The Gold Market: Making Sense of Chaos
The Gold Market: Making Sense of Chaos
The third quarter began well for gold and proceeded to get better until September 21 when it seemed to step into space, falling 20% ($280) in just a few days. This event demonstrated how sensitive gold is to perceptions of central bank policy. What happened?
First, the September 21 Federal Reserve FOMC meeting did not produce a plan for further expansion of the Fed's balance sheet. Some investors in gold clearly expected such a development. Three Fed governors voted their disapproval of the small steps towards easing that were adopted at the meeting. The aggressive selling of gold began that night after the FOMC statement was released.
Secondly, as the debt situation in Europe continued to deteriorate, European securities fell sharply, forcing European gold holders to liquidate in order to reduce leverage. Much of the selling pressure on gold during late September originated in Europe. Widespread reductions in Euro Zone growth estimates and open disagreement and confusion over the next tranche of Greek bailout funding contributed to an abrupt downturn in markets. Gold performed its traditional role of providing emergency liquidity.
Perhaps most importantly, investors began to anticipate a disorderly Greek default and interpreted it as a possible Lehman moment. All of us remember that, in the fall of 2008, the authorities let Lehman go into a disorderly bankruptcy with immense unintended consequences. In the ensuing liquidity crunch, gold fell. The Fed and the Treasury acted promptly to address the crisis. The Fed provided an alphabet soup of liquidity programs, fulfilling its mandate as lender of last resort. The Troubled Asset Relief Program (TARP) recapitalized the banking system, containing the Lehman contagion effect. Gold began to recover and was one of very few assets to close higher on the year. Would a Greek default or the failure of a major European bank trigger a similar response? Would a dysfunctional Euro Zone be able to produce a TARP response quickly enough? Would the European Central Bank (ECB) be able to act as a lender of last resort? Anticipating that gold could fall in such circumstances before effective money printing could be implemented, investors sold gold.
A Fed change of heart
In its November 2 meeting, the FOMC sang a different tune. The hawks were gone. Three dissenting votes against easing were replaced with one dissenting vote against not easing immediately. Suddenly Fed officials are broadly hinting at their support for further expansion of the Fed balance sheet, known as quantitative easing or, simply, money printing. The Japanese and Swiss central banks once again are printing to weaken their currencies, other central banks are dropping their interest rates (Australia, Brazil) while a growing number of others are trading in their paper currency reserves for gold. With central banks once again proving their infidelity, investors are returning to gold and its price is on the mend. Perhaps markets will not need another reminder of how central banks actually think. The one question remaining is the Euro Zone.
Europe descends into confusion
As we go to press, the news is "all-Europe, all day". The debt crisis which we have long predicted is upon us. Greece is now irrelevant...it was important only because it marked the initial point of infection for the sovereign debt sickness which had to be contained. It could have been contained, there was the time to do it and the resources were at hand, but European institutions failed to deal responsibly with the Greek problem, confidence has been lost and contagion has been unleashed with the yield on 10 year Italian debt now exceeding 7%.
Italian sovereign debt, at E1.9 trillion, is nearly 120% of GDP and more than five times the debt of Greece. The term structure of Italy's debt is perfectly suited to disaster as nearly E300 billion is due over the next 12 months. Italy cannot afford to roll this debt at 7% (a more than doubling of the yield) and there is no reason to think that 7% is the top. The European Financial Stability Facility (EFSF) is not nearly large enough to handle this problem.
Nein, nein, nein
How we got here is instructive. The Euro Zone tried to rescue Greece on the cheap, relying on creating the perception of a resolution rather than making firm, realistic commitments. There were five main components to the Greek bailout announced in late October. First, Greece would get further money for more austerity which was certain to depress its economy further and increase the already unmanageable debt load just as the last round of austerity has done.
Second, Greek debt in private hands would be written down by 50% but not Greek debt held by the ECB and other EU institutions. Effectively, this reduced Greece's sovereign debt load from E350 billion to E275 billion...not enough to make Greece solvent and setting the stage for a further default. Under the most optimistic predictions of economic growth and austerity success, this would only have reduced Greece's debt -to-GDP ratio to 120% in 2020.
Third, the 50% 'haircut' taken by private investors was to be' voluntary' so as not to constitute a credit event which would trigger default and a payout under Credit Default Swaps (CDS). Good faith purchasers of Greek CDS were told that the rules had changed. In a further example of the 'Law of Unintended Consequences', holders of Italian debt are now selling because CDS insurance is no longer reliable. There is no problem that governments cannot make worse.
Fourth, Europe's 90 largest commercial banks were required to raise additional capital totaling an estimated E110 billion. However, it was every bank for itself. If some needed help, they would have to look to the central bank of their home nation, not the ECB nor the EFSF.
And finally, the E440 billion EFSF would be buttressed by additional capital from undefined sources...perhaps by selling bonds to private investors, perhaps from China or the G20 nations but not from the ECB. The first EFSF bond issue failed and was withdrawn while other nations declined to contribute to the EFSF, noting that Europe has to solve its own problems and has the resources to do so.
The weakness of the Euro Zone proposal stems from what is not included. Germany dictated that the ECB would not be the lender of last resort, unlike every other central bank in the world. The ECB would not backstop the EFSF, not buy the bonds of EMU countries unless the purchases were small, temporary and sterilized by the sale of other securities, would not recapitalize the commercial banks and would therefore not, under any circumstances, continue to expand its balance sheet or otherwise print money. For Germany, the 'stability' of the Euro and the 'credibility' of the ECB seem to be more important than jeopardizing the solvency of Euro Zone countries and the continued existence of the European Monetary Union itself.
The conservative nature of the ECB is evident in the fact that its balance sheet has increased by about one-third since the financial crisis began in 2008 while the Federal Reserve has tripled its balance sheet.
As previously stated, in our view one of two things will happen in Europe. Either the Germans will relent and let the ECB print several trillion euros, thus accommodating sovereign debt refinancing requirements and propping up the commercial banks. Or the EMU will dissolve into chaos and the European banking system will collapse. Either way, gold will be the go-to asset for wealth preservation. Which option is more likely?
The history of the Exchange Rate Mechanism (a precursor to the euro) in the early 1990s is instructive. Fearing inflation, the German Bundesbank kept interest rates very high, which pushed up the mark, forcing other members of the ERM to support their currencies in order to maintain the agreed exchange rates. Eventually, German intransigence blew up the ERM; Britain withdrew, much to the profit of George Soros. Germany then relented, too late for Britain. In the current scenario, the ECB is Germany's Bundesbank. We believe that Germany will once again relent but only after enormous damage has been done. In our view, rational Europeans should convert euros to gold which will survive whatever transition may ensue. Many appear to be doing so.
The world has too much debt. As matters now stand, this debt cannot be rolled over. The 'solution' to the unfolding debt crisis will, in our view, be more money printing and a higher gold price. That's the way central banks have dealt with every similar crisis in the past. Why would this time be any different? In our May annual report to shareholders, we advised gold investors to buckle up. Given the expected volatility, we suggest seat belts remain firmly in place.