Archive for July, 2010
The early July pullback in gold to 1190ish has at least some people scratching their heads. My take is this. Gold ran up $100 to its all-time high of $1,268.50 as worried Europeans dumped Euros and bought gold in May. Then the European Central Bank (ECB) signaled that it will protect the Euro, and its own existence, by any means necessary, see this, and this.
And so, the Euro dissolution trade is dead, at least for now. I suspect that traders who bought gold because they feared the end of the euro, are selling gold and buying euros back.
To understand what is going on, look at the ECB’s secondary market purchases of sovereign bonds, which began in early May. I think the purchases may be a decisive element in the measures that have preserved the Euro, at least for now, and also led to gold’s pullback.
Recall that in response to the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) debt crisis the EU put together its bailout package in April. The package had an impressive headline number, $1 trillion in assistance. Many traders thought the headline number was more impressive than the substance. The euro kept falling and gold kept screaming higher.
Then in early June, it became clear that the ECB’s purchases of sovereign bonds on the secondary market were part of a continuing program, not a one time event (h/t naked capitalism). The Euro bottomed on June 7. I don’t think this is coincidence. Furthermore, gold, which made an intermediate high of $1,254.50 on June 7, can now be seen to have struggled since then, before finally selling off on July 1.
I would argue, though, that while the ECB punished gold holders in the short-term, ECB bond purchases are a positive for gold in the long-term. The purchases smack of “money printing” and amount to a backdoor aid package for the financially weak PIIGS. They peg the debt of the issuing countries to artificially high prices, and might even allow PIIGS to issue new debt at artificially low rates – assuming the ECB stood ready to buy bonds to support their prices. All of this can only lead to further debasement of the Euro versus gold.
Moreover the rebound in the Euro corresponds to at least a possible topping in the dollar. It almost has to, given the Euro’s large weight in the Dollar Index. (Hopefully this dip in the dollar will not bring to the fore, my longterm concerns about the dollar.) Some analysts suspect the Euro’s bounce mean that the risk trade is back on, and maybe it is for at least a little bit, given this week’s corresponding bounce in stocks.
The European bank stress tests also demonstrate Europe’s determination to save the Euro by propping up both the banks and financially weak PIIGS. The guidelines say that European banks may value Spanish Government bonds at 97% of par, and Greek bonds at 87%. That way the banks can, well, lie about the value of these assets and artificially prop up their equity. Of course, the banks will say that if the bonds will pay off at par (and if the EC can make that happen, they will) who needs to mark the bonds to market?
Allowing Europe’s banks to value the weak sovereign debt at such generous numbers, will also provide incentives for the banks to keep holding these bonds rather than dump them. Therefore the stress test guidelines provide a backdoor subsidy for the debt issuing countries as it would help keep their borrowing rates down. Of course, no one believes that these bonds are worth anywhere near that much.
But, in addition to the subsidy for issuing countries, the stress test guidelines matter because they indicate that Europe is following the US playbook on stress tests and bank bailouts. Last year, US regulators announced stress tests for US banks that would supposedly show that the banks would stay “solvent” under various economic scenarios.
As most readers know, these tests were ludicrously easy. Not many analysts thought that the major banks (with the possible exception of Wells Fargo, WFC) were viable at the time – not without government assistance, at least. But the stress tests provided a fig leaf to justify government help through TARP, the alphabet soup of Fed lending programs, and more lenient accounting treatments for banks’ securities holdings.
The change in bank accounting also marked the US stock market bottom in March 2009. Clearly the Europeans hope that European bank bailouts will make the financial markets happy as well. And in the short to medium term, if the US experience is any guide, the bailouts may enable the Euro bottom to hold (at least when measured against other paper currencies) longer than many people think. Even if, as in the US, European banks will continue to hold their fair share of underwater assets. In other words, short-term measures that kick the can down the road, can have important short-term results, even if they don’t solve long-term problems.
The European moves to bail out their banks tell you something else: not to worry about those reports that the Bank for International Settlements (BIS), is lending to commercial banks and taking gold as security, under repurchase agreements. Some gold traders seemed to fear that if the banks failed to make good on these loans, the BIS would dump the gold collateral on the market. My response: the EU will not let a big European bank fail anytime soon; that’s the whole point of their stress test charade. And if big European banks did start going down, I suspect the demand for gold would soar.
So what’s an investor to do? Chartists note that the June top was not much higher than the previous highs in December 2009, and point to what looks like a double top. In response to this and the July 1 gold selloffs, gold timing newsletters turned understandably bearish. Of course, the Hulbert Letter holds up this pessimistic timer consensus as a contrarian indicator, and calls it a buy signal (h/t Daily Crux). Still, if you are a long gold, the chart has to concern you.
My thinking is, if you are a trader and you don’t like gold’s double top (not to mention its closes below the 50 day moving average), why not lighten up? The chart doesn’t tell me that gold is going higher anytime soon. But I wouldn’t sell a core position, because the European move only underscores the long-term weakness of paper money around the world.
Disclosure: long GLD, SGOL