Recovery of the euro supports gold

One of the factors contributing to the fall of gold and other precious metals in late September was the weakness of the euro versus the US dollar. Beside the inability of politicians to solve the debt crisis in the eurozone and fears that the troika of IMF, EU and ECB would block the payment of the next tranche of bailout funds, the euro weakened also on speculation that the ECB would quickly reverse the direction of monetary policy. However, the ECB disappointed hopes to cut rates already at the October council meeting. The ECB repeated its stance in the monthly bulletin released last week. Inflation is expected to stay high during the final months of this year and is expected to decline next year. The risks for economic activity have increased due to the heightened uncertainty, especially in financial markets.

At least, the ECB forecast appears to be right for the trend of consumer price inflation. In the eurozone, the HICP inflation rate increased to 3.0% in September after 2.5% in August. Also the core inflation rate increased to 1.6% from 1.2% in August. Now also the underlying trend of inflation is getting closer to the crucial 2% mark. Thus, before cutting interest rates and embarking on a more expansionary monetary policy, the rate setting council might wait until the inflation data indicates that the peak has been reached. This would argue more for a rate cut at the end of this year or the beginning of 2012.

The fall of the manufacturing PMI for the eurozone to 49 in September and to 48.5 in October was probably a factor contributing to the warning of the ECB that downside risks for economic activity have increased. However, is seems that the turbulences in financial markets had an impact on the PMI, while actual economic activity is affected far less by the plunge of stock markets in August and September. The consensus of City economists expected that industrial production in the eurozone would decline by 0.8% in August. Instead industrial output increased by 1.2% on the month. While the fall of the PMI below the 50 threshold indicated a contraction in the manufacturing sector, industrial production expanded even faster than in July, which had been revised up to +1.1%. Despite increased risks, they have not yet materialized.

Thus, the ECB appears to be in a fix. Cutting rates early despite still robust economic activity data and inflation above the target by a full percentage point could prevent inflation to come down significantly next year. Waiting too long with a rate could bear the risk that economic activity eventually follows the PMI indicators down and that a possible downswing might be aggravated. This also indicates that the ECB would not be as quick in cutting interest rates as the market consensus had expected.

Keeping interest rates on hold will have an impact on gold and other precious metals via two channels. First, it has an impact on the exchange rate of the euro versus the US dollar. As long as money market rates remain higher in the eurozone compared to the US, there is an incentive to invest funds in the euro instead of the dollar. However, in this context also the eurozone debt crisis and the impact on the banking system play a crucial role. Plans to shield banks against the fallout of a possible default of Greece could reduce the risk of investing funds with European banks and thus could also contribute to a further appreciation of the euro versus the US dollar.

The second channel is via stock markets and risk appetite of investors. A delay of a rate cut due to firm economic data could reduce the fear that the global economy would head towards a recession. Value oriented investors already regard stock valuations as cheap after the drop in August and September. Thus, the risk appetite of investors could increase further and push stock market indices higher. A higher risk appetite would also be positive for gold and other precious metals.

Despite the better than expected economic data in the eurozone and also the US, the crucial factor remains the debt crisis in the eurozone. The G20 finance ministers urged the eurozone to present a solution to the debt crisis within one week at the next EU summit. Germany’s finance minister promised that the eurozone would deliver a solution. If it will be one convincing the markets, the euro might firm further and precious metals would probably be a beneficiary.