America. In North American trading hours we are often focused on the New York Mercantile Exchange, commonly referred to as the Comex. The London Market in 2013 saw close to 76 percent of gold trading in terms of volume in 2013, whereas Comex volumes were closer to 16.5 percent. Numbers for London are quite often best estimates because not all clearing is actually reported. Regardless of volume, research into which market leads the price of gold is inconclusive between the two. Despite London dwarfing all other markets, volume does not necessarily mean influence.

Twice a day in London, the price of gold is fixed. It’s done so for many reasons, some being settling client orders who purchase or sell based on that fix. Clients may be precious metal dealers, mining companies, or jewellers. The fix is also used by financial institutions for portfolio valuation. To fix the price, five member bullion banks come together to determine a price. The member banks are Scotia-Mocatta, Barclays, Deutsche Bank (who recently announced they were giving up their seat), HSBC, and Société Générale. They hold a conference call where they offer their book of client good ‘till cancelled orders along with their own orders. Once they have a price where they can settle within 50 kilos matching buyers and sellers, the price is fixed.

The potential issue with the gold fix is that member banks that participate are not restricted from proprietary trading (trading for their own positions) and are not restricted from trading derivatives markets (like the Comex) while the conference call is underway. As well, the banks continue to take client orders while the call is taking place. It becomes a problem of adverse information as the five members have insight into the direction of the market before all other market participants, and the author of the study seems to suggest collusion between the five banks in terms of manipulating the price.

The motivation for the research paper comes from suspicious trading activity seen on the Comex in a brief period during the conference call of the second fix and following publication of the London Fix. Nothing has been proven at this point, but the researcher making the observations has also been credited for research that unveiled potential manipulation in the setting of the LIBOR. A probe that has led to banks being penalized along with the traders participating in that rate setting process.

It is more a story of potential corruption amongst bankers than manipulating the price of gold. For a brief moment, perhaps five minutes, there is opportunity of making excess profit by knowing the direction of the market, before the market itself has time to adjust. And stories of late show it is not just the gold market and the LIBOR scandal, over the last year there have been probes into the currency markets showing evidence of rate rigging. Unfortunately though, these markets are so vast, ethics seems to be the only regulation that can guide these particular people in power, and clearly that does not always work.