The US dollar is not the only driver of gold prices

Last week, the US dollar firmed against the euro and other major currencies but nevertheless, gold rallied. While the US dollar is a major factor for the development of the gold price, it is not the only one. In our quantitative fair value models for gold, also the price of crude oil, the S&P 500 index as well as the yield on 10yr US Treasuries play a crucial role in explaining the price development of gold. Furthermore, there are factors, which play a role for a certain period of time, but which could not be included in a quantitative model. One such factor is the current debt crisis in the eurozone.

On Tuesday, when markets were already closed in Europe, Moody’s announced that it downgraded Portugal government debt to junk status because the rating agency does not believe the new government would be able to implement the austerity measure and would be able to borrow in capital markets again in two years time. Thus judgment is not well founded because the new government is just a few days in office and this is too short to make a sound assessment. Also the new government in Portugal has a broad majority in the parliament to push through necessary reforms. Furthermore, Moody’s forecast could become a self-fulfilling prophecy. Again a rating agency poured oil in the fire. Nevertheless, financial markets reacted on the downgrade by selling the Portuguese government bonds, driving CDS higher and selling the euro. Gold was sought as a safe haven.

Rumors about European banks failing to pass the stress test were spread around. However, on Friday a report about an EU draft that governments should recapitalize banks pushed spreads over German government bond benchmarks higher and set the euro under further pressure. This increased the attractiveness of gold even more.

The ECB increased the refinancing rate at its policy setting council meeting as expected. At the press conference, ECB president Trichet indicated that another rate hike later this year is likely by using the key words “monitoring very closely” the development of the inflation rate. However, this supported the euro only briefly.

Supportive for gold had been that crude oil prices and the S&P 500 Index ended the week higher, despite the losses both suffered on Friday. Thus, both factors were on balance supportive for gold and compensated the negative impact of a firmer US dollar.

Gold got a stronger push to the upside last Friday after the release of the US labor market data. The ADP estimate of private sector payrolls released the day before surprised to the upside. Thus, the market revised its expectations for the non-farm payroll figure even higher. However, with only 18 thousand new jobs created, the non-farm pay roll figure came in even below the downward revision for May. Also the unemployment rate edged higher again to 9.2%. The 10yr US T-Note future rallied by more than a full point from the previous close and more than 1.5 points from the low of the day. Gold also jumped higher after the release of the US labor market data. This indicates clearly, that the markets expect not only that the Fed will keep interest rates at the low level for an extended period of time, but also speculates the Fed would embark on QE3.

However, there are a few points to keep in mind when drawing conclusions about the labor market report and the further Fed policy. First, one reason for the weak non-farm payroll figure was the government sector. US states have to reduce staff to keep the budget balanced. The state of Minnesota is practically bankrupt despite still being rated AAA by the agencies. The Federal government faces the deadline for an increase of the debt ceiling approaching quickly without a compromise being in sight. Thus, it should not come as a surprise that the public sector is reducing its workforce. The US economy has worked through the impact of the catastrophe, which hit Japan in March. This is reflected in the slow increase of new jobs in the private sector. The summer vacation season is period, where companies are a bit hesitant to hire new staff. This might also have played a role for the June labor market data. Seasonal adjustments can even aggravate the problem if there are slight deviations from the seasonal pattern.  In addition, the labor market is not a leading indicator of economic activity but a lagging one. The leading economic figures all indicated lately, that the US economy is recovering from the negative impact of the catastrophe hitting Japan. Thus, it is far more likely that the Fed is just waiting to get a clearer picture of the state of the US economy. Talk about QE3 might prevail for some time. However, the recent labor market report is not a reliable indication that the Fed would resume buying Treasury paper. Thus, the rally of gold might continue in the short-run, but if the US economy continues recovering, it might not be on a sound foundation.