Gold and the euro – neither decoupled nor a crisis hedge

Gold and the euro – neither decoupled nor a crisis hedge

                                                            

The first nine trading days of the year 2012 had been positive for gold. Compared to the close of the preceding year, gold rose by almost 100$/oz. The euro, on the other hand, came already under pressure after the Christmas holidays. The trigger had been a big sell order in cable in a thin market, which also dragged the EUR/USD exchange rate lower. After rebounding at the first trading day of this year, the euro weakened again versus the US dollar. However, the US dollar also firmed against other currencies and the US dollar index increased. Therefore, some market commentators already talked about a decoupling of gold from the US dollar movement.

Correlation is not causation. Thus, a weaker or even inverted correlation over a short period of time is not an indication that the traditional relationship between gold and the US dollar has broken down. Furthermore, the correlation coefficient would only be a suitable indicator if the there were only a mono causal relationship between gold and the US dollar. In econometric models for the price development of gold, the US dollar index would have to be the only significant explanatory variable. However, this is not the case! In our quantitative fair value model for gold, other variables like the S&P 500 composite index or the price of crude oil also have a statistical significant impact on the price of gold.

The implication of various factors having an impact on the price of gold is that other factors could move stronger and thus could more than compensate the impact of the US dollar. This is exactly what happened during the first two weeks of this year. The increase of the official PMI in China but also better than expected US economic data including the ISM indices triggered a rise in stock market indices as fears of a global recession decreased somewhat. This also had a positive impact on the price of crude oil, which also profited from geo-political tensions. The Western countries are preparing an embargo of oil imports from Iran while the regime in Tehran threatens to block the Strait of Hormuz. Furthermore, crude oil got support from a strike in Nigeria.

A major factor is still the concern about funding requirements of various countries in the eurozone. The placements of short-term money market paper went well. Germany could even sell 6mth bills at a negative yield. But more important, other countries, which had to pay higher rates in late 2011, could place their papers at lower yields. The litmus test had been the auctions of longer dated paper by Spain and Italy on Thursday and Friday last week. Spain found strong demand and sold twice as much as initially intended. Also Italy’s auction on Thursday went well. This had been positive for gold as it supported the euro and also stock markets moved higher.

However, last Friday showed that gold is not a perfect hedge against the crisis in the eurozone. Italy could raise the amount announced at lower yields. However, the market was disappointed about the bid/cover ratio, which was much lower compared to Spain’s auctions the day before and Italian auctions in December (when yields were far higher). This example shows that expectations are not always rational in financial markets. The Italian auctions already weighed on the EUR/USD exchange rate and lead to stocks paring earlier gains. Gold also traded lower dragged down by the firmer US dollar and stock market indices giving back gains. However, the major blow came in the afternoon.

Some eurozone government sources acted like criminal market manipulators by leaking to Reuters and other media that Standard & Poor’s would downgrade several countries in the eurozone, without providing further details. Normally, the rating agency announces a downgrade of a sovereign debtor after the close of US markets. The agency stuck to this procedure also last Friday. The downgrade rumors and the uncertainty about which country would be downgraded by how many notches sent shock waves through markets. The euro dropped by more than 2.5 cents and stock markets turned negative. Gold could not escape and also traded lower.

The US stock market recovered and closed near the high of the day. France was expected to be downgraded by two notches, but S&P reduced the rating by only one step to AA+. Thus, the initial reaction during European trading hours might have been an overshooting to the downside. Nevertheless, as we have pointed out several times, bad news about the debt crisis in the eurozone is no longer positive for gold, as it might have a negative impact on the major factors for the price of gold.

Thus, we still expect that gold will trade rather volatile during the first quarter of 2012 and could fall below 1,500$/oz. However, improvements of the crisis situation in the eurozone might set the stage for a strong upward move.