“In Gold We Trust”

This is the headline at the title page of a German business weekly this weekend. It is an old market adage that it is time to exit a market if magazines report about this market on its title page. Given the price development of gold over the last two trading days of the previous week, the old wisdom seems to get it right again.

However, it is certainly not the reason gold dropped by 3.7% from the high reached on Wednesday to the close on Friday that a German business magazine devoted the title page to gold. The two factors causing this decline had been the FOMC meeting and the second press conference by Fed chairman Bernanke as well as the debt crisis in Greece and how the eurozone handles it.

Greece’s PM Papandreou reshuffled his cabinet the week before and faced a confidence vote in parliament last week. He survived this confidence vote. This week, the Greek parliament will vote on his austerity package. If markets were forming expectations rationally, as academic theory postulates, then markets should price in that with expressing the confidence to PM Papandreou, the majority of the lawmakers would also vote for his austerity package. However, financial markets still fear that the austerity measures demanded by the EU to support Greece would fail to pass the approval of parliament in Athens. As a result, the credit default swaps for Greek government bonds are still surging and the spread over benchmark German bonds and notes are rising. However, also the yield on German government bonds are falling due to safe haven flows into Bunds. The yield of 10yr Bunds dropped to 2.83% and is only 13bp above the eurozone inflation rate. Institutional asset managers taking their fiduciary duties seriously should not invest in bonds yielding less than the inflation rate. Nevertheless, they buy German government bonds along the curve and thus, harm their clients by holding bonds with a negative real yield.

Therefore, the Greek debt crisis has a negative impact on the euro directly and indirectly. The direct impact is the flight of capital out of the eurozone based on the fear of a Greek default. The indirect negative impact is via the yield and interest rate spreads, despite the ECB is going to hike the refi rate at the rate setting council meeting in July.

However, also the FOMC meeting had a negative impact on gold. The Fed revised its forecast for GDP growth down to 2.7 – 2.9% compared with 3.1 – 3.3% in April. The unemployment rate is now expected slightly higher at 8.6 – 8.9%. But unlike some market commentators and bank economists predicted, the FOMC decided to terminate QE2 as scheduled by the end of this month. In addition, as Fed chairman Bernanke pointed out, the Fed does not consider the implementation of QE3. However, it will reinvest proceeds from interest payments as well as maturing notes. Thus, the Fed will remain its current stance, but will not become more expansionary. As the market priced in further easing measures to support the economy, the US dollar recovered and this is a negative factor for gold.

We were never convinced by the argument that QE2 would be inflationary. The rise of headline CPI is the result of the supply shocks in the agricultural and crude oil markets. Both shocks are not the result of the Fed monetary policy. Nevertheless, those investors believing that QE would be inflationary had to revise their expectations about inflation after the Fed announce that they are not considering QE3, which is also a negative factor for gold and other precious metals.

All in all, we still expect the precious metal markets to consolidate over the summer month. The low reached in early May at 1,463$/oz should be a stronger support level.