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.