Precious metals under renewed pressure

It had been pointed out several times in this blog that the status as a safe haven does not imply that precious metals were immune against stronger downside moves. This past week is another proof for this statement. Precious metals were under renewed pressure and only a rebound last Friday prevented even bigger losses. Gold ended the week down by 6.6% and platinum lost only slightly less at -6.4%. Silver and palladium are the more volatile precious metals dropping by 7.9 and 9.0% respectively.

The traditional fundamental factors for the precious metals were all negative again. The US dollar firmed not only against the euro but also against the other major currencies. The stock markets in Europe and the US headed all south and crude oil prices came under pressure. However, also the flow of funds data indicates that investors reduce holdings of precious metals. According to the latest CFTC report on the “Commitment of Traders”, large speculators have reduced their long positions in gold and slightly increased the short positions. Thus, the net long position has dropped by 9,208 to 150,503 contracts, the lowest value since the beginning of November. Also holdings in the biggest ETF, the SPDR Gold Trust, have been reduced last week by 15.4 tons to 1,280.0 tons.

The major factor weighing on precious metals remains the debt crisis in the eurozone. The rating agencies are not satisfied with the result of the EU summit on December 9. Standard & Poor’s already warned that all member states of the eurozone might be downgraded before the summit took place. Now also Moody’s has reduced the outlook for the eurozone to negative and Fitch also warns that six member states might face a lower rating. All three agencies refer to the outlook for GDP growth. However, the rating agencies became a part of the problem and are an obstacle for a solution. When the crisis broke out, the agencies demanded that austerity measures had to be taken to restore confidence. However, as soon as those measures had been taken, they lowered the rating of various states and referred to the lower growth prospects due to the austerity measures. This is now going on for various cycles and more and more countries face a downgrade. As long as the agencies threaten to cut the ratings of eurozone member countries, the market for government bonds in the eurozone has difficulties to calm down. This has also a negative impact on the euro exchange rate. Furthermore, fears of a global recession will not subside. Quite the opposite, they are more likely to get stronger like the warning of the IMF last Friday showed by comparing the current situation in the eurozone with the early 1930^th, the beginning of the global depression.

Have you ever wondered that there is only one German among the Noble laureates in economics? Just take a look at the German economic orthodoxy and it is no longer a wonder. The German government and the Bundesbank believe that a fiscal austerity policy would be sufficient to solve the debt crisis in the eurozone. However, they completely ignore the German past when the austerity policy of Chancellor Bruenning steered Germany right into the depression of the 1930^th. Furthermore, they are obsessed with the experience of the hyperinflation of the early 1920^th. This obsession leads to the refusal to accept any involvement of the ECB and national central banks in solving the debt crisis. Germany blocks the proposal to grant the EFSF or EMS a banking license, which would allow these institutions to buy government bonds in the secondary market and to obtain credit from the ECB, while the state owned Landesbanks in Germany and state owned savings institutions in other eurozone countries could also hold government bonds refinanced by loans from the ECB. Economically, this differentiation does not make any sense because the ECB is also indirectly involved in state financing if state owned commercial banks buy government paper.

At the EU summit on December 9, there was an agreement that central banks of the eurozone should lend 200bn euro to the IMF, which then could leverage the funds of the EFSF and the EMS. However, the Bundesbank is blocking this solution by demanding that the German parliament would have to approve such a loan and by insisting that further leading countries outside the eurozone also participate in providing loans to the IMF. However, the US already announced that they would not grant a loan to the IMF. The Fed can not participate due to legal reasons as chairman Bernanke explained. The president of the Bundesbank argues that providing a loan to the IMF, which then lends to eurozone governments, would be circumventing forbidden lending of the ECB system. However, the Maastricht treaty only rules out direct lending to governments. Without any involvement of central banks, the market for government bonds could not be stabilized in the short-run. As Lord Keynes ones said, “in the long run we all are dead”. Waiting for the austerity measures to restore investors’ confidence might take too long.

As long as Germany refuses that central banks play a direct or indirect role in stabilizing the government bond market in the eurozone, fears of a global recession will prevail. The markets already ignored positive economic data last week. The implications for the precious metals remain negative in this case. The rebound seen last Friday might just been some short covering.

This was the last article in this blog for 2011. The next article will be published on January 7, 2012. We wish all readers of this blog a merry holiday season as well as a happy and successful New Year 2012.

Precious metals down again on eurozone debt crisis

Most precious metals posted losses again the past week. Only palladium bucked the trend and gained 6.4% on the week. Palladium is driven by the outlook for a supply deficit in 2012 due to declining stocks and production in Russia. The usual drivers for the price of gold were mixed last week. The US dollar index firmed slightly, which was a bit negative. The price of crude oil declined and thus weighed on gold. The rise of the S&P 500 index was a supportive factor, but could not compensate the negative factors. However, one has to take into account, that the strong rise of the S&P index on Friday pushed the index back into the black. Gold followed the stock markets most of the week, but not on the last trading day of the week.

The S&P 500 has also been influenced by the developments in Europe. However, also US economic data had an influence. While a few month ago, most US economists were convinced that the US economy would head towards a double dip recession, the macro-economic data is by and large better than economists predicted. We pointed out several times in August and early September that we don’t expect a recession in the US. Also the labor market shows signs of improvement. Therefore, from our point of view, the S&P 500 index has further upside potential, especially in the case that the debt crisis in the eurozone gets solved. However, one caveat has to be made. The winter season could lead to slower economic activity as it had been the case in Q1 this year. Thus, our medium-term assessment of the price development in precious metal markets remains positive.

It could not be repeated often enough; the key for rising precious metal prices is a convincing solution of the debt crisis in the eurozone. This past week brought a major improvement, but also a major set-back. At the beginning of the week, France and Germany agreed on a proposal to change the EU treaty. According to this plan, national states would have to include the requirement of balancing the budget in their constitutions. Individual states violating the 3% deficit criterion of the Maastricht treaty would face an automatic procedure to get penalized. The EU commission would have to send the case to the EU court. At the EU summit, 26 of the 27 member states approved this proposal, only the UK opposed it. However, the 26 supporting states will go ahead without the UK in implementing the proposals. These proposals that eurozone member countries follow a responsible fiscal policy might be important in the medium-term, but they unlikely solve the problem in the short-run. As one of the five economic advisers to German chancellor Merkel put it, the German chancellor sees the problem of the debt crisis as one-dimensional while it is multi-dimensional in reality.

And it was this one-dimensional position of Germany, which prevented a solution convincing financial markets also in the short-term. However, Germany also had to make some concessions. The national central banks will lend 200bn US dollar to the IMF, which then can provide funds for leveraging the EFSF. In addition, the EMS, the stabilization mechanism, which should be a permanent institution, will start working already in July 2012 instead of January 2013. The major task is to restore confidence in the market for government bonds in the eurozone. These measures are probably insufficient to fulfill this task. Given the volume of bonds, which have to be refunded in 2012 by the countries being under attack in bond markets, the funds of the EFSF could be exhausted already in H1 next year in the worst case. Bond market strategists pointed this out already in their research papers.

Further measures to stabilize the government bond markets in the eurozone would be either to provide the EFSF or EMS with a banking license or that the ECB acts as lender of last resort. However, both measures have been blocked by Germany. It appears that Germany follows a new kind of beggar my neighbor policy as it is profiting from absurdly low interest rates on government bonds and notes, while other countries with similar or even better fiscal positions (Spain has a far lower debt/GDP-ratio than Germany) have to pay far higher interest rates to sell their bonds.

The ECB demonstrated again that a few words could do more harm than the benefits of some right measures taken. At the monthly rate setting meeting, the ECB Council decided to cut the refinancing rate by 25bp to 1.0%. Furthermore, the ECB extends credits to banks to up to 3years and accepts collateral with lower credit quality. The intention of these measures is to increase bank lending to the real economy. However, these measures are likely less effective as long as the tensions in the government bond markets persist. At the speech given to the EU parliament, ECB president Draghi created the impression that the ECB would be ready to buy government bonds in the secondary market more aggressively, if the EU agrees on stricter rules for fiscal policy in the eurozone. At the press conference following the council meeting, Mr. Draghi stated he was surprised by the interpretation of his remarks. He turned a cold shoulder to buying government bonds to reduce yields on bonds of pressured countries like Spain and Italy. That was not super, Mario!

As long as the ECB is not acting as a lender of last resort and uses its unlimited power to restore confidence in the market for eurozone government bonds, there is no lasting and convincing solution of the debt crisis in the eurozone. Furthermore, it is likely that the measures taken by the ECB fail to stimulate bank lending to the private sector sufficiently. The risk of stagnation of even recession in the eurozone is increasing. In this environment, also downside risks for the precious metals prevail. However, once the market for government bonds are stabilized and yields on Spanish and Italian government bonds come down to more sustainable levels, the precious metals might be in for another strong move upwards.         

Precious metals rebound, but not yet out of the woods

A report in an Italian paper last Sunday, that the IMF would lend 800bn US dollars to Italy, led to a rebound of precious metals in Asian trading on Monday. The amount stated in this report is above the lending limit of the IMF, thus, financial and commodity markets should have spotted this report easily as false. Also the IMF later denied being in talks with Italy about a bail-out loan. Nevertheless, precious metals rose and closed the day near the high of the respective trading ranges. On Wednesday, precious metals got another push higher by two measures from central banks. First, the Chinese central bank, the People’s Bank of China, reduced the reserve requirements by 0.5 percentage points. Second, the Fed and five other central banks agreed on mutual unlimited swap lines to provide sufficient US dollar liquidity to the banking system. This measure was targeted primarily for European banks after US investors withdraw funds from European banks and money market funds.

Among the precious metals, palladium posted the strongest weekly gain, soaring by almost 14.0%, the biggest weekly rise in 3 years. The cut of reserve requirements by the PBoC is probably positive for car sales and China and thus, for the palladium demand by the automotive industry. Furthermore, Norilsk Nickel, the world biggest palladium producer, expects the palladium market to be in a supply deficit next year.

After the rebound last week, also the technical situation for most precious metals has improved. However, does this imply that the assessment made last week in this blog was wrong? We still stick to our view that lasting and sustained rises of the precious metal prices require a convincing solution of the debt crisis in Europe. The rise last Monday was based at best on hopes that European politicians finally come to get their act together. However, there are many stumbling blocks on the road to a solution of the debt crisis in the eurozone.

On Thursday, the ECB will hold its rate setting meeting. After the swap agreement announced last Wednesday, some economists expect that the ECB might cut the refinancing rate again by 25bp. This would be helpful but would not eliminate the risk of a credit crunch in the eurozone with negative implications for activity in the real economy. At the hearing in the European parliament, ECB president Draghi repeated the stance that bond purchases would be limited and only temporary. However, one remark has been interpreted as keeping the door open for more active bond buying. Thus, the markets will also pay close attention to his statements at the ECB press conference.

At the EU economic summit on Friday, December 9, France and Germany want to push ahead to the formation of a fiscal union and want to present changes of EU treaties. German Chancellor Merkel insists on automatic punishments of countries violating the fiscal discipline and rules set in treaties. Also balanced budgets should be anchored in the constitutions of the eurozone member countries. While the creation of a fiscal union would repair at least to some extent the errors in the construction of the single European currency, the German demands do not provide a quick solution of the crisis. They might lead to a rebuild of confidence in the medium-term at best. Furthermore, Germany is only demanding what other countries should do but refuses to make any offer.

As we pointed out already earlier, the failure of politicians to act quickly and in a decisive manner contributed to the destruction of the government bond market in the eurozone. Government bonds are no longer a risk free asset. Investors have to fear that haircuts will not be only limited to Greece as a special case. Furthermore, the demand from Merkel and Sarkozy that a referendum considered in Greece should be about staying or leaving the euro, has opened the Pandora’s Box. Now, investors have to factor in the risk that they will get the redemption of a bond in a currency other than the euro. Furthermore, the European Banking Authority also contributed to the destruction of the government bond market in the eurozone by counterproductive regulations. The requirement, to value all government bond holdings at market values, not only those in trading books but also bonds intended to be held to maturity, has eroded the capital ratios of banks. In addition, they had to sell government bonds to reduce risk, which made the situation in the market only worse. In the short-run, the ECB is the only institution being able to act as a lender of last resort and to restore confidence. However, as long as German economic religion opposes such a step, the crisis will probably not be solved.

Thus, the second half of this new week will be very crucial for the further outlook for the precious metal markets. Currently, we regard the risks as more biased to the downside. We would not rule out that the announcement of an agreement would lead to a relief rally the following trading day. However, this relief faded more and more quickly after each EU summit. We remain skeptical that it will be different this time. But the next blog article provides an opportunity to comment on the EU summit. For those who went long precious metals, we recommend to keep tight stops.

Madame NO weighs on precious metals

The precious metals suffered during the course of the week and all metals ended in the red. Gold held best with a loss of only 2.5%, while silver and platinum were down by 4.0% each and palladium was the worst performer with a loss of 6.4% over the week. The three major fundamental factors of our quantitative fair value models all had a negative impact on the precious metals. The US dollar index strengthened while the S&P 500 index and crude oil fell and thus signal slower future economic activity and a declining inflation risk.

However, there remains one common factor behind the fundamental variables of our fair value models, the never ending debt crisis in the eurozone. Spain was now the fifth country in the eurozone, in which the debt crisis led to a change of the government. The conservative people’s party gained a broad majority of the seats in parliament and its leader Mr. Rajoy will become the next prime minister. Already during the election campaign, he indicated that more austerity measures and economic reforms would be needed to regain confidence of investors in Spanish government bonds. But investors gave Spain the cold shoulder. At an auction of short-term bills, Spain had to pay interest rates at a record high since the introduction of the single currency in 1999. The lackluster auction also led to rising yields on longer dated government bonds. The ECB bought Spanish paper, but the amount was not sufficient to prevent yields to rise.

At the beginning of last week, French government bond yields rose after a report from Moody’s was understood as an indication that France could loose the AAA rating soon. An economist at this rating agency warned that "Elevated borrowing costs persisting for an extended period would amplify the fiscal challenges the French government faces amid a deteriorating growth outlook, with negative credit implications". This demonstrates how dangerous it is, when an economist chooses the wrong reference. Elevated could refer to the average of historical yields, but even at around 3.7%, yields on 10yr French OATs are relatively low by historical standards. The spread of almost 170bp over 10yr Bunds is rather high. However, is the 10yr yield spread the appropriate benchmark to judge the creditworthiness of France? The answer is absolutely no, from our point of view. The right comparison would be either nominal bond yields with nominal GDP growth or real yields with real GDP growth. At the current eurozone inflation rate of 3.0%, the real yield on 10yr French OATs is just 0.7%. The projected real GDP growth for 2012 is currently at 0.5%. As France is also implementing measures to reduce the budget deficit further, the difference between the real yield and real GDP growth rate should hardly give any concern about the creditworthiness of France. It appears again that rating agencies, which were a major culprit of the debt crisis in 2008, attack those who came to the rescue, namely the governments.

Many investors, but also politicians, thought that Germany would be the safe haven. Even when other core countries with a triple A-rating came under pressure, yields on 10yr German Bunds declined to a recorded low of 1.65%. Germany appeared to be the only solid rock. But last week, also Germany came under pressure. The auction of 10yr Bunds was a disaster and shows that investors are no longer willing to fund the budget deficit of the federal government, which will increase next year according to the 2012 budget. The German debt management agency planed to sell 6bn euro of 10yr paper, but investors bid for only 4bn euro. Thus, the remaining 2bn euro of 10yr Bunds will now be sold by the Deutsche Bundesbank in the open market. The Wall Street Journal accused Germany that it would accept the Bundesbank buying Bunds but would resist that the ECB buys bonds of other eurozone member countries. However, the WSJ did not understand the procedure. The Bundesbank only acts as a fiscal agent for the government. It is not buying the Bunds from the German government. The federal government will only receive the funds after the Bundesbank has sold the paper in the secondary market.

Nevertheless, the WSJ is right in pointing out that Madame NO is the major problem for solving the debt crisis. German chancellor Merkel is not only opposing the introduction of Eurobonds but even wants to oppress any discussion about this instrument, as her attacks on the head of the EU Commission, Mr. Baroso, showed last week. She also opposes that the ECB acts as the lender of last resort. As the debt crisis turned into a wide spread crisis of confidence, the ECB is the only institution, which has sufficient funds available to bring yields down to a sustainable level and to prevent further escalation of the debt crisis. The EFSF will fail miserable to reach the target level as press reports revealed over this weekend. Mrs. Merkel and her consultants are obsessed that solving the debt crisis would lead to a transfer union or rising inflation. In her naivety, Madame NO believes that a change of EU treaties would be sufficient to restore confidence.

The market for government bonds in the eurozone has been destroyed. The root cause is the ballooning Greece budget deficit during the Karamanlis government. However, the German chancellor played a major role that the initial problem could not be contained and the contagion now reached even the core countries of the eurozone. The demand that private investors would have to pay for the bailout of Greece while sovereign creditors get fully repaid was a major blow for holding government bonds. But also the European Banking Authority eba contributed to the destruction of the government bond market by several changes of regulations, which all lead to banks selling government bonds in a market, which is not ready to absorb them. It is a major construction failure of the euro that the ECB is not officially the lender of last resort. As long as Madame NO rejects all proposals which would involve a determined buying of eurozone government bonds by the ECB in the secondary market, the debt crisis will still prevail. For precious metals, this is a negative development. The current correction is likely to continue this week, unless there will be a convincing breakthrough to solve the eurozone debt crisis.

Precious metals dragged down by eurozone debt crisis

At the start of last week, gold approached the 1,800$/oz mark again, but reversed direction and closed lower. During the course of the week, gold headed further down and ended the week at 1,723$/oz, a loss of 3.6% over the week. Also other precious metals ended the week lower.

It might sound like a broken record, but the reason for the weak performance of the precious metals has been the never ending story of the debt crisis in the eurozone. After Mr. Berlusconi resigned and Italian President Napolitani asked former EU commissioner Mario Monti to form a new government, the financial markets got concerned that technocrat led governments in Italy and Greece would lack the skills of politicians. The week before, a major concern of financial markets was that politicians would not be able to solve the problems. This demonstrates how much financial markets are in panic. One week they are spooked by one factor and the next week just by the opposite. In Greece and Italy, technocrats now lead the new governments and in both countries, the new leaders have won confidence votes. Nevertheless, the debt crisis in the eurozone worsened further.

Yields on 10 year Italian BTP rose again above the 7% mark temporarily. After an auction of Spanish paper, where the yield was higher than at a comparable auction in October, also the yield on 10 year Spanish government bonds rose to the 7% level, which the markets regards as crucial because other eurozone countries asked for a bail-out once yields rose above this level. However, purchases by the ECB helped to push yields lower again. But the crisis is not contained to these two countries. Instead it has now also reached the core countries. France and Austria have both a triple A-rating, nevertheless, the spreads of 10 year bonds of both countries widened last week considerably over the benchmark German Bunds and reached almost 200bp.

The only institution, which could stop the panic in financial markets, is the ECB. During a conference last Friday in Frankfurt, Germany, the ECP president Draghi as well as the head of the Bundesbank Weidmann made it clear that they oppose to be the lender of last resort. Mr. Weidmann is even opposing the current purchases of government bonds in the secondary market. Also German chancellor Merkel still rejects calls that the ECB should be the lender of last resort and should assure the markets by setting a line in the sand for the yields on government bonds and defending this line by unlimited interventions. The common fear is that such a defense would lead to inflation.

Those fears appear to be overdone for several reasons. First, buying government bonds is not just printing new money. It is a traditional instrument of monetary policy to provide liquidity for the banking system by open market policy operations. Thus, the ECB could absorb the liquidity provided by open market operation by reducing the allotments in the weekly repurchase agreements. Second, even the announcement to buy unlimited amounts of government bonds to keep yields at a certain level does not necessarily lead to an increase of central bank money. Often the markets adjust to the target level and only smaller amounts are required to convince financial markets. A recent example has been the peg of the Swiss franc to the euro by the Swiss National Bank. Third, even in the case that the central bank money stock increases, the monetary impulse has to be transmitted to the real economy. The banking system has to increase the lending activities to governments and the private sector. However, banks in the eurozone reduce the holdings of government debt. The requirements to increase core capital ratios have also a dampening effect on lending to the private sector. Therefore, from our point of view, the risk of accelerating inflation rates as a result of acting as lender of last resort is overemphasized by the ECB.

As long as the debt crisis in the eurozone remains unsolved, it has to be expected that weaker stock markets, declining crude oil prices and a firmer US dollar will weigh on precious metals. In addition, also a technical indicator, the MACD, points to a trend reversal in gold. Thus, the correction in precious metals, which started last week is likely to continue.

Safe haven buying versus the fundamentals

In calls from journalists, the author of this blog is often asked lately, why precious metals declined during days the debt crisis in the eurozone worsened. This crisis has two effects. On the one hand, as politicians are unable to find a quick and convincing solution, there is an incentive to buy precious metals as a safe haven. However, one should not forget that this crisis now lasts for already two years. Thus, there was ample opportunity to buy precious metals and new buyers would have to enter the markets to push prices higher. On the other hand, the debt crisis also has an impact on the fundamentals of the precious metals. An escalation of the debt crisis normally has a negative impact on these fundamentals. Therefore, selling of precious metals driven by the fundamentals could have a stronger impact on the price development than the safe haven buying. But prices could also rise on days of slight improvements in the eurozone as buying driven by the fundamental factors outweighs the possible profit taking by safe haven investors.

Last week, all precious metals posted gains compared to the preceding weekly close. However, it was an up and down trading, where on one day safe haven buying dominated and fundamentals were the stronger influence during the other days. But on all days, political developments rather than economic data were at centre stage.

In the preceding week, Greece was in the spotlight. But after Mr. Papandreou won the confidence vote late Friday night, some movement came into the political landscape. After the publication of the previous blog article, also the conservative New Democracy party agreed to the formation of a national unity government. While it took some time to form a new government, there was finally an agreement that Mr. Papademos, the former ECB vice president, should lead the new government. Last Friday, he was sworn in.

However, last week, Greece was more on the sidelines and Italy was on centre stage. After protests over the preceding weekend and declining support from his own coalition parties, financial markets expected Mr. Berlusconi to loose a vote in parliament in Monday and to resign immediately. From various comments in the media, we got the impression that many market participants did not fully understand what the subject of the vote was. In Italy, the parliament has to approve the report of the PM about the preceding fiscal year’s budget. The parliament voted last Monday on the report for the 2010 budget, but many commentators were under the impression it would be a vote on a budget for a future fiscal year. The opposition parties abstained from voting, there was no risk for some former supporters of Mr. Berlusconi to demonstrate their dissatisfaction by not voting with a yes. Thus, the report was approved by parliament but not with the absolute majority.

But in financial markets, there was widespread disappointment. Some commentators were disappointed that the report was approved while other commentators were emphasizing that Mr. Berlusconi failed the absolute majority was the reason for the negative market reaction. However, gold and other precious metals profited from their safe haven status. Late Monday, after consultations with the president of the Republic of Italy, Mr. Berlusconi announced to resign after a reform package promised to the EU leaders has passed both houses of parliament. On Saturday, Mr. Berlusconi resigned and at the time of publishing this article, President Napolitano was still in consultations before announcing who should form a new government. Markets expect that former EU commissioner Mario Monti would be the next PM in Italy.

In the bond markets, the 2010 budget report had a devastating impact on Tuesday. The yields of Italian government bonds soared over all maturities. The yield on 10yr BTPs reached 7.5% in the peak. This massive sell off weakened the euro and stock markets. Thus, negative fundamentals weighed on precious metals. While the ECB was reported to buy Italian bonds, the purchases intensified towards the end of the week. This brought yields significantly down. Stock markets and the euro recovered. Thus, on Friday, precious metals rose also significantly driven by positive fundamental factors.

The panic in financial markets can only be stopped if the ECB accepts the role of the lender of last resort for government bonds in the eurozone, despite resistance from Germans. Well conducted, it is by no means inflationary. However, it would be far more effective to prevent a recession than another 25bp rate cut. For precious metals, it would also be positive. Unfounded fears of inflation accelerating might be a reason for some buyers. But the main factor would be improving fundamentals for the demand for precious metals by recovering stock markets and a firmer euro.

The Greek Tragedy and Precious Metals

Last week, we argued that the comments from German finance minister Schaeuble concerning the markets initial reaction on the EU summit could lead to declining prices in precious metals markets. While this remarks also played a role, two other actors entered the stage on Monday and one of them moved even to centre stage for the whole week and is likely the dominating figure this week.

The first actor was the Bank of Japan, which intervened in foreign exchange markets to weaken the Japanese yen against the US dollar. The BoJ already intervened on several occasions before. Thus, it should not have come as a total surprise that the BoJ would try to prevent a further strengthening of the yen. The yen was regarded as one of the safe havens. This is very strange with respect to two factors. First, the earthquake and the Fukushima disaster have hurt the Japanese economy, which is in a recession. GDP dropped in Q2 by 1.1% compared to the same quarter of the preceding year. Industrial production in September was down 4.0% yoy and the trend is still further down. Currencies of an economy being in recession usually tend to depreciate but this is not the case for the Japanese Yen.

Second, government debt in relation to GDP in the US and in Europe appears to be a major concern for investors. However, the debt/GDP ratio in Japan is exceeding those ratios in the other industrialized regions by far, being around 200%. According to the criteria presented by Professors Kenneth Rogoff and Carmen Reinhard, Japan should already be beyond the point of no return and bankrupt. However, as the example of Japan shows, some critical ratios are not set in stone. The level of interest rates on government debt is also a crucial variable in the calculation at which debt/GDP ratio the interest payments are unbearable. With a yield on 10yr JGBs of just 1.0%, Japan is in a far more comfortable position.

Especially former and current German members of the ECB council should have a look at Japan. The quantitative easing of the BoJ contributed significantly to the decline of yields on 10yr government bonds. Despite the extension of the balance sheet by the BoJ, inflation has not emerged in Japan. Of course, one could not transfer the situation and monetary policy response in Japan on a 1:1 basis to the eurozone. Nevertheless, buying of government bonds of those countries in the eurozone, which came under attack from financial markets, is not a sure way to inflation.

After the Swiss National Bank pegged the Swiss franc to the euro, the appreciation of the yen increased. The yen fell to 75.5 at the last day of October. This induced the BoJ to intervene. The US dollar did not only firm against the yen, but also against other major currencies. This dollar strength send stock markets lower, which also pulled crude oil lower. As investors risk aversion increased, also yields on safe haven government bonds like the US Treasury paper or German Bunds dropped. In addition, the Schaeuble remarks contributed to a flight into Bunds as investors worried about the still open details of the EU summit package. As a result, also precious metals had been sold.

However, the centre stage was taken on late Monday by the Greek PM Papandreou, who announced to hold a confidence vote in parliament and later a referendum by the population. It was not clear, what would be the question for the referendum. However, given the polls on the rescue package decided at the EU summit, the markets feared that Greece would vote with a “no” in a referendum. This increased uncertainty send risky assets lower and safe haven Bunds and US Treasury notes higher. Precious metals initially fell further, but could already recover on Tuesday. The situation calmed somewhat after German Chancellor Merkel and French President Sarkozy called for a meeting with Greece’s PM Papandreou on Wednesday ahead of the 2day G20 summit. Both demanded that a referendum should be about Greece staying or leaving the eurozone. Furthermore, they announced that no funds would flow to Greece as long as the bailout package decided the week before will be fully implemented.

Holding a referendum on remaining a member of the euro would have been like playing with matches at a fill station. As soon as such a referendum had been called officially, the only rational behavior would be to withdraw all deposits with banks in Greece and transfer them to banks in other eurozone countries. If the result of a referendum would be to leave the euro, the new Greek currency would depreciate against the euro. Thus, one would make a profit. If the majority voted for staying in the eurozone, no currency gain would be made. However, there would be also no loss. Therefore, the financial system in Greece would have collapsed like a house of cards even before a referendum took place.

One Thursday, some movement came into the Greek political landscape. The finance minister opposed holding a referendum on staying in the eurozone. The PM Papandreou offered to give way to a coalition government of “national unity”, which should stay in power for some months to push all necessary legislation through parliament to implement the rescue package as agreed at the EU summit. Also opposition parties moved and showed some willingness to cooperate, but demands for snap elections in December remained on the table.

Friday night, PM Papandreou survived the confidence vote in the parliament. However, it is quite unclear how the political situation in Greece will develop. The major opposition party New Democracy insists on immediate snap elections. Some other parties in the centre appear to be willing to form a coalition government with currently ruling PASOK party. The main problem is that the party responsible for the mess torpedoes the clean-up work of the incumbent government to return back to power as soon as possible. Mrs. Merkel and Mr. Sarkozy should also make a strong call to Mr. Samaras, the leader of the New Democracy. All three are associated within the European Peoples Party, the conservative party in the EU parliament. But as long as Mr. Samaras puts his own interests above those of the Greece population, a solution appears hard to find. Thus, the political developments in particular in Greece, but also within the eurozone, are most likely the dominating factor for financial and metals markets. Investors should be on the defensive side as strong movements in both directions appear to be possible.