Intermarket relationships between equities and metals markets

This week, the outlook on the coming week is exceptionally not the main focus of this blog. Over the past week, we received some inquiries from Bloomberg and Reuters to comment on market movements of gold and industrial metals. The journalists were a little surprised that the price of gold rose, though, investors have once again leave the safe havens. It is a wide spread view that gold is a crisis metal. Too often, we read that gold and equities were not correlated, so that a simultaneous recovery of gold and stock markets, as in the previous week, surprises many market observers. Therefore, in this blog posting, we focus on the interactions between equities and metals markets as well as the status of gold as a safe haven.

Gold has the function of a safe haven for investors, but not in any crisis situation. It is essential, what kind of crisis it is, whether the price of gold also increases in a flight to a safe haven. Gold is then strongly in demand if investors fear the loss of purchasing power of their currency. The relationship between the gold price in USD and the inflation rate in the U.S. is indeed weak, but not between the gold price and the momentum of inflation. Rising inflation rates are positive for the gold price, while a trend of lower inflation rates leads to falling gold prices. It is also observed that the gold price rises normally, if the external value of the U.S. dollar falls (dollar weakness), and a firm dollar is negative for the gold price.

There is also often a flight into gold when it comes to a crisis of the financial system. However, in such a crisis, gold prices could also be falling, namely when other asset prices plunge, and investors, who partially funded their positions through credit, need to sell gold to offset the losses in other assets. Then gold can also be dragged down despite a crisis situation. However, This should not have been the case in the third week of May, given the fact that gold holdings by the largest gold ETF, the SPDR Gold Trust, were still increasing.

Gold is indeed secure against a loss by atrophy, but not against a loss of value due to price fluctuations. It should therefore come as no surprise that investors consider gold as a risky investment. If the risk aversion of investors increases, this is also negative for the risky investment gold. The volatility indices for the equity markets, as the VIX in the U.S. or the VDAX in Germany, are a common measure of risk aversion. When these indices rise sharply, it is usually negative for gold. The stock market is a leading indicator for economic development, though not very reliable one. Nobel laureate Paul Samuelson once mocked that the U.S. stock market has properly anticipated nine of the last five recessions. If stock markets panic, then investors almost reflexively flee in government bonds as a safe haven, but not in gold. This reflects the sharp decline of yields for U.S. Treasuries and German Bunds. Falling stock indices signal a weaker economic activity, this is also a negative signal for the demand for industrial metals, so that even this group of commodities is pulled down by falling stock indices.

Towards the close of trading before Pentecost, the U.S. stock market had recovered significantly from the lows recorded at the end of trading in Europe. This development led to a stabilization of stock markets also in Asia and Europe at the start of the previous week. Markets came again a bit under pressure in the short term after the FT reported that China would turn away from European government bonds. But the denial from China then triggered a rally of stocks, precious and industrial metals. After the close of trading in Europe on Friday, the rating agency Fitch has announced that it lowers the rating of Spain to AA+ from AAA because the austerity measures would lead to lower growth. Too bad, the rating agencies have threatened to downgrade Spain if no measures were taken to reduce the budget deficit. One could get easily the impression that Spain should be downgraded, no matter on what grounds. For the equity markets this could trigger a new wave of falling prices, which should then also have the negative impact metals markets.

Panic on financial markets weighs on metals

The international financial markets are in a state of panic, and this weighs on the metals markets. Even the precious metals can not take advantage of their status as a safe haven but are under considerable pressure too. As long as there is fear among investors, the metals markets should also struggle to recover.

"We have nothing to fear but fear by itself" This quote a former U.S. President, which was taken up by the former Fed chairman Greenspan during the crisis after the bursting of the dot.com bubble is also true in the current situation again. Markets are dominated by fear, initially that Greece would go bankrupt. After the yield spreads over the Bunds as benchmark for the eurozone had widened and the CDS had risen strongly, the rating agencies fanned the fear further with the downgrading of Greece, Spain, and Portugal or with the threat of deteriorating ratings. A rescue package for Greece missed the expected effects on the markets due to the reluctance of the German government, particularly of Chancellor Merkel and Foreign Minister Westerwelle. Although Greece was hereby able to meet the payment obligations in 2010 and 2011, the markets fell further into trouble. The EU had to agree on a second bailout package totalling 750 billion euros and the ECB has taken the decision to buy government bonds from the countries concerned in the secondary market. But even this could not calm the situation sustainably and the euro fell to 1.21 versus the US dollar.

The widening of the yield spreads for the countries of the euro zone periphery, which went so far that Greece could not finance on the capital market, naturally has an impact on the budget policies of the countries concerned. They have taken additional measures to reduce the budget deficit and avoid a further downgrading by the rating agencies. Actually, this would have to be welcomed by financial markets, as it reduces the likelihood of bankruptcy. But in the financial markets, it has only reinforced the fear. Now the major fear is that these savings will reduce the growth in Europe. But this overlooks that the weak euro makes a positive contribution to the euro zone economy as exports get more competitive.

The culmination of the panic in financial markets was recorded in the past week and starting point was once again Germany. The Finance Ministry has informed a long time that it is working on a bill, among other things, also the general prohibition of naked short selling is scheduled. Thus, in fact, the decision of last Tuesday to ban from Wednesday on naked short sales in shares of financial institutions, government bonds in the euro zone and the purchase of CDS without actual risk positions should not come as a surprise. Nevertheless, the financial markets panicked. Markets have overlooked that covered short sales are still allowed. This is actually the normal procedures to the financial markets. Especially pronounced was the panic on the U.S. markets, although here naked short selling is not allowed for some time. Furthermore, in Germany the settlement in the spot market takes place after two or three days, thus, there is little scope for naked short selling anyway. Thus, the financial markets have made a mountain out of a molehill and fell panic. The comments in the media have intensified the panic. In this situation, it seems almost paradoxical that investors did not flight into the safe haven of gold, but in U.S. Treasuries, whereas the debt of the United States is significantly higher than that of the eurozone as a whole. Even Bunds continued to rally, even though they are no longer needed as an instrument for spread trades against bonds of the periphery in the case the ban by Germany should be as effective as markets fear.

On the metal markets  it is argued that investors needed to sell gold to cover losses elsewhere. This argument is unconvincing. The stock markets have fallen in the first week of May already under pressure and it came to the so-called "flash crash" in the US. This should have been even then a reason for investors to sell gold to cover losses in stocks. But gold continued to rise up to a new record high. The latest data from the CFTC on the "commitment of traders' does not provide evidence that the large speculators have liquidated their gold positions to a considerable extent. Furthermore, the gold holdings in the largest gold ETF, the SPDR gold trust, increased in the previous week yet.

The precious metals are regarded among investors as a risky investment. It often appears that the prices of precious metals also come under pressure if the risk aversion of investors rises dramatically. Then not only stock prices are dropping, but also metal prices are falling. The volatility indices like the VIX in the US or the VDAX are regarded as a measure of risk aversion. Both indices have increased significantly in the last week and have more than doubled since the lows of April. In the previous week, they reached the highest levels since early 2009. It often appears that gold gives way to a sharp rise in VIX index. It is a negative factor for the metals of the platinum-group that the car's shares also fell strongly in the previous week, which is considered in the markets as a sign of lower demand for platinum and palladium from this industry for the production of catalysts.

The other fundamentals have not developed positively for the precious and industrial metals. The US economic data were somewhat weaker than expected. The oil price has fallen temporarily under the mark of 70$/bbl. Although the US dollar traded weaker versus the euro in a week-over-weeks, comparison, the euro traded very weak at the beginning of the week and EUR/USD fell to 1.21. But the U.S. dollar traded firm against other major currencies. Thus, the US dollar was probably on balance more a burden for precious metals.

On Friday, the US stock recovered in the last hour of trading after the indices had pared previously made profits. In the case this was merely short covering before the weekend, the market could remain under pressure in the coming week, which would be negative for the metals markets. However, if the stock markets continue to stabilize, then this would be positive for the metals markets. But given the panic in the previous week, continued caution is appropriate.

Gold with new record high

After gold has reached a new record high in the previous week and also closed above the previous high, there is certainly still scope for a further rise. However, we advise caution, because the reasons for the increase to a new record are by no means convincing, and gold does not follow the usual fundamentals. Once investors return again to a sober analysis, this could have a negative impact on gold.

The participants in the financial markets form rational expectations. This is assumed by the academic theories. But it was observable during the financial crisis in 2008 that this assumption is not justified. And the development in the financial markets in the previous week clearly underlines this again. The herd of lemmings and the "stories" of analysts and so-called star economists to get the attention of the media play an essential role in the development of the markets. In addition, some commentators do not understand the context. The best example is the German magazine Wirtschaftswoche, which reproduced on the front page of the current issue a death notice for the euro. But it is well known, that those who are assumed to be dead live very long.

The EU decided in a late night meeting before the market opened last Monday (11th May) to defend the euro with a package with a total volume of € 750 billion. The ECB has held the same night a conference call and voted with a broad majority that it buys government bonds in the secondary market, but is absorbing the liquidity provided thereby otherwisee. The ECB has taken the right decision in this situation, because it is their mission to secure the currency. The threat was a conflagration and the collapse of the European Monetary Union as a result of attacks by the rating agencies and financial markets on the countries of the so-called periphery. Through the purchase of bonds of the countries concerned, however, the yield spreads against government bonds and credit default swaps have reduced again. Again, it was the representative of a German institution being responsible that the initial positive development could not continue, but reversed. Bundesbank chief Weber has commented negatively on the impact of the purchase of government bonds in the secondary market. It is incomprehensible that this man is supposed to be the next President of the ECB.

It is criticized by commentators that the ECB would have given up its independence with the decision on the purchase of government bonds in the secondary market. This is absurd, because the decision was still made by the Governing Council. The ECB is challenged to act quickly in crisis situations, and this was at the weekend concerned the case. Just because the head of the German Bundesbank does not understand the seriousness of the situation and the effect of the purchase of government bonds in the secondary market, it is not an issue of independence if the majority of the Council comes to a different assessment. Moreover, the ECB buys also bonds in the repo transactions. The only difference is that the ECB has not fixed timing for the sale of the bonds back to the original owner and the title can be held to maturity. And when ECB was forced to take the decision of the direct purchase of government bonds in the secondary market, this was due to developments on the markets. And of these, no central bank is truly independent.

The other criticism is the argument that the purchase of bonds in the secondary market would lead to inflation. This argument only testifies a fundamental lack of understanding of economic relationships. ECB President Trichet rightly stresses that the purchase of government bonds in the secondary market is no "quantitative easing is" as it is operated by the Fed or the Bank of England. The liquidity that is flowing through the purchase of the bonds in the market is absorbed again by other means. If the liquidity effect of a measure is sterilized, however, a widening of the balance sheet of a central bank - which is a prerequisite that can lead to inflationary effects - will be avoided. But even with a balance sheet extension, a rise of inflation is not the inevitable consequence. If the interbank money market does not function properly because the banks trust each other no more and prefer deposits with the bank, the balance sheet of a central bank can extended, but the net loans to commercial banks do not necessarily have to rise. The ECB sticks to its primary goal, to keep the inflation rate below, but close to 2%. Whoever sees inflation risks, also believes in ghosts in English castles or the monster of Loch Ness.

It is found also in another context that the expectations of market participants are rational. For many weeks the dominant fear in financial markets was that Greece could suffer a national bankruptcy and other countries in the euro area might be infected thereof. Germany has repeatedly stressed that further savings in the national budgets of the affected countries with a large deficit to GDP ratio is an indispensable prerequisite to agree to an aid package. With the decision of the previous weekend, the risk of state bankruptcy or a "hair cuts" has clearly diminished. But now the financial markets fear the impact of the austerity measures, which they themselves have forced governments to impose, on the GDP growth rates in the euro zone. A weaker growth would not lead to an acceleration of inflation. It is absurd to expect both developments simultaneously. After the initial recovery up to 1.307 against the U.S. dollar, the euro has therefore once again come under pressure and fell to 1.236 U.S. dollars by the close of the week.

The rise in gold prices is thus based on a total of no load bearing foundation. Major fundamental factors as the EUR / USD exchange rate and the oil price are negative. Inflation fears may well have driven the flight to gold as a safe haven, but it is unfounded and in the medium term, the eurozone is more likely to struggle with the opposite. The gold price may rise even further in the short run, but it applies the principle of "caveat emptor".

Gold now on the way to a new historic high

In assessing the development of the gold price in the previous week we were correct, but the main reasons for the increase were the continued fear of a default of  Greece as well as a contagion of Portugal and Spain. But as long as the investors act out of pure panic and do not reflect the fundamentally different situation in other countries of the eurozone, a continuing flight to the safe harbour of gold has to be expected. The next goal is a rise to a new historical high above 1,226.1$/oz. 


After Standard & Poor's has already down graded the rating of the two Iberian countries, now Moody's  threatens to lower rating of Portugal’s creditworthiness. Spanish bonds at an auction had to be offered a higher return, but the demand exceeded expectations. This underlines really that Spain can continue to finance on the capital and is far from a bust. However, since the ECB had not discussed in their meeting on Thursday the purchase of government bonds in the secondary market, the market fell again in panic. 


The Greek Parliament has approved on Thursday the austerity package negotiated by the Government with the EU and the IMF. In Germany, the aid package for Greece, as was expected, has found a broad majority in the Bundestag and Bundesrat on Friday. The Act came into force on the same day. The Federal Constitutional Court has rejected an emergency petition to stop the credit disbursement to Greece. Therefore, the conditions exist that Greece receives timely financial resources to be able to afford this month pending redemption and interest payments. Nevertheless, the market has not calmed down. 


Gold could also benefit from falling prices on the international stock markets, particularly on Thursday after the Dow Jones index within minutes fell by almost 10% compared to the previous close. As long as it is not clear what caused this plunge, the nervousness in the equity markets is likely to prevail, as it has shown so well on Friday. This then remains for gold also a positive factor. 

On foreign exchange markets the euro is under continued pressure against the major currencies. Against the US dollar, the euro fell within a week up to about 8 cents to $ 1.252. In particular, the comments from U.S. analysts and investors are negative about the prospects for the euro. Some commentators even argue that Germany could leave the euro. This argument is absurd, given the advantages Germany pulls out of monetary union. But it could be repeated in the case of a defeat of the ruling parties in state elections in North Rhine-Westphalia. 

The EU leaders, at their meeting on Friday announced that the institutions of the EU were decided to fight against speculations and attacks against the euro and the monetary union. They have thus, in the words of former U.S. Treasury Secretary Hank Paulson during the financial crisis in 2008, put the bazooka on the table. However, this is not enough any more. The EU institutions also need to use it to calm the situation in financial markets. This would require that also the ECB supports the measures. Both, interventions in the foreign exchange market and the direct purchase of government bonds from the periphery of the euro zone on the secondary market, would be necessary. Only if speculators are forced to cover their short positions in the euro and the government bonds of Greece, Portugal and Spain, it may lead to a sustainable stabilisation. For gold, this is by no means negative. First, a recovery of the euro should stimulate demand for gold rather than be a burden as some investors who bought gold as a hedge against a state bankruptcy, are likely to remain sceptical and are expected to hold their stocks. Second, some market participants might classify the necessary measures of the ECB as inflationary, if the liquidity provided will not be absorbed otherwise. Gold could very well rise to a new historic high.

Gold is likely to test 1,200$/oz mark

The Greek government has reached an agreement with the EU and the IMF on an additional savings program. This should stop the decline of the euro and could lead to a recovery against the US dollar. Gold should benefit from this development. The large speculators should increase their net long positions further, as it was the case in the previous week. Therefore, gold could test the psychological resistance mark of 1,200$/oz. Indeed, even an increase to a new all time high is not excluded.

Early on Sunday morning, the Greek government has agreed in the negotiations with the IMF and the EU on an austerity program that contains further cuts in civil servants salaries and pensions. Also another increase in the VAT rate is on the program. The decision by EU finance ministers still pending at the time this blog post was written. But it should be positive for Greece. In Germany, the federal government will on Monday decide on the bill and the legislative process is scheduled to be completed by Friday of this new week. Greece could obtain the funds timely before the maturity date of 8.5 billion euro for mid-month and thus, can redeem the bonds. Overall, Greece will receive 45 billion euro of credit by EU and IMF this year. So far it has been assumed that this is sufficient to avoid bankruptcy in Greece. However, the Greek Prime Minister Papandreou said today that his country would need 60 billion euro in order to avoid state bankruptcy.

In the financial markets, some recovery should therefore occur, although, it might be only a modest one, given any remaining doubts about the solvency of Greece. The euro is likely to stabilize and recover slightly against the US dollar. Thus, any effect on the gold price is positive. Those investors who bought gold as insurance against bankruptcy of Greece are expected to keep their positions. And investors buying gold as a hedge against a weaker dollar should return as the buyer to the gold market.

According to the latest report from the CFTC on the "commitment of traders", large speculative addresses such as hedge funds have increased their net long position in the week ending 27 April again. Now it stands at its highest level since mid-January. In the chart, the gold price is shown as of the reporting deadlines for the net long position of the large speculators. As the price of gold after 27 April has risen further, large specs should not have reduced their positions. With rising gold price, net long positions could increase and thus support the rally in gold. Gold is expected to test at least the psychological resistance mark at 1,200$/oz. In the case of a breakthrough, even a new historic high could be reached.