Precious metals rally on central bank policy

It were the policy action of the ECB and the expectations of further Fed policy action which drove precious metal prices sharply higher last week. However, whether prices will advance further during the next trading week will depend on the German constitutional court ruling on the EMS and the FOMC decision on another round of quantitative easing.

The ECB presented the details of its new bond purchase program called ‘outright monetary transactions OTM’, which is not the optimal solution. However, it is far better than following the advice of the German Bundesbank to do nothing at all. The ECB has attached some conditions, which make the program less effective. First, the ECB will only purchase bonds in the secondary market after a government has requested a bailout from the EFSF/ESM. In addition, the IMF should be involved in determining the conditions of a bail-out program, even if the IMF will not provide own funds. However, it is just the IMF conditionality, which makes governments hesitant to ask for a help. The doctrine of the IMF is to implement severe austerity measures. Even staff members of the IMF showed in a recent working paper, that austerity measures aggravate a recession and are not a cure to reduce a budget deficit if a country is already in a recession. The two main candidates for ECB bond purchases are Spain and Italy, which are already in a recession. Thus, both governments might not be too eager to ask for help from the EFSF/ESM and from the ECB to bring down borrowing costs.

Second, the ECB is limiting any purchase to bonds with a remaining life to maturity of up to three years.  This limit has to be seen against the background of critics that the ECB would violate its mandate and would finance governments illegally. The limit of three years is regard as being in compliance with the ECB’s legal framework. From the perspective of market impact, of course, no limitation of the maturity range would have been preferable.

Third, there appears to be now concrete target for yields. Thus, markets are probably trying to test the ECB once a country applies for help. By stating a concrete target, the markets might have moved to the target level without any need of the ECB to purchase bonds. But it is positive that the ECB is willing to purchase unlimited amounts of bonds in the selected maturity range.

The ECB’s outright monetary transaction program will not be a measure of quantitative easing. The amount of bonds purchased will be sterilized by withdrawing liquidity by other means, for example at the weekly refinancing operations. Thus, the OTM is not going to extend the ECB balance sheet.

Despite the ECB’s OTM is not quantitative easing, it is positive for precious metals. Those buying gold on fears the ECB policy would lead to higher inflation make the right decision but for the wrong reason. Without having spent even one euro on buying bonds of Spain and Italy, yields on government paper of these two eurozone member states already came down. Yields declined significantly not only at the short end of the yield curve but also for longer maturities. After the ECB announcement of OTM, speculators have to fear that anytime soon, Spain and Italy might apply for a bail-out and the ECB starts buying bonds. Thus, they already began to cover their short-positions in government paper of these two countries. And it is this decline of yields, which mitigates the funding situation. At the same time, also the risk of countries leaving the euro declines considerably. The debt crisis in the eurozone is not yet solved, but the ECB’s OTM is major step towards ending the crisis. Thus, the euro recovered against the US dollar, which is positive for gold. Also investors bought more stocks and the rise of equity indices is another positive factor for gold as investors’ risk appetite is increasing and they also buy not only stocks but also commodities again.

The US labor market report for August had been mixed, but overall it disappointed. It has increased the odds that the FOMC might already decide in the coming week at the meeting on September 12/13 to implement QE3. However, as a fiscal cliff in the US is not yet avoided, we see a slightly higher probability that the FOMC might keep its powder dry. In the case that the FOMC does not embark on QE3 at the next meeting, precious metals might suffer a set-back.

A potential risk for precious metals is also the ruling of the German constitutional court on the ESM. The majority of the German population favors that the highest court in Germany stops the ESM. However, this would be an economic disaster. But one never knows how the judges at a court will decide. Thus, this is an event risk and the result is hard to predict. In the case that the constitutional court paves the way for the ratification of the treaty, precious metals are likely to advance further. However, any blocking would probably be negative for the euro and risky assets, including the precious metals.