Why The Cyprus Bailout Crisis Is Sending Gold Prices Higher

Includes: GLD, IAU
by: Tim Iacono

Officials in Cyprus are in the process of modifying the bank deposit confiscation scheme so as to lessen or eliminate the blow to small savers, part of the tumultuous 10 billion euro bailout plan with the EU and the IMF announced over the weekend.

The latest reports indicate that even this measure stands little chance of being approved by parliament, but, at this point, it makes little difference for precious metals markets.

Confidence in the banking system and trust in policy makers has been shattered and, regardless of what happens in the tiny Mediterranean nation, this will drive more investors around the world to seek safety in precious metals.

More importantly, this should cause demand for physical gold to rise sharply as more ordinary citizens and wealthy investors around the world reject paper promises (in this case, in the form of deposit insurance) from institutions they once had faith in.

(Note: This is a fast-moving story and for the latest developments, a Google news search on "Cyprus Bailout" is recommended. It's also worth pointing out that the U.K. Telegraph has revived its live coverage of the European debt crisis, re-titled "Cyprus Bailout - Live".)

There are all sorts of possible bad outcomes that may develop in the days and weeks ahead such as possible bank runs in Spain and Italy where similar action is now feared or Russia retaliating by cutting natural gas supplies to Germany.

But, at this point, as far as precious metals are concerned, it doesn't really matter what happens since the damage has already been done.
Banks are, by nature, institutions that are based on trust.

While some people may cling to the notion that the money they deposited is sitting there in the local bank's vault under the watchful eye of bank officials, most customers understand that banks hold only a fraction of the money on deposit.

A few years ago, we were all reminded that bank runs are still possible in our modern world as we witnessed governments taking over failing banks during the 2008 financial crisis and confidence has not yet been fully restored.

But, what makes developments in Cyprus far different (and much worse) than anything seen then is that, rather than rescuing both the banks and the depositors as was the case in 2008, government policy makers have abrogated a very important promise to investors - deposit insurance.

The long-standing principle that insured European Union bank deposits of up 100,000 euros has been cast aside with a simple stroke of the pen.

The fact that senior bond holders are being protected makes it even worse.

This should serve as a wake up call to bank depositors around the world that, now, not only can't they trust their banks, but maybe their government can't be trusted either.

This is sure to cause depositors large and small to seek out alternatives to bank deposits and one of the most ready alternatives is gold in physical form.

I wouldn't begrudge any investor making purchases of popular ETFs such as the SPDR Gold Shares (NYSEARCA:GLD) and the iShares Gold Trust (NYSEARCA:IAU), but the developments in Cyprus are another shining example of the benefits of physical possession over "paper gold" that comes with counter-party risk.

Gold is once again filling its role as a safe-haven and investment banks are, perhaps, warming up to precious metals again, at least according to Commerzbank comments found in this Mineweb report:

Gold should profit from the possibility that savings are no longer regarded as safe, and should thus enjoy strong demand in the current market environment. We therefore expect to see prices continuing to rise.

This could also have ripple effects elsewhere in the world, particularly in India, the world's biggest gold buyer.

For more than a year now, the Indian government has been prodding citizens to buy paper assets over physical bullion in order to reduce their gold imports. The brazen moves by policy makers in Europe who have misread the situation badly are not likely to instill confidence in Indian buyers contemplating a switch from their long cultural affinity for gold jewelry to some form of "paper gold."

In the rest of Europe, demand for physical bullion should rise sharply as it did in 2011 at the height of the sovereign debt crisis. As shown below via the World Gold Council, this was a key factor in driving the gold price to a record high at the time.

It's not surprising that the outlook for gold has become increasingly bullish in just the last few days. The recent sell-off has, for the most part, been a U.S.-driven event via futures market traders who never really understood the gold story.

The gold price bottomed at around $1,560 an ounce about a month ago and it is now trading at over $1,600 an ounce amid rapidly changing sentiment.

Holding the $1,600 level and advancing from there will be key and increasingly aggressive physical buying will go a long way in making this happen.

While short-term prices are dictated by futures traders, physical buyers will determine precious metals prices over the long term and, due to what's happening in Cyprus, there will now be many more physical buyers in the market in the period ahead.

Disclosure: I am long GLD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I also own gold coins.