Madame NO weighs on precious metals

The precious metals suffered during the course of the week and all metals ended in the red. Gold held best with a loss of only 2.5%, while silver and platinum were down by 4.0% each and palladium was the worst performer with a loss of 6.4% over the week. The three major fundamental factors of our quantitative fair value models all had a negative impact on the precious metals. The US dollar index strengthened while the S&P 500 index and crude oil fell and thus signal slower future economic activity and a declining inflation risk.

However, there remains one common factor behind the fundamental variables of our fair value models, the never ending debt crisis in the eurozone. Spain was now the fifth country in the eurozone, in which the debt crisis led to a change of the government. The conservative people’s party gained a broad majority of the seats in parliament and its leader Mr. Rajoy will become the next prime minister. Already during the election campaign, he indicated that more austerity measures and economic reforms would be needed to regain confidence of investors in Spanish government bonds. But investors gave Spain the cold shoulder. At an auction of short-term bills, Spain had to pay interest rates at a record high since the introduction of the single currency in 1999. The lackluster auction also led to rising yields on longer dated government bonds. The ECB bought Spanish paper, but the amount was not sufficient to prevent yields to rise.

At the beginning of last week, French government bond yields rose after a report from Moody’s was understood as an indication that France could loose the AAA rating soon. An economist at this rating agency warned that "Elevated borrowing costs persisting for an extended period would amplify the fiscal challenges the French government faces amid a deteriorating growth outlook, with negative credit implications". This demonstrates how dangerous it is, when an economist chooses the wrong reference. Elevated could refer to the average of historical yields, but even at around 3.7%, yields on 10yr French OATs are relatively low by historical standards. The spread of almost 170bp over 10yr Bunds is rather high. However, is the 10yr yield spread the appropriate benchmark to judge the creditworthiness of France? The answer is absolutely no, from our point of view. The right comparison would be either nominal bond yields with nominal GDP growth or real yields with real GDP growth. At the current eurozone inflation rate of 3.0%, the real yield on 10yr French OATs is just 0.7%. The projected real GDP growth for 2012 is currently at 0.5%. As France is also implementing measures to reduce the budget deficit further, the difference between the real yield and real GDP growth rate should hardly give any concern about the creditworthiness of France. It appears again that rating agencies, which were a major culprit of the debt crisis in 2008, attack those who came to the rescue, namely the governments.

Many investors, but also politicians, thought that Germany would be the safe haven. Even when other core countries with a triple A-rating came under pressure, yields on 10yr German Bunds declined to a recorded low of 1.65%. Germany appeared to be the only solid rock. But last week, also Germany came under pressure. The auction of 10yr Bunds was a disaster and shows that investors are no longer willing to fund the budget deficit of the federal government, which will increase next year according to the 2012 budget. The German debt management agency planed to sell 6bn euro of 10yr paper, but investors bid for only 4bn euro. Thus, the remaining 2bn euro of 10yr Bunds will now be sold by the Deutsche Bundesbank in the open market. The Wall Street Journal accused Germany that it would accept the Bundesbank buying Bunds but would resist that the ECB buys bonds of other eurozone member countries. However, the WSJ did not understand the procedure. The Bundesbank only acts as a fiscal agent for the government. It is not buying the Bunds from the German government. The federal government will only receive the funds after the Bundesbank has sold the paper in the secondary market.

Nevertheless, the WSJ is right in pointing out that Madame NO is the major problem for solving the debt crisis. German chancellor Merkel is not only opposing the introduction of Eurobonds but even wants to oppress any discussion about this instrument, as her attacks on the head of the EU Commission, Mr. Baroso, showed last week. She also opposes that the ECB acts as the lender of last resort. As the debt crisis turned into a wide spread crisis of confidence, the ECB is the only institution, which has sufficient funds available to bring yields down to a sustainable level and to prevent further escalation of the debt crisis. The EFSF will fail miserable to reach the target level as press reports revealed over this weekend. Mrs. Merkel and her consultants are obsessed that solving the debt crisis would lead to a transfer union or rising inflation. In her naivety, Madame NO believes that a change of EU treaties would be sufficient to restore confidence.

The market for government bonds in the eurozone has been destroyed. The root cause is the ballooning Greece budget deficit during the Karamanlis government. However, the German chancellor played a major role that the initial problem could not be contained and the contagion now reached even the core countries of the eurozone. The demand that private investors would have to pay for the bailout of Greece while sovereign creditors get fully repaid was a major blow for holding government bonds. But also the European Banking Authority eba contributed to the destruction of the government bond market by several changes of regulations, which all lead to banks selling government bonds in a market, which is not ready to absorb them. It is a major construction failure of the euro that the ECB is not officially the lender of last resort. As long as Madame NO rejects all proposals which would involve a determined buying of eurozone government bonds by the ECB in the secondary market, the debt crisis will still prevail. For precious metals, this is a negative development. The current correction is likely to continue this week, unless there will be a convincing breakthrough to solve the eurozone debt crisis.

Precious metals dragged down by eurozone debt crisis

At the start of last week, gold approached the 1,800$/oz mark again, but reversed direction and closed lower. During the course of the week, gold headed further down and ended the week at 1,723$/oz, a loss of 3.6% over the week. Also other precious metals ended the week lower.

It might sound like a broken record, but the reason for the weak performance of the precious metals has been the never ending story of the debt crisis in the eurozone. After Mr. Berlusconi resigned and Italian President Napolitani asked former EU commissioner Mario Monti to form a new government, the financial markets got concerned that technocrat led governments in Italy and Greece would lack the skills of politicians. The week before, a major concern of financial markets was that politicians would not be able to solve the problems. This demonstrates how much financial markets are in panic. One week they are spooked by one factor and the next week just by the opposite. In Greece and Italy, technocrats now lead the new governments and in both countries, the new leaders have won confidence votes. Nevertheless, the debt crisis in the eurozone worsened further.

Yields on 10 year Italian BTP rose again above the 7% mark temporarily. After an auction of Spanish paper, where the yield was higher than at a comparable auction in October, also the yield on 10 year Spanish government bonds rose to the 7% level, which the markets regards as crucial because other eurozone countries asked for a bail-out once yields rose above this level. However, purchases by the ECB helped to push yields lower again. But the crisis is not contained to these two countries. Instead it has now also reached the core countries. France and Austria have both a triple A-rating, nevertheless, the spreads of 10 year bonds of both countries widened last week considerably over the benchmark German Bunds and reached almost 200bp.

The only institution, which could stop the panic in financial markets, is the ECB. During a conference last Friday in Frankfurt, Germany, the ECP president Draghi as well as the head of the Bundesbank Weidmann made it clear that they oppose to be the lender of last resort. Mr. Weidmann is even opposing the current purchases of government bonds in the secondary market. Also German chancellor Merkel still rejects calls that the ECB should be the lender of last resort and should assure the markets by setting a line in the sand for the yields on government bonds and defending this line by unlimited interventions. The common fear is that such a defense would lead to inflation.

Those fears appear to be overdone for several reasons. First, buying government bonds is not just printing new money. It is a traditional instrument of monetary policy to provide liquidity for the banking system by open market policy operations. Thus, the ECB could absorb the liquidity provided by open market operation by reducing the allotments in the weekly repurchase agreements. Second, even the announcement to buy unlimited amounts of government bonds to keep yields at a certain level does not necessarily lead to an increase of central bank money. Often the markets adjust to the target level and only smaller amounts are required to convince financial markets. A recent example has been the peg of the Swiss franc to the euro by the Swiss National Bank. Third, even in the case that the central bank money stock increases, the monetary impulse has to be transmitted to the real economy. The banking system has to increase the lending activities to governments and the private sector. However, banks in the eurozone reduce the holdings of government debt. The requirements to increase core capital ratios have also a dampening effect on lending to the private sector. Therefore, from our point of view, the risk of accelerating inflation rates as a result of acting as lender of last resort is overemphasized by the ECB.

As long as the debt crisis in the eurozone remains unsolved, it has to be expected that weaker stock markets, declining crude oil prices and a firmer US dollar will weigh on precious metals. In addition, also a technical indicator, the MACD, points to a trend reversal in gold. Thus, the correction in precious metals, which started last week is likely to continue.

Safe haven buying versus the fundamentals

In calls from journalists, the author of this blog is often asked lately, why precious metals declined during days the debt crisis in the eurozone worsened. This crisis has two effects. On the one hand, as politicians are unable to find a quick and convincing solution, there is an incentive to buy precious metals as a safe haven. However, one should not forget that this crisis now lasts for already two years. Thus, there was ample opportunity to buy precious metals and new buyers would have to enter the markets to push prices higher. On the other hand, the debt crisis also has an impact on the fundamentals of the precious metals. An escalation of the debt crisis normally has a negative impact on these fundamentals. Therefore, selling of precious metals driven by the fundamentals could have a stronger impact on the price development than the safe haven buying. But prices could also rise on days of slight improvements in the eurozone as buying driven by the fundamental factors outweighs the possible profit taking by safe haven investors.

Last week, all precious metals posted gains compared to the preceding weekly close. However, it was an up and down trading, where on one day safe haven buying dominated and fundamentals were the stronger influence during the other days. But on all days, political developments rather than economic data were at centre stage.

In the preceding week, Greece was in the spotlight. But after Mr. Papandreou won the confidence vote late Friday night, some movement came into the political landscape. After the publication of the previous blog article, also the conservative New Democracy party agreed to the formation of a national unity government. While it took some time to form a new government, there was finally an agreement that Mr. Papademos, the former ECB vice president, should lead the new government. Last Friday, he was sworn in.

However, last week, Greece was more on the sidelines and Italy was on centre stage. After protests over the preceding weekend and declining support from his own coalition parties, financial markets expected Mr. Berlusconi to loose a vote in parliament in Monday and to resign immediately. From various comments in the media, we got the impression that many market participants did not fully understand what the subject of the vote was. In Italy, the parliament has to approve the report of the PM about the preceding fiscal year’s budget. The parliament voted last Monday on the report for the 2010 budget, but many commentators were under the impression it would be a vote on a budget for a future fiscal year. The opposition parties abstained from voting, there was no risk for some former supporters of Mr. Berlusconi to demonstrate their dissatisfaction by not voting with a yes. Thus, the report was approved by parliament but not with the absolute majority.

But in financial markets, there was widespread disappointment. Some commentators were disappointed that the report was approved while other commentators were emphasizing that Mr. Berlusconi failed the absolute majority was the reason for the negative market reaction. However, gold and other precious metals profited from their safe haven status. Late Monday, after consultations with the president of the Republic of Italy, Mr. Berlusconi announced to resign after a reform package promised to the EU leaders has passed both houses of parliament. On Saturday, Mr. Berlusconi resigned and at the time of publishing this article, President Napolitano was still in consultations before announcing who should form a new government. Markets expect that former EU commissioner Mario Monti would be the next PM in Italy.

In the bond markets, the 2010 budget report had a devastating impact on Tuesday. The yields of Italian government bonds soared over all maturities. The yield on 10yr BTPs reached 7.5% in the peak. This massive sell off weakened the euro and stock markets. Thus, negative fundamentals weighed on precious metals. While the ECB was reported to buy Italian bonds, the purchases intensified towards the end of the week. This brought yields significantly down. Stock markets and the euro recovered. Thus, on Friday, precious metals rose also significantly driven by positive fundamental factors.

The panic in financial markets can only be stopped if the ECB accepts the role of the lender of last resort for government bonds in the eurozone, despite resistance from Germans. Well conducted, it is by no means inflationary. However, it would be far more effective to prevent a recession than another 25bp rate cut. For precious metals, it would also be positive. Unfounded fears of inflation accelerating might be a reason for some buyers. But the main factor would be improving fundamentals for the demand for precious metals by recovering stock markets and a firmer euro.

The Greek Tragedy and Precious Metals

Last week, we argued that the comments from German finance minister Schaeuble concerning the markets initial reaction on the EU summit could lead to declining prices in precious metals markets. While this remarks also played a role, two other actors entered the stage on Monday and one of them moved even to centre stage for the whole week and is likely the dominating figure this week.

The first actor was the Bank of Japan, which intervened in foreign exchange markets to weaken the Japanese yen against the US dollar. The BoJ already intervened on several occasions before. Thus, it should not have come as a total surprise that the BoJ would try to prevent a further strengthening of the yen. The yen was regarded as one of the safe havens. This is very strange with respect to two factors. First, the earthquake and the Fukushima disaster have hurt the Japanese economy, which is in a recession. GDP dropped in Q2 by 1.1% compared to the same quarter of the preceding year. Industrial production in September was down 4.0% yoy and the trend is still further down. Currencies of an economy being in recession usually tend to depreciate but this is not the case for the Japanese Yen.

Second, government debt in relation to GDP in the US and in Europe appears to be a major concern for investors. However, the debt/GDP ratio in Japan is exceeding those ratios in the other industrialized regions by far, being around 200%. According to the criteria presented by Professors Kenneth Rogoff and Carmen Reinhard, Japan should already be beyond the point of no return and bankrupt. However, as the example of Japan shows, some critical ratios are not set in stone. The level of interest rates on government debt is also a crucial variable in the calculation at which debt/GDP ratio the interest payments are unbearable. With a yield on 10yr JGBs of just 1.0%, Japan is in a far more comfortable position.

Especially former and current German members of the ECB council should have a look at Japan. The quantitative easing of the BoJ contributed significantly to the decline of yields on 10yr government bonds. Despite the extension of the balance sheet by the BoJ, inflation has not emerged in Japan. Of course, one could not transfer the situation and monetary policy response in Japan on a 1:1 basis to the eurozone. Nevertheless, buying of government bonds of those countries in the eurozone, which came under attack from financial markets, is not a sure way to inflation.

After the Swiss National Bank pegged the Swiss franc to the euro, the appreciation of the yen increased. The yen fell to 75.5 at the last day of October. This induced the BoJ to intervene. The US dollar did not only firm against the yen, but also against other major currencies. This dollar strength send stock markets lower, which also pulled crude oil lower. As investors risk aversion increased, also yields on safe haven government bonds like the US Treasury paper or German Bunds dropped. In addition, the Schaeuble remarks contributed to a flight into Bunds as investors worried about the still open details of the EU summit package. As a result, also precious metals had been sold.

However, the centre stage was taken on late Monday by the Greek PM Papandreou, who announced to hold a confidence vote in parliament and later a referendum by the population. It was not clear, what would be the question for the referendum. However, given the polls on the rescue package decided at the EU summit, the markets feared that Greece would vote with a “no” in a referendum. This increased uncertainty send risky assets lower and safe haven Bunds and US Treasury notes higher. Precious metals initially fell further, but could already recover on Tuesday. The situation calmed somewhat after German Chancellor Merkel and French President Sarkozy called for a meeting with Greece’s PM Papandreou on Wednesday ahead of the 2day G20 summit. Both demanded that a referendum should be about Greece staying or leaving the eurozone. Furthermore, they announced that no funds would flow to Greece as long as the bailout package decided the week before will be fully implemented.

Holding a referendum on remaining a member of the euro would have been like playing with matches at a fill station. As soon as such a referendum had been called officially, the only rational behavior would be to withdraw all deposits with banks in Greece and transfer them to banks in other eurozone countries. If the result of a referendum would be to leave the euro, the new Greek currency would depreciate against the euro. Thus, one would make a profit. If the majority voted for staying in the eurozone, no currency gain would be made. However, there would be also no loss. Therefore, the financial system in Greece would have collapsed like a house of cards even before a referendum took place.

One Thursday, some movement came into the Greek political landscape. The finance minister opposed holding a referendum on staying in the eurozone. The PM Papandreou offered to give way to a coalition government of “national unity”, which should stay in power for some months to push all necessary legislation through parliament to implement the rescue package as agreed at the EU summit. Also opposition parties moved and showed some willingness to cooperate, but demands for snap elections in December remained on the table.

Friday night, PM Papandreou survived the confidence vote in the parliament. However, it is quite unclear how the political situation in Greece will develop. The major opposition party New Democracy insists on immediate snap elections. Some other parties in the centre appear to be willing to form a coalition government with currently ruling PASOK party. The main problem is that the party responsible for the mess torpedoes the clean-up work of the incumbent government to return back to power as soon as possible. Mrs. Merkel and Mr. Sarkozy should also make a strong call to Mr. Samaras, the leader of the New Democracy. All three are associated within the European Peoples Party, the conservative party in the EU parliament. But as long as Mr. Samaras puts his own interests above those of the Greece population, a solution appears hard to find. Thus, the political developments in particular in Greece, but also within the eurozone, are most likely the dominating factor for financial and metals markets. Investors should be on the defensive side as strong movements in both directions appear to be possible.