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.