Macro Wrap-Up

All That Glitters

Topics - Macroeconomics

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All That Glitters

No figures loom over commodities markets quite like the Hunt brothers. Nelson Bunker Hunt and William Herbert Hunt were wealthy oil heirs who hatched a scheme in the late 1970s to corner the silver market. It was said that at their peak they owned over two-thirds of the privately held silver in world. 1 1 Close Business Insider: “Here’s the story of how the Hunt brothers tried to corner the silver market,” 5/17/16. Their plot attracted so much attention that Tiffany & Co. took out an ad in the New York Times accusing them of market manipulation. 2 2 Close The ad didn’t include an empty blue box. It was only after some bold moves by the COMEX exchange that they were foiled. 3 3 Close They would have gotten away with it, if it weren’t for those meddlesome futures exchanges. Still, their legacy includes being the inspiration for the Duke brothers in Trading Places and the institution of position limits. During the Hunts’ heyday, silver was probably the most newsworthy market in the world, which makes its current status in the market hierarchy seem a little sad. This summer, silver was one of the best-performing assets of any kind, without attracting much media attention. Its price appreciated so quickly that it looked like it was going to go back in time on price charts. It even outperformed its press-hogging brother, gold, but few people seemed to notice. Last week silver gave up some of its gains, one the many market reversals of early September. Articles in the financial press strained to find grand theories to tie together moves in short rates, the shape of the yield curve, value stocks, and momentum factors. But few if any writers considered silver in their convoluted theories. This week, we’ll correct that oversight.

Chemists will tell you there are many types of metals in the periodic table. Traders will tell you there are only two: base metals, which derive their value from their use in industry, and precious metals, which derive their value from their use as “a store of value.” 4 4 Close Yes, it’s circular. It has value because people think it has value. In the past, physical gold and silver were used as a medium of exchange, but that’s just not practical anymore. For nitpickers, there are also ferrous metals, but most traders don’t care about them. Anyone disagree? Copper, aluminum, nickel, and zinc are all base metals. 5 5 Close Can you imagine a world without zinc? Gold is the quintessential precious metal. Despite having many potential practical applications, it is primarily used to make jewelry and to take up space in vaults. 6 6 Close So it’s got that going for it. Which is nice. The characteristics that make it precious are its limited supply, its shininess and the fact that it can’t be reproduced even by the best medieval wizards. The amount of gold mined each year is small compared to the amount outstanding in the world, so supply is relatively stable. Gold has a long tradition of use in currency. 7 7 Close It dates back to King Croesus and the ancient Lydians. Croesus, who is credited with first using gold as currency, was defeated in war by Cyrus II of Persia in 546 BC, but to this day he still appears in crossword puzzles.

Silver has some of these characteristics as well. It had been used as currency for hundreds of years. However, it is more plentiful than gold and often appears as a biproduct in the mining of base metals. It is used in electronics and other industries, so it can be considered as either a base or a precious metal. In reality, silver is probably more of a precious metal only because people think it is a precious metal. It usually seems to behave like one.

For much of this year most base metals have underperformed precious metals. 8 8 Close One big exception is nickel. It is up over 60%. That’s a lot more than 5 cents. Source: Bloomberg. This divergence is consistent with poor manufacturing and industrial production numbers. The trade war and slowing growth in China is weighing on demand for base metals. This weakness in global business investment, however, doesn’t explain why precious metals have done so well, only why base metals have lagged. There are additional drivers unique to the precious metals.

Investors often view precious metals as safe-haven assets. They think that when there are financial crises, gold and silver can hold their value while other assets such as equities collapse. Precious metals are also used as an inflation hedge. The idea is that as excess supply of a currency causes it to be devalued, precious metals can appreciate as people look for literally harder currency, which remains in limited supply. So some people think precious metals can do well when prices go up and when prices go down. 9 9 Close Kind of nice if it were true. The history is very mixed. Silver and gold performed very well in the inflationary heyday. Since then, the relationship hasn’t been as clear to either inflation or crisis. Neither performed well after the 1987 crash, but gold did well post-financial crisis. Silver is considered somewhat less precious than gold, so it may lean more toward being an inflation hedge. Probably the best environment for silver would be high growth and high inflation, at least in theory. 10 10 Close Silver may underperform gold in a high inflation and low growth environment.

The current environment does not seem ideal for either inflation hedges or safe-havens. Consumer prices have been steady. While some economists are forecasting weaker growth or recession, the global economy is still growing, and equities are up in most countries so far this year. It is possible that unrest in Hong Kong and the trade war are fueling demand for silver, but most articles and research pieces attribute its recent meteoric run to the fall in interest rates. Now, it is always a good idea to exercise caution when analysts attribute things to interest rate moves. If a butterfly flaps its wings in the wild, macro commentators will say it was caused by a change in interest rates. Nonetheless, in this case, the interest rate argument makes sense on the economics. The yield on paper assets can be viewed as the opportunity cost of holding precious metals. When yields fall, it costs less to hold gold or silver. However, market action doesn’t always conform to theory. When bonds rallied in the spring of 2019, the price of silver fell. It wasn’t until the first Fed cut became imminent that silver started to rally. When the Fed cut rates in July, silver took off and continued to rally until expectations of future cuts cooled.

The rise in silver tells us something about investor sentiment right now. It is as much about perception as it is about any fundamental driver. It shows that investors are concerned about the effects of low interest rates even if they haven’t resulted in higher consumer prices. Some investors are reaching for return when it is difficult to find yield anywhere in the developed world, which may be why silver is especially sensitive to interest rates now. It may be an indication that loose central bank policy is getting some traction, although not in the areas that the policy-makers want. Investors should take silver’s rise as a reminder to watch inflation numbers. Still, it’s no reason to panic: even though the move was sharp, silver is well within its historical range. It is nowhere near levels that would make you think that Duke and Duke were trying to corner the market.

What We Are Watching

 FOMC Meeting (Wednesday)

The Fed faces a challenging environment for monetary policy. While U.S. manufacturing data has weakened and global growth and trade uncertainties remain, the U.S. consumer has remained resilient and it appears U.S. and Chinese trade negotiations have improved at the margin. Fed Funds futures are currently pricing around two more 0.25% rate cuts in 2019, with one of those cuts fully priced for this week’s meeting. Recent Fed speeches suggest the Committee is divided around the path forward, with some policymakers sounding hesitant to commit to cuts after the September meeting. Looking at the recent rise in core goods inflation in the U.S. and the continued strength in the labor market, the Fed may not be inclined to endorse the market’s pricing around further easing. The post-meeting statement and Chair Powell’s press conference will be closely watched for any hints around what would trigger further easing and the Fed’s current view on outstanding risks. The Summary of Economic Projections (SEP) to be released at this meeting will also provide a quantitative read on the Fed’s expectations. A less dovish tone or an SEP that shows fewer cuts than the market is expecting could fuel further weakness in fixed income.

Switzerland Central Bank Meeting (Thursday)
Recent statements indicate the Swiss National Bank (SNB) views the Swiss franc as “highly valued” and is willing to intervene in the foreign exchange market to curb its appreciation. Following this week’s rate cut from the European Central Bank (ECB), it would not come as a surprise if the SNB decided to cut rates as well to avoid further currency appreciation. The low level of the policy rate in Switzerland does not preclude additional cuts. The SNB appears open to further rate cuts from the low current level of -0.75%, as the central bank believes its system for mitigating the cost of negative rates for financial institutions has been effective. On the other hand, SNB head Thomas Jordan recently played down risks of a global recession, which would argue for no need to change policy imminently. The decision is a close call, and a hawkish outcome could lead to a rally in the franc.

Bank of Japan Meeting (Thursday)
Japanese monetary policy has been broadly unchanged over the last three years, with the overnight rate steady at -0.1% and a target interest rate of 0% for 10-year Japanese Government Bonds (JGBs). As global growth has slowed in recent quarters, the Japanese economy has lost momentum as well, and an upcoming Consumption Tax hike in October could further weigh on growth. The Bank of Japan (BoJ) has sounded relatively upbeat on the outlook for growth and inflation, but noted in its most recent statement that “the Bank will not hesitate to take additional easing measures if there is a greater possibility that the momentum toward achieving the price stability target will be lost.” 11 11 Close Bank of Japan Statement on Monetary Policy, 7/30/2019. While no policy change is expected at this month’s meeting, Japanese fixed income markets are pricing additional easing over time, with both short-term and long-term bond yields currently below BoJ targets. 12 12 Close As of this writing, 2-year and 10-year JGB yields were at -0.27% and -0.21% respectively, pricing data from Bloomberg. If BoJ Governor Kuroda indicates that the BoJ is considering a rate cut, it could support Japanese fixed income and put downward pressure on the yen.

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