Lessons from Brussels: Trust in gold but not politicians

After the troika of EU, ECB and IMF found a compromise with Cyprus to avoid a bankruptcy, which was approved by eurozone finance ministers in early Monday morning hours, gold pared part of the gains made the week before. It was a typical reaction as the worst case could be evaded. However, it was not a smart move.

The bailout plan now excludes that deposits below the guaranteed sum 100,000 euro will be partly expropriated. However, bank deposits above this sum will still be confiscated. This has not been the case in Ireland or Spain, where the banking system had been bailed out without depositors being robbed by the troika. And as pointed out last week, the banking crisis in Cyprus was not the result of banks lending recklessly to a booming real-estate sector. The solvency crisis in Cyprus was the collateral damage of the default of Greece on its government debt held by private investors, which was also enforced by the troika.

Dutch finance minister and Eurogroup chairman Jeroen Dijsselbloem stated on Monday afternoon that the solution enforced by the troika and eurozone finance ministers would be a blue print for further banking sector bailouts in the eurozone. While he later paddled back, he already had let the cat out of the bag. Also an initiative of a member of the European parliament points to the same direction. Saver be aware, if in trouble the government will steal your money!

So far, there has been no contagion in other southern European countries and even the situation remained relatively calm in Cyprus after banks re-opened on Thursday. However, in Cyprus, this is only due to massive capital controls, which violate the spirit of the Lisbon treaty and are only allowed in cases of emergency. But as mistakes made by politicians are often the root-cause of a crisis and then politicians decide again on the imposition of capital controls, investors can not rely on the freedom of moving capital from one place to the other.

The financial system of the eurozone was never a single market as it is the case in the US. However, with the launch of the single currency, a process of more integration started. Until the financial crisis broke out, a successful process of integration within the eurzone took place. Rates of lending from banks converged to only small spreads. Thus, the monetary policy of the ECB acting upon the maxim of one size fits all had the same impact throughout the single currency area. But this all changed after the financial crisis of 2008, and the management of the debt crisis by the Eurogroup finance ministers made the situation worse.

ECB president Draghi was successful in calming the situation down last summer, when he gave his pledge that the ECB would do everything within its mandate to secure the euro. The capital flight within the eurozone not only came to a stop but reversed as some investors repatriated funds again to domestic banks. The balances of the Target system, which reflected the flight into the safe haven of German Bunds, declined again albeit still being far above pre-crisis levels. With the solution to solve the banking crisis in Cyprus, dictated by the jurists Mrs. Lagard and Mr. Schaeuble, this trend is likely to reverse again, once the capital controls in Cyprus are fully lifted.

For investors, the Cyprus crisis management adds another dimension to risk management. Investments in financial institutions should be held not only with several legally separated entities in one country, but also spread over various countries within the eurozone. But in the case of a crisis bigger than the one in Cyprus, even that might not be sufficient. Deposits would also have to be held outside the eurozone. It is an old wisdom that gold can not go bankrupt. Thus, due to the political risk in the eurozone, gold is definitively an asset, which should be part of a diversified portfolio. And to avoid any confiscation, it is best held in secure vaults outside of the eurzone.

The biggest bank robbery

Gold was the only precious metal, which rose on balance by 16$/oz. However, gold gave back part of the gains made last Monday. The SPDR Gold Trust ETF still recorded outflows, which dampened the rise of gold. But on the other hand, large speculative accounts increase their net-long position in gold futures by slightly more than 19K to 135,610 contracts in the week ending Tuesday, March 19.

The reason for the rise of the gold price was the decision taken at a eurozone summit in the early morning hours on Saturday, March 16, which gave the term bank robbery a complete new meaning. In order to provide a rescue package for Cyprus, the German finance minister, Mr. Schaeuble, and IMF chief, Mrs. Lagard, acted like a modern version of Bonnie and Clyde by insisting that the Cypriot government had to steal the amount of 5.8bn euro from deposits at banks in Cyprus. The two lawyers and also the head of eurozone finance ministers demonstrated that there is no economic intelligent life at summits in Brussels. In order to keep the rate, at which bank deposits would have to be expropriated, below 10%, Cyprus’ newly elected president proposed that also deposits below 100,000 euro should be included in the bank robbery. And again the lawyers failed miserably. According to EU law, deposits up to this amount have to be protected against a bank failure. The eurozone finance ministers would have had to reject this proposal.

In principle, there is nothing wrong that also holders of bank bonds or depositors lose money in the case of a bank failure. However, in the case of the Cypriot banking system, EU finance ministers insisted on violating this principle because not all bank debt is equal. In the case of a default, share holders lose all money at first, and then sub-ordinate debt as the most risky debt will be liable. At the end of the chain, there are the deposits, which will only participate in covering losses on amounts above the maximum of the deposit insurance, which is 100,000 euro. For bearing higher risk, investors get compensated by higher interest rates the higher the likelihood to lose money in the case of a default. However, the EU finance ministers insisted on a contribution from all depositors independent of the risk category and compensation for taking this risk. Share holders in Cypriot banks have suffered losses as the price of their shares plunged. However, they still own their shares and will not have to make a contribution according to the rescue plan. Thus, share holders and investors in subordinate bank debt are treated best because they normally would lose the total investment.

The crisis of the Cypriot banking system is not the result of irresponsible lending to a booming real-estate sector as it has been the case in Ireland and Spain. They also did not buy highly leveraged CMBOs backed by worthless sub-prime US mortgages as the German Landesbanken (government owned institutions) did. It is also not the result of pouring money into investments, which were regarded as highly risky already at the time the investment was made. Due to the close link between Cyprus and Greece, Cypriot banks invested in Greek government bonds, which were regarded as safe by the regulators even in early 2009. With the forced default of Greece, remember the driving forces were again Mr. Schaeuble and Mrs. Lagard, Cypriot banks suffered losses on what was supposed to be a safe investment. These losses caused a solvency crisis.

Germany’s finance minister was a young boy at the age of five years when Germany had its second state bankruptcy in the past century, which is now 65 years ago. It led to the introduction of the D-Mark, which became a strong currency later. However, the currency reform also caused that German banks would have gone insolvent if there had not been a measure to prevent the insolvency. The German government allocated claims to the banks, which just filled the gap in bank balance sheets.

This compensation claims had a long maturity and a low coupon with annual redemptions. To restore the solvency of Cypriot banks, the government could purchase bank shares and pay by providing long-term claims with no or only a rather small coupon. However, such a solution is rejected by the ECB as being too close to state financing. But this could be avoided by excluding those compensation claims from the collateral for refinancing at the ECB.

The parliament in Cyprus rejected the proposal that bank deposits should be subject to a special tax. However, a tax on deposits above 100,000 euro is still on the agenda when eurozone finance ministers meet later on this Sunday. Mr. Schaeuble promised that the default of Greece would be a special situation. Now, he pretends again that the solution for Cyprus would be a special situation and would not repeat again. This finance minister has lost all credibility. The decision of the eurozone finance ministers could lead to a bank run when banks open again in Cyprus. The ECB prepares for capital controls while the Lisbon treaty guarantees the freedom of capital flows.

All this amateurish handling of the crisis by the eurozone finance minister underlines that investors can not trust politicians. Investments at banks are not as safe as assumed. So far, there is not spill-over effect or contagion in other countries in Southern Europe. Nevertheless, the eurozone finance ministers provide a good argument for holding gold in a portfolio and store it in vaults located in safe countries outside of the reach by the jurisdiction in the country of residence.   

Is the price of gold manipulated?

The Wall Street Journal reported this week that the top U.S. derivatives regulator – the Commodity Futures Trading Commission (CFTC) - has started internal discussions on whether the daily setting of gold and silver prices in London is open to manipulation. The CFTC has not jet formally started an investigation of the matter, but would be examining various aspects of price fixings, including whether they are sufficiently transparent, according to the WSJ.

Induced was the discussion by the LIBOR manipulations scandals in which many British banks were involved. CFTC Commissioner Bart Chilton stated in an interview at the annual Futures Industry Association conference in Boca Raton: "Given the clubby manipulation efforts we saw in Libor benchmarks, I assume other benchmarks - many other benchmarks - are legit areas of inquiry".

What is striking first is that CFTC Commissioner Bart Chilton is again attacking institutions at financial centers outside the US jurisdiction. There have been claims that also the gold price in the US would be manipulated by leading US banks. The name of a major bank, who was also subject of a US Senate hearing last Friday, is often mentioned in this context. We do not believe in those conspiracy theories about manipulations of the gold or silver market. Nevertheless, the CFTC has not investigated those accusations. This makes all the statements from Mr. Chilton more looking like a political blame game in order to gain a competitive advantage for US financial markets. The UK watchdog, which is responsible for the gold and silver fixings in London, is not aware of any manipulation accusations.

The LIBOR rates are set based on reports from banks in London estimating at which interest rate they could obtain unsecured credits in the interbank market. Thus, LIBOR rates could be but are not necessarily based on real transactions. After dropping a number of highest and lowest estimates, the average of the remaining estimates is then published as the LIBOR rate for the corresponding maturity.

The gold and silver fixing in London has a long tradition. As the London Bullion Metals Association (LBMA) rightly pointed out in a statement, the fixing price is based on real transactions. The purpose of a fixing is to concentrate supply and demand coming to the market at a certain time of the day to obtain the best price available. Ideally, at the fixing price, supply and demand are balanced. In practice, this could not allows be reached. In this case, the fixing price should lead to the highest trading volume, which implies that excess supply or demand would be minimized.

The fact that fewer banks are involved in the fixing of the gold and silver price compared to the LIBOR rate estimations is per se not an indication for possible manipulation. Beside the few banks being a member of the fixing committee, many other banks and institutions being active market participants in the foreign exchange markets also quote prices for the precious metals. Gold and silver are traded almost 24 hours per day, of course with some intraday periods being less liquid than others. However, during the time of the fixings, the market is quite active and liquid. Thus, also during the fixing periods, other banks and institutions could trade with members of the fixing committee based on their quotes in the FX markets. In addition, as a possible fixing price is called out, supply and demand could change as the fixing member banks can receive new orders from clients. It is only after several rounds of adjustment when no further improvement could be reached that the price is fixed.

If one defines market manipulation as bringing the fixing price to a certain level, then it is theoretical also possible. However, it would require that one or more banks of the fixing committee are ready to buy or sell gold or silver in unlimited amounts and to take the risk of pricing moving to their disadvantage after the fixing price has been published. Thus, in practice, it is rather unlikely that the fixing price is manipulated in a systematic fashion over a longer period of time as it had been the case in the LIBOR scandal.

Gold futures and options are traded in the US at the CME, which provides access to level 2 quotes (details of the order book about bid and ask size for various possible prices above and below the recent traded price). Furthermore, they provide the opportunity of co-hosting for high frequency trading firms. This system is far more vulnerable for manipulating the price to a certain level. It could be seen how many contracts would have to be bought or sold to push the price to a desired level, for example to trigger a barrier of an OTC derivative. Has anybody heart the CFTC would investigate whether trading at the US futures exchanges could be misused for price manipulation?

What really drives gold and silver lower!

Gold and silver traded sideways last week after giving back the gains made after the Italian election lead to a hung parliament. However, both precious metals are in a downward move since reaching a peak in early October last year. A German business paper provided the reason for this negative performance of both metals, the movement of interest rates. But are interest rates really the factor driving gold and silver lower?

First, it has to be identified which interest rates or bond yields are relevant for the two precious metals. If investors bought gold and silver as a safe haven against the impact of the debt crisis in the eurozone periphery, then it might be the yield on Spanish and Italian government bonds. Since the ECB decided on the OMT program, the yields on bonds of these two governments came indeed down significantly since the peak of gold and silver in early October 2012. However, the yields on 10yr Italian and Spanish bonds rose in February from the low they made at the end of January this year. But gold experienced its strongest decline in February. Thus, a movement out of the two metals and into peripheral government bonds in the eurozone is very likely not the major factor for the weakness of gold and silver.

Another argument is the development of yields on the safe haven government bonds. The yield on 10yr US Treasury notes has risen and is trading again above 2%. However, is this a convincing reason to switch out of gold and silver and into US Treasury notes? It would not be a smart move. First, even at the current yield level, the 10yr US Treasury notes provide hardly a real return. Many investors bought precious metals as a hedge against the risk that the Fed policy would lead to rising inflation rates. Despite the discussion within the FOMC about reducing QE 3, the Fed still follows a policy of balance sheet extension. Thus, the risk the FOMC might be expansionary too long and miss the right point for changing the course of monetary policy is still existent. Furthermore, a rise of bond yields is accompanied by falling prices of the bonds. Thus, it would not be smart to sell the hedge instruments (gold and silver) just when the insurance policy is needed most and to invest in an instrument, where further losses have to be expected over the medium-term horizon. The argument of higher bond yields as opportunity costs is only a good reason for selling gold and silver and buying the bonds when the rise of yields has come to an end.

Another segment is short-term interest rates. The Fed has set the guideline that it will keep the Fed Funds target rate at the current extremely accommodative level at least until early 2015. Thus, short-term interest rates are likely to stay at levels, which are unattractive for a switch out of the precious metals. Furthermore, their return is negative in real terms and they provide no protection against inflation.

What about the development of the other major factors driving the prices of gold and silver? The S&P 500 index has risen considerably on balance since the two precious metals reached their peak. Usually, a positive performance of the US stock market is also supportive for precious metals as it indicates a positive outlook for global economic activity. Crude oil has pared some of the gains recently, but is also trading higher compared to the level prevailing at the start of October last year. Thus, these two fundamental drivers could not be blamed for the decline of gold and silver prices.

Looking at the development of the US dollar, the picture gets less clear. Many analysts focus on the exchange rate of the US dollar against the euro. Since ECB president Draghi stated that the ECB would do everything to defend the euro, the single currency recovered. Even taking into account the correction in February, the euro is still firmer compared to early October 2012. However, the US dollar index shows a different picture. The USDX has risen, which reflects that the US dollar strengthened against the major five currencies. While the US dollar was weaker against the euro, it appreciated considerably against the Japanese Yen.

Thus, from our point of view, it is the change of economic policy in Japan with the election of PM Abe, which triggered the weakness in gold and silver. Hedge funds moved out of holding long positions in gold and used the funds to short the yen against the US dollar. Thus, it is still currency movements, which play a role for the precious metals, but it is not only the EUR/USD exchange rate, which counts.