The tail wagging the dog and metal prices fall thereafter

The correction in precious metals prices might be approaching its end, because in the previous week panic has engulfed the financial markets and this is often a sign of a speedy turnaround. The trigger for this panic is the development of credit default swaps (CDS) with which investors can hedge against a possible insolvency of an issuer. The 5yr CDS rate for Greek government bonds climbed in the previous week, according to data from Markit to 425.18 bp, which is 20.84 bp higher than the level of the previous week and this, although, the EU imposed tight controlling measures on the budget of the Hellenic Republic, to reduce the deficit in relation to GDP and to push it back under the limit of 3% by 2012. Also the CDS rates on government bonds have increased significantly in Spain and Portugal, after Portugal at an auction, has not accepted the buyer demands and reduced the volume of emissions below the level intended originally.

Rising CDS rates on government bonds are supposed to be positive for precious metals as a safe haven, because they reflect that the financial markets priced in a higher probability of failure of a sovereign debtor. But things are not so simple, unfortunately. The yield spreads between government bonds of different countries in the euro zone and German Bunds as a benchmark are based on the development of CDS rates. If the CDS rates for Greece, Spain and Portugal desend, it also widens the corresponding yield spread over Bunds. This relationship is now providing for hedge funds and proprietary trading desks of investment banks, a very attractive playground. The market for CDS is in fact much narrower and less liquid than that for government bonds. Hedge funds can therefore already pushing CDS rates upwards with a low risk. At the same time they sell their bonds, so for example, from Greece, and buy in return German Bunds with approximately the same maturity. Rising CDS rates can therefore lead other investors to the assessment that the affected country really is heading for bankruptcy. These investors will be compelled either to sell their holdings in these bonds, or secure the holdings by buying CDS. They will, however, reinforce moves in the CDS induced by hedge funds, which in turn has an impact on the yield spread. The tail wags so successfully with the dog.



On the foreign exchange markets, the interest rate difference plays a major role. For the exchange rate of the euro against the U.S. Dollar, this is at the short end of the term curve, the difference between the 3M or 12M USD Libor and the Euribor. At the long end of the curve, the foreign exchange market has so far mostly focused on the yield spread between the 10yr U.S. Treasury and the 10yr German Bunds. With the outbreak of the crisis over the deficit in the Greek state budget late last year, this is pushed into the background and focus on the foreign exchange market is also directed to the CDS rates. Quite a few foreign exchange strategist and professor of Doom, Nouriel Roubini, predicted an end to the euro. With rising CDS rates for Greece, Spain and Portugal, the euro exchange rate against the U.S. dollar got more and more under pressure. Since the high of 1.514 at the beginning of December 2009, the euro has fallen by over 10% until 1.358 against the U.S. dollar.

Rising CDS rates for southern European countries in the euro area not only lead to an exodus of investors from the euro, but because of the stronger U.S. dollar also out of gold. But as pointed out above, a market panic indicates often that a movement is nearing an end. The technical picture of EUR/USD and gold indicates that the sell-off could be petering out. The recommendation might be, then, buyer beware, because unlike in the opera and theatre, there will not be a bell ringing for the entry.