Mario Draghi wants to keep his job – good for gold

Last week, we wrote in this blog that the risk for precious metals was still biased to the downside for the following trading week. At the time of publishing the article, the interview with Germany’s vice-chancellor and leader of the liberal party had not been released. His comments about a Greek exit from the eurozone sent shock waves through financial markets. Precious metals were dragged lower as investors sold risky assets.

Vice-chancellor Roessler was not the only German politician demanding Greece to leave the eurozone even before the troika arrived in Athens for their talks. Also the party secretary of the liberals as well as the finance minister of the German state of Bavaria voiced calls for a violation of the Maastricht treaty. Many German politicians underestimate the costs of Greece leaving the eurozone, not only for Germany but also for other European countries. So far, Germany has given only guarantees, but in the case of a Greek exit, Germany would realize losses. In addition, a forced Greek exit would trigger a chain reaction. Financial markets would immediately attack the next weak link in the chain, which is currently Spain. Thus, it was not surprising that yields on Spanish government bonds soared and maturities up to 5 years traded even below the yield on 10yr Spanish government paper. This inversion of the yield curve is a clear indication that bond markets price in a default of Spain. At the same time, yields on 10yr German Bunds reached a new historic low. As pointed out in the article published last week, a flight to save haven government bonds, the US Treasuries and German Bunds, is not positive for precious metals.

However, the negative impact of comments from German politicians did not last long. On Tuesday, speculation about quantitative easing emerged again. There was talk in the market the Fed would explore new tools to boost US economic growth. However, after the release of Q2 US GDP data on Friday, the Fed seems to be in no hurry to implement new tools of quantitative easing already at the August FOMC meeting. We already pointed out, that it is more likely the Fed would embark on QE3 after the presidential election in November.

Since providing liquidity to the banking system for three years by two long-term refinancing operations (LTRO), the ECB took the position of a sideline spectator. The argument was that the task of the ECB would be to maintain price stability and it was now up to the politicians to do their job. It is understandable that the ECB took a more cautious stance towards Greece, in particular during the period of uncertainty over the general election. However, the argument for the security markets program (SMP) was still in place with respect to Spain, but even more so in the case of Italy. Spain still has a problem with the recapitalization of some banks. The smartest solution had been torpedoed by financial markets but also by eurozone finance ministers. Spain has now got a 100bn euro bailout program for its banking sector. However, conflicting comments from European finance ministers, especially from the German FM, are responsible for the ongoing skepticism of financial markets. Fears that Spain had to ask for a full bailout became more and more widespread among investors and the probability of a self-fulfilling prophecy increased rapidly.

However, the situation of Spain’s public finances was largely ignored by investors as irrational fears dominated. It is exactly this situation of disturbances of the transmission mechanism of monetary policy, the SMP was designed for. But the ECB remained absent in bond markets since March. Some ECB council members still oppose the use of the SMP to calm financial markets. But this past week, there appears to be some momentum coming into the debate over renewed bond purchases. First, the head of Austria’s central bank, Mr. Novottny, proposed to provide the EFSF with a banking license to enable this institution to buy bonds in the secondary markets. Second, last Thursday, ECB president Draghi pledged at a conference in London that the ECB would do whatever is necessary to preserve the euro. The financial markets interpreted this statement as the ECB would be ready to buy again bonds of Spain and Italy in the secondary markets. Yields on government bonds of these two countries dropped and yields and 10yr German Bunds edged higher. The euro also pared some of the losses against the US dollar. Thus, the focus will be now on the ECB council meeting with investors wanting to see deeds following Mr. Draghi’s words. One has to hope that not only Mr. Draghi wants to keep his job at the ECB. If the ECB fails to meet market expectations and to restore orderly market conditions, the pressure in financial markets on the euro and on Spain will increase. With mounting pressure on Spain and rocketing funding costs, it will be only a question of time that Spain asks for a full bailout.

In an interview over the weekend, Germany’s finance minister Scheuble made again a stupid comment about opposing the ECB buying bonds in the secondary markets. He should respect the independence of the ECB and the SMP is also no violation of the Maastricht treaty, as many Germans pretend. As investors ignore the fundamentals, interventions in the secondary market, either by the ECB or by the EFSF equipped with a banking license are the only way to prevent a full bailout of Spain and then further attacks on Italy. Waiting for the ESM to start operating in September, being the preferred position of Mr. Scheuble as a report from Reuters suggests, is a dangerous game. First, Germany has to ratify the treaties and the German constitutional court will only decide on September 12, if the treaty to set up the ESM is in accordance with the German constitution or violates it. An approval is not a done deal. Second, financial markets might not wait until the ESM is set-up and operating. Investors and traders could push yields already in August to unsustainable levels that the Government in Madrid would have to ask for a full bailout.

The pledge of ECB president Draghi but also the joint statement of French president Hollande and German chancellor Merkel have stabilized the situation in the eurozone. But the ECB would have to let deeds follow the words at the ECB council meeting on Thursday, August 2. In the case the ECB does meet market expectations, precious metals might move further up. However, any disappointment is likely to hurt the euro versus other major currencies and would also drag precious metals lower.

Precious metals suffer under eurozone debt crisis

Only silver managed to close marginally higher than the week before. Without the news that Russia increased its gold reserve holdings in June, also gold would have posted a stronger decline in the week over week comparison. However, two of the major fundamental drivers had been positive for precious metals. Despite losses on last Friday, the S&P 500 index and crude oil prices ended the week higher compared with the previous week’s close. Only the US dollar strengthened and this pushed precious metal prices lower. For the week ahead, the risk for precious metals appears to remain still biased to the downside.

The reporting season of companies will continue. So far, they surprised more on the downside than companies beating market expectations. In addition, many companies got more cautious on the earnings outlook. This is probably not going to change. On Tuesday, the flash estimates of the PMI will be released again. Over the last couple of month, these flash estimates had a strong negative impact on stock markets. Thus, one has to take another negative market reaction into account. Therefore, stock markets might not be a supportive factor for precious metals next week.

For most of the last week, the euro exchange rate versus the US dollar showed some wider swings, but managed to close slightly up on the day. But on Friday, EUR/USD opened near the high of the day and closed about 120 pips lower at 1.2154 near the low of the day (according to data from ThomsonReuters).

The first push lower was triggered by a media report quoting a lawmaker from the German coalition government, a member of the Bavarian junior partner CSU, stating that Greece would have to stick to the agreements with the troika or would have to leave the eurozone. Later the day, the party secretary of the CSU, Mr. Dobrindt, made a comment along the same line. It is always astonishing that those who insist that others have to stick to treaties want to violate treaties. The EU treaties offer no legal way to push a country out of the euro. It is only up to the Greece government to decide staying in the eurozone or to leave not only the eurozone but also the EU. After the Greek elections in mid-June, markets had calmed down and a Greek exit was no longer on the radar screens of many investors. However, after this comment, markets fear again that Greece might have to leave the eurozone. This comment about Greece is also counterproductive as the debt crisis will be prolonged. As regional elections will be held in Bavaria next year, one has to expect that politicians from the ruling CSU will repeat those stupid comments. Therefore, the risk of further weakness of the euro against the US dollar remains at elevated levels.

Another negative factor had been the announcement of the ECB. At least during the review of the bailout program, it would stop accepting Greek bonds and other collateral used by Greek banks to tap ECB funding. However, Greek banks could turn to their Greece’s national bank for Emergency Liquidity Assistance (ELA) funds. Thus, Greek banks could still obtain liquidity, but the ECB and thus other national central banks are shielded from the risk of Greece not meeting its obligations.

The second negative factor had been Spain. Yields on Spanish government bonds had been rising already for six consecutive days before and rose above 7.3% for 10yr bonds on Friday. The Spanish government decided to take further measures to curb the budget deficit in a situation where the economy is already in a recession. Bond investors feared that the measures taken would only worsen the economic slump. Furthermore, the Spanish government revised the forecasts for GDP in this and the next year further down, expecting Spain to be in recession for two years. After protests on late Thursday in Madrid turned partly violent, many investors likened the situation in Spain with Greece. However, the situation is Spain is different from that in Greece. In Spain, the banking sector is the problem. After the German parliament approved the bailout program for Spanish banks, also the EU finance minister finalized the treaty with Spain to release the first 30bn out of the 100bn euro program. However, it did not calm down nervous investors, which sell Spanish government bonds on the fear that also the government would need a bailout. Franklin D. Roosevelt said in his inaugural speech “the only thing we have to fear is fear itself”. This also applies to the situation of Spain. The fear of investors that Spain might need a bailout could eventually turn out as a self-fulfilling prophecy. Last year, the ECB acted and bought Spanish government bonds. But after Mr. Trichet is no longer ECB president, the ECB under its new president Mr. Draghi behaves like spectators on the sideline. However, maintaining orderly conditions in financial markets is also the task of the ECB and not only of finance ministers.

It has been noted several times in this blog that declining yields of safe haven government bonds are not a positive environment for precious metals. Yields on 10yr German bunds dropped to new record low of 1.12% last Friday. Investors even paid more for 2yr German notes than they will get redeemed at maturity. The probability is rather high that the developments described above will continue during the coming trading week. A fight to safe haven government bonds like the German Bunds and weakness of the euro against major currencies might be accompanied with declining stock markets. As precious metals trade like risky assets and not as safe havens, one has to expect further weakness. For all four metals, a test of the lows recorded in June can not be ruled out.

Range trading likely to continue in precious metals markets

Only a rally, which set in with the start of trading in Europe and accelerated in the afternoon, prevented on Friday that Gold ended the week lower. Many analysts expect gold to break out to the upside soon. In an interview with ThomsonReuters, we pointed out that an upside breakout from the current trading range appears more likely during the final quarter than during the current one. In this article, we provide a more detailed explanation for this assessment.

Precious metals currently trade most of the time in line with other risky assets. However, if there is a new wave of speculation that the FOMC will embark on QE3, then gold is more driven by falling yields on 10yr US Treasury notes. But safe haven flows into US Treasury notes and German Bunds as a result of the eurozone debt crisis are not positive for gold as it trades like a risky asset in this case. Therefore, from our point of view, either the risk appetite of investors has to increase considerably and stock markets have to trend higher or the market would have to speculate on the Fed implementing QE3.

The release of the recent FOMC minutes brought some bond bulls back to earth last week. The Fed is always ready to act if needed. However, to implement QE3, the economic situation of the US would have to worsen significantly. A dip of the ISM manufacturing index below 50 is not enough. New orders and industrial production would have to contract sharply over a few months. The labor market report also provides no convincing argument that the Fed would react quickly as the US economy still creates new jobs and the unemployment rate stagnated at 8.2%. Thus, unless there is a sharp deterioration of the economic situation in the United States, the FOMC is likely to extend just operation twist until the end of this year, but does not take further measures in the current quarter to stimulate the economy.

Also political considerations could play a role. Of course, the Fed is an independent central bank and would act if the economy requires monetary policy measures. However, the closer the US presidential election gets, the more the likelihood for a further Fed stimulus before the election date decreases. Furthermore, one has to keep in mind that both houses of the Congress have to find a compromise on reducing the budget deficit to prevent automatic cuts, which are regarded as a fiscal cliff. A failure of reaching an agreement can not be ruled out, given the experience from July and August last year. Thus, the Fed is right at keeping the powder dry.

After the release of Chinese GDP growth in the second quarter, which came in line with consensus forecasts, stock markets traded higher. Probably, some traders had already priced in a sharper deceleration of economic expansion. Furthermore, sentiment with respect to rate cuts by the PBoC has changed. Now the market welcomes the outlook for further rate cuts. However, is this positive news already enough to establish an upward trend in global stock markets? We have some doubts.

In the US, the earning season started last week. Wall Street traded higher last Friday after JP Morgan released its results. However, this was probably only a relief rally as JPM still posted a strong gain after losing up to 5.8bn US dollars on its credit hedge book by the ‘London whale’. On the other days of last week, earning warnings especially in the tech-sector dominated. Furthermore, companies gave a more cautious outlook. Against this backdrop, it appears as less likely that a new upward trend in stock markets will be established.

One has to keep in mind the seasonal factors also. August and September are traditionally among the weakest months of the year. Of course, there are exceptions and stock markets also performed well in August and September as it had been the case in 2009. However, in the current environment it appears less likely that 2012 will be an exceptional year and stock markets rally over the summer months.

Furthermore, the debt crisis in the eurozone is far from being over. The German constitutional court needs more time to decide whether the German president can sign the law on the fiscal pact and ESM. Without the president’s signature, the treaties can not be ratified. Given the weight of Germany, the ratification of the treaties by Germany is necessary for the start of the ESM.

Thus, a breakout of gold to the upside is not impossible. However, we would put a higher probability for this event to take place during the final quarter of this year. One should also keep in mind, that a fall below the support of the current trading range could also not excluded, especially in the case that stock markets and other risky assets get under pressure and fall to new lows of the year. But our base line scenario is a continuation of range trading for the time being.

Return of investors’ risk aversion weighs on precious metals

The increased risk appetite, which set in after the EU summit, did not last long. After only a few days, the risk aversion of investors returned again. At least during the first half of the next trading week, there is no major economic data release scheduled. This might provide some support for precious metals. Nevertheless, several central bankers will hold speeches, which could move the markets. In addition, the release of the FOMC minutes on Wednesday could move precious metal markets, depending on how close the FOMC is on embarking on QE3.

After consolidating the gains made on the last trading day in June, precious metals rose on Tuesday on speculation of further monetary stimulus by major central banks. However, as various central banks eased monetary policy, precious metals turned negative. But this was not just a typical “buy the rumor and sell the fact” behavior of traders. It reflects more an irrational behavior. The smallest impact probably had the decision by the Bank of England to implement another quantitative easing round by buying 50bn GPB of UK Treasury paper.

The People’s Bank of China lowered interest rates for the second time within four weeks. The lending rate has been lowered by 31bp to 6% and the deposit rate by 25bp to 3%. After the first rate cut, one should have expected that more steps will follow. The market was surprised by the quick next step, but the PBoC does not react as slowly as the ECB. Normally, financial markets had been forward looking. Two rate cuts within a short period of time had been regarded as positive. The central bank was considered to be determined to improve growth prospects. Traders and investors normally bought risky assets as the economic outlook was expected to brighten. However, traders and investors panicked and interpreted the rate cut as an indication the PBoC would expect a much steeper slow-down of economic activity. But what those jittery traders ignore is the fact that China’s official PMI just dipped below the 50 level. Thus, the PBoC reacted in a timely manner to stimulate the economy again.

The 25bp rate cut by the ECB had been widely expected, at least by the economists polled for the various consensus figures published by the media. Some economists as members of shadow committees of some financial news papers even recommended a 50bp rate cut, but were obviously not convinced the ECB would make such a strong move. After the release of the ECB rate cut, markets traded lower, but during the ECB press conference another major push lower set in. Media reports quoting traders provided several reasons for the sell off. One can divide them into two broad categories, irrational expectations or bad communication skills of Mario Draghi, the ECB president.

With the decision to lower the ECB main refinancing rate by 25bp to a new historic low of 0.75%, the ECB also reduced the deposit rate and the rate for the marginal lending facility by 25bp each to 0.0% and 1.5% respectively. This is the traditional behavior of the ECB that all three key interest rates move in line. However, financial markets were surprised by the cut of the deposit rate. They sold risky assets and bought safe haven German Bunds. This clearly is a case of irrational expectations and behavior as the ECB just did what it normally does when cutting or hiking rates. If markets were efficient as academic theory (especially from the Chicago school) pretends, then this should have already been priced in.

Furthermore, after the EU summit and the comments of Mario Draghi on the results of the summit, some market participants expected the ECB to take bolder steps than only cutting the key interest rates by 25bp. Some traders expected the ECB would announce another LTRO (long-term refinancing operation) with a maturity of maybe even more than 3 years. Others speculated the ECB might start buying again government bonds from Spain and Italy in the secondary market. However, Mr. Draghi did not provide any hint that one of these two instruments might be used again in the near future. Netherland’s central bank governor Knot even ruled out that the ECB would ever buy again government bonds in the secondary market. However, one has to keep in mind the June press conference of the ECB, where Mr. Draghi already stated that the ECB has done enough and it would be now up to the politicians to do their homework. Thus, it was also irrational to expect more than cutting rates from the ECB.

At the introductory remarks, Mr, Draghi stated “… economic growth in the euro area continues to remain weak, with heightened uncertainty weighing on confidence and sentiment.”  Furthermore, he added “The risks surrounding the economic outlook for the euro area continue to be on the downside. They relate, in particular, to a renewed increase in the tensions in several euro area financial markets and their potential spillover to the euro area real economy.” These remarks of the ECB increased the already high nervousness of financial markets. Risky assets were sold off. Yields on 10yr Spanish government bonds rose from below 6.5% below the ECB rate decision and press conference to more than 7.0% within 24 hours. Also yields on Italian government bonds rose, albeit less than those on Spanish paper. This rise of yields in peripheral eurozone bond markets is the result of spooking investors and traders by the ECB.

But not only risk aversion in bond markets intensified. The euro already pared gains make on the final trading day in June against the US dollar. However, after the ECB press conference, the euro got hammered and lost another 2.5 cents and fell even below the low reached at the start of June. The US dollar index gained 2.15% on the week.

Beside central banks, also some negative surprises from economic data releases played a role. The US manufacturing ISM index dropped below the 50 threshold and also the service sector ISM index declined strongly, but remained above the 50 mark. The ADP private sector payrolls estimate surprised on the upside. Thus, economists and traders revised their estimate for the non-farm payroll report higher. However, the labor market report disappointed with only 80k new jobs created instead of estimated 100k. The unemployment rate remained unchanged. But this report was not as bad as the previous one. The number of additions to the payroll was higher than the month before, which had been revised up to 77K from 69K. Average hourly earnings increased by 0.3%, which was stronger than expected and also the figure for the preceding month was revised from 0.1% to 0.2%. Also the average hourly workweek increased in June. Thus, the report still points to further growth of the US economy, but only at a modest pace. Nevertheless, stock markets dropped further and other risky assets were also sold. Precious metals could not escape the increased risk aversion of investors.

Uncertainty about the economic outlook might weigh further on the euro and stock markets. This would be negative for precious metals too. However, as there is no major economic data release scheduled for the first part of the new trading week, risky assets including the precious metals might stabilize. Nevertheless, there is one event scheduled for Tuesday, whose result is unpredictable. The German constitutional court will decide about the laws concerning the ESM and the fiscal stability pact. The ruling could push markets strongly in either direction.

20th EU crisis summit triggers rally in precious metals

At the 20^th EU summit since the start of the debt crisis, it seems that the European politicians finally learned the lesson and moved in the right direction. Before the start of the summit, markets traded down as the rhetoric of German politicians indicated that this summit would be a complete failure. However, after many hours of negotiations, a breakthrough had been reached on Friday in the early morning hours. Risky asset markets, stocks and commodities, rallied. Yields on eurozone peripheral government bonds came down, but it was a roller-coaster ride. Safe haven government bond prices dropped like a stone at but later pared a major part of initial losses. The push on the last trading day of June was so strong that most precious metals ended the weak in the plus, only palladium closed lower than the Friday before.

Germany’s iron chancellor, Mrs. Merkel, is also known as Madam No because she rejected all proposals, which were suitable to mitigate the pressure on Spain and Italy in financial markets. The narrative of her policy is a widespread misperception in Germany that the peripheral eurozone countries were sinners, which have to be punished for running too high budget deficits. Ahead of the summit, her rhetoric got even more aggressive by stating that common Eurobonds would not be introduced as long as she lives. Thus, it appeared that Mrs. Merkel would not move even one inch from her position and the EU summit would end in a disaster. However, many analysts and strategists in the City of London are performing only mediocre in analyzing political negotiations.

After the summit, a session of the German parliament was scheduled with a vote on the fiscal compact and the ESM on the agenda – both votes reached the necessary majority. As a modification of the German constitution was necessary, both topics on the agenda required a two-thirds majority. The coalition government has only a simple but not a qualified majority in the lower house. Furthermore, parties supporting Mrs. Merkel’s government do not have the majority in the upper house. Thus, Germany’s iron chancellor needs the backing of the two main opposition parties for changing the constitution and pushing the vote on ESM and fiscal compact through both houses. One pre-requisite for the support from the social democrats and environmentalists, the greens, was that the EU also agrees on a growth stimulus package at the summit. Thus, Mrs. Merkel could not afford that the EU summit would end without the growth initiative designed together with the French president and the prime ministers from Spain and Italy.

While the high paid analysts and traders in the City of London overlooked this detail of domestic German politics, Messrs Rajoy and Monti did not. Thus, the prime ministers of Spain and Italy threatened to veto the EU growth pact. Germany’s chancellor had to make concessions. And for Europe, it was worth to give up resistance. The major breakthrough was cutting the link between bailing out banks and escalating government debt to GDP ratios. Direct bailouts of banks without increasing the debt of national governments will be possible.

Furthermore, investors dumped Spanish government bonds and pushed yields up after EU finance ministers decided to provide up to 100bn euro for recapitalizing Spanish banks. Normally, a bailout led to senior debt status of official lenders over private creditors. This rise in yields on Spanish government bonds increased the risk that beside the banks, also the government might need to be bailed out by the EFSF and the ESM. With the decision that the recapitalization of Spanish banks would not lead to a senior status of bailout loans over the private sector, yields came down and the risk is reduced that the Spanish government would not be able to obtain funds in bond markets at reasonable costs.

Another important step has been the agreement on a more flexible use of eurouzone rescue funds. Countries meeting the EU deficit criteria could ask for help to buy government bonds and thus to keep yields on the country’s bonds at an affordable level. Especially Spain and Italy could profit from this agreement without having to undergo the imposition of austerity measures by the troika.

These measures are important steps forward. However, more measures would have to follow. These include the creation of a single eurozone banking supervision and a banking union with joint deposit guarantees. A single currency area also requires a single financial market. The current crisis and fears of a failure of the euro has led to a tendency towards segregated national financial markets again. Furthermore, a movement towards a fiscal and political union as a medium-term target has to remain on the agenda.

The EU summit has surprised with positive results heading in the right directions. The crucial question is now, how long will the improvement in investor’s risk appetite last? If the initial impact is not petering out quickly, stock markets might head higher and the euro could recover further against the US dollar, which would be supportive for precious metal markets. This could also improve the sentiment in major economies. However, the risk is that analysts and strategists turn negative on the EU summit results in reports published over the weekend. Also economic data is likely to come in week in the short run. If investors will be more concerned about past economic data than the improved outlook for solving the eurozone debt crisis, then risky assets might head lower again over the summer months and this would apply also for precious metals.