The Greek Tragedy and Precious Metals

Last week, we argued that the comments from German finance minister Schaeuble concerning the markets initial reaction on the EU summit could lead to declining prices in precious metals markets. While this remarks also played a role, two other actors entered the stage on Monday and one of them moved even to centre stage for the whole week and is likely the dominating figure this week.

The first actor was the Bank of Japan, which intervened in foreign exchange markets to weaken the Japanese yen against the US dollar. The BoJ already intervened on several occasions before. Thus, it should not have come as a total surprise that the BoJ would try to prevent a further strengthening of the yen. The yen was regarded as one of the safe havens. This is very strange with respect to two factors. First, the earthquake and the Fukushima disaster have hurt the Japanese economy, which is in a recession. GDP dropped in Q2 by 1.1% compared to the same quarter of the preceding year. Industrial production in September was down 4.0% yoy and the trend is still further down. Currencies of an economy being in recession usually tend to depreciate but this is not the case for the Japanese Yen.

Second, government debt in relation to GDP in the US and in Europe appears to be a major concern for investors. However, the debt/GDP ratio in Japan is exceeding those ratios in the other industrialized regions by far, being around 200%. According to the criteria presented by Professors Kenneth Rogoff and Carmen Reinhard, Japan should already be beyond the point of no return and bankrupt. However, as the example of Japan shows, some critical ratios are not set in stone. The level of interest rates on government debt is also a crucial variable in the calculation at which debt/GDP ratio the interest payments are unbearable. With a yield on 10yr JGBs of just 1.0%, Japan is in a far more comfortable position.

Especially former and current German members of the ECB council should have a look at Japan. The quantitative easing of the BoJ contributed significantly to the decline of yields on 10yr government bonds. Despite the extension of the balance sheet by the BoJ, inflation has not emerged in Japan. Of course, one could not transfer the situation and monetary policy response in Japan on a 1:1 basis to the eurozone. Nevertheless, buying of government bonds of those countries in the eurozone, which came under attack from financial markets, is not a sure way to inflation.

After the Swiss National Bank pegged the Swiss franc to the euro, the appreciation of the yen increased. The yen fell to 75.5 at the last day of October. This induced the BoJ to intervene. The US dollar did not only firm against the yen, but also against other major currencies. This dollar strength send stock markets lower, which also pulled crude oil lower. As investors risk aversion increased, also yields on safe haven government bonds like the US Treasury paper or German Bunds dropped. In addition, the Schaeuble remarks contributed to a flight into Bunds as investors worried about the still open details of the EU summit package. As a result, also precious metals had been sold.

However, the centre stage was taken on late Monday by the Greek PM Papandreou, who announced to hold a confidence vote in parliament and later a referendum by the population. It was not clear, what would be the question for the referendum. However, given the polls on the rescue package decided at the EU summit, the markets feared that Greece would vote with a “no” in a referendum. This increased uncertainty send risky assets lower and safe haven Bunds and US Treasury notes higher. Precious metals initially fell further, but could already recover on Tuesday. The situation calmed somewhat after German Chancellor Merkel and French President Sarkozy called for a meeting with Greece’s PM Papandreou on Wednesday ahead of the 2day G20 summit. Both demanded that a referendum should be about Greece staying or leaving the eurozone. Furthermore, they announced that no funds would flow to Greece as long as the bailout package decided the week before will be fully implemented.

Holding a referendum on remaining a member of the euro would have been like playing with matches at a fill station. As soon as such a referendum had been called officially, the only rational behavior would be to withdraw all deposits with banks in Greece and transfer them to banks in other eurozone countries. If the result of a referendum would be to leave the euro, the new Greek currency would depreciate against the euro. Thus, one would make a profit. If the majority voted for staying in the eurozone, no currency gain would be made. However, there would be also no loss. Therefore, the financial system in Greece would have collapsed like a house of cards even before a referendum took place.

One Thursday, some movement came into the Greek political landscape. The finance minister opposed holding a referendum on staying in the eurozone. The PM Papandreou offered to give way to a coalition government of “national unity”, which should stay in power for some months to push all necessary legislation through parliament to implement the rescue package as agreed at the EU summit. Also opposition parties moved and showed some willingness to cooperate, but demands for snap elections in December remained on the table.

Friday night, PM Papandreou survived the confidence vote in the parliament. However, it is quite unclear how the political situation in Greece will develop. The major opposition party New Democracy insists on immediate snap elections. Some other parties in the centre appear to be willing to form a coalition government with currently ruling PASOK party. The main problem is that the party responsible for the mess torpedoes the clean-up work of the incumbent government to return back to power as soon as possible. Mrs. Merkel and Mr. Sarkozy should also make a strong call to Mr. Samaras, the leader of the New Democracy. All three are associated within the European Peoples Party, the conservative party in the EU parliament. But as long as Mr. Samaras puts his own interests above those of the Greece population, a solution appears hard to find. Thus, the political developments in particular in Greece, but also within the eurozone, are most likely the dominating factor for financial and metals markets. Investors should be on the defensive side as strong movements in both directions appear to be possible.