Precious metals down again on eurozone debt crisis

Most precious metals posted losses again the past week. Only palladium bucked the trend and gained 6.4% on the week. Palladium is driven by the outlook for a supply deficit in 2012 due to declining stocks and production in Russia. The usual drivers for the price of gold were mixed last week. The US dollar index firmed slightly, which was a bit negative. The price of crude oil declined and thus weighed on gold. The rise of the S&P 500 index was a supportive factor, but could not compensate the negative factors. However, one has to take into account, that the strong rise of the S&P index on Friday pushed the index back into the black. Gold followed the stock markets most of the week, but not on the last trading day of the week.

The S&P 500 has also been influenced by the developments in Europe. However, also US economic data had an influence. While a few month ago, most US economists were convinced that the US economy would head towards a double dip recession, the macro-economic data is by and large better than economists predicted. We pointed out several times in August and early September that we don’t expect a recession in the US. Also the labor market shows signs of improvement. Therefore, from our point of view, the S&P 500 index has further upside potential, especially in the case that the debt crisis in the eurozone gets solved. However, one caveat has to be made. The winter season could lead to slower economic activity as it had been the case in Q1 this year. Thus, our medium-term assessment of the price development in precious metal markets remains positive.

It could not be repeated often enough; the key for rising precious metal prices is a convincing solution of the debt crisis in the eurozone. This past week brought a major improvement, but also a major set-back. At the beginning of the week, France and Germany agreed on a proposal to change the EU treaty. According to this plan, national states would have to include the requirement of balancing the budget in their constitutions. Individual states violating the 3% deficit criterion of the Maastricht treaty would face an automatic procedure to get penalized. The EU commission would have to send the case to the EU court. At the EU summit, 26 of the 27 member states approved this proposal, only the UK opposed it. However, the 26 supporting states will go ahead without the UK in implementing the proposals. These proposals that eurozone member countries follow a responsible fiscal policy might be important in the medium-term, but they unlikely solve the problem in the short-run. As one of the five economic advisers to German chancellor Merkel put it, the German chancellor sees the problem of the debt crisis as one-dimensional while it is multi-dimensional in reality.

And it was this one-dimensional position of Germany, which prevented a solution convincing financial markets also in the short-term. However, Germany also had to make some concessions. The national central banks will lend 200bn US dollar to the IMF, which then can provide funds for leveraging the EFSF. In addition, the EMS, the stabilization mechanism, which should be a permanent institution, will start working already in July 2012 instead of January 2013. The major task is to restore confidence in the market for government bonds in the eurozone. These measures are probably insufficient to fulfill this task. Given the volume of bonds, which have to be refunded in 2012 by the countries being under attack in bond markets, the funds of the EFSF could be exhausted already in H1 next year in the worst case. Bond market strategists pointed this out already in their research papers.

Further measures to stabilize the government bond markets in the eurozone would be either to provide the EFSF or EMS with a banking license or that the ECB acts as lender of last resort. However, both measures have been blocked by Germany. It appears that Germany follows a new kind of beggar my neighbor policy as it is profiting from absurdly low interest rates on government bonds and notes, while other countries with similar or even better fiscal positions (Spain has a far lower debt/GDP-ratio than Germany) have to pay far higher interest rates to sell their bonds.

The ECB demonstrated again that a few words could do more harm than the benefits of some right measures taken. At the monthly rate setting meeting, the ECB Council decided to cut the refinancing rate by 25bp to 1.0%. Furthermore, the ECB extends credits to banks to up to 3years and accepts collateral with lower credit quality. The intention of these measures is to increase bank lending to the real economy. However, these measures are likely less effective as long as the tensions in the government bond markets persist. At the speech given to the EU parliament, ECB president Draghi created the impression that the ECB would be ready to buy government bonds in the secondary market more aggressively, if the EU agrees on stricter rules for fiscal policy in the eurozone. At the press conference following the council meeting, Mr. Draghi stated he was surprised by the interpretation of his remarks. He turned a cold shoulder to buying government bonds to reduce yields on bonds of pressured countries like Spain and Italy. That was not super, Mario!

As long as the ECB is not acting as a lender of last resort and uses its unlimited power to restore confidence in the market for eurozone government bonds, there is no lasting and convincing solution of the debt crisis in the eurozone. Furthermore, it is likely that the measures taken by the ECB fail to stimulate bank lending to the private sector sufficiently. The risk of stagnation of even recession in the eurozone is increasing. In this environment, also downside risks for the precious metals prevail. However, once the market for government bonds are stabilized and yields on Spanish and Italian government bonds come down to more sustainable levels, the precious metals might be in for another strong move upwards.