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.