For the past and coming weeks, to predict moves in gold and the US dollar, watch the euro, for volatility in the euro is what is driving both gold and the dollar. That’s the asset that is showing the most volatility and markets are watching it, and for good reason. In the past month the EU debt crisis has proven to even the doubters that it is indeed the primary threat to the global economy and banking system, and further deterioration will leave no one unscathed.
Recently, The Euro Is The Prime Driver Of Gold
As we discussed in The Must Know Truth About Gold, gold is neither a risk nor safe-haven asset. Its prices are driven by anxiety over the value of fiat currency, which can occur in optimistic times because growth threatens inflation, and also in very pessimistic times, when markets fear for the existence of the financial system and its currency.
Gold’s sole appeal is as a currency hedge. As the second most liquid currency, euro troubles create plenty of demand for gold.
Note the chart below (click to enlarge) for the EUR/USD, and how the EUR began its most recent move down May 21st.
EURUSD DAILY CHART COURTESY AVAFX 19 may 27
Now note the below gold chart (click to enlarge), and how gold began its reversal the same day.
Gold Daily Chart Courtesy AVAFX 18 may 27
The only event gold could have been responding to was the renewed drop in the euro. That makes sense, given that gold is in its essence a currency hedge, so worries about the second most liquid major currency losing value should indeed boost gold.
The Euro Is Also The Prime Driver Of The USD
The EUR/USD pair comprises 33% of all forex trade by itself. That means for every 3 EUR bought or sold, a USD is involved, and vice versa. Thus these two always exert a major influence on each other, pushing each other in opposite directions like children on a seesaw. That influence has strengthened as events in the EU have taken center stage over the past months. The US has seen mildly improving economic data, but nothing to match the drama of the threatened financial collapse in the EU. As long as jobs growth and inflation remain quiet, the Fed is not raising rates any time soon, so no big market moving news expected from the Fed. Thus the euro has been the prime driver of the USD as well as of gold.
Thus in the coming days if you want to know where the USD and gold are likely to be moving, watch the euro, for it will be moving in the opposite direction.
EU Debt Crisis Is The Prime Driver of All Asset Markets, Including US Treasury Bonds
Note however, that T-Bonds do not generally move together with the price of gold.
I received a comment suggesting that long-term US Treasury bonds were a better indicator of inflation than gold, and that thus T-Bond prices should fall and their yields should rise as gold rises. This is a confusion worth addressing, just like that of gold being a risk or safe-haven asset (clarified, I hope, in The Must Know Truth About Gold).
The short answer is that T-bonds and gold do not move with the same factors, though at times the two may move in the same direction and they would indeed move in opposite directions with rising inflation risk.
Gold is a hedge against falling currency value, like we have now with the EUR, and had last year with the USD.
Bonds, however, are a general hedge against risk. Inflation is one kind of risk, but so is the collapse of the EU, the euro, global stocks, etc. All of these can push T-bond prices higher and yields lower on rising demand for the safe haven asset. Inflation risk would push bond prices lower and yields higher to compensate for the lost future value of the payment and return of principal.
Gold and T-bonds are rising now not because of inflation fears, but rather :
- Gold is rising from anxiety about the higher risks that the EUR and possibly other currencies will lose value.
- Bonds prices are rising more as demand for a general safe haven asset to hedge against general market risk. Bonds should in theory respond to inflation with falling prices/rising yields. But bonds can rise or fall for other reasons. As we see today, there is a longer term threat of inflation that should hurt T-bond prices, but these are rising because investors in stocks and other risk assets are fleeing these assets and buying the US T-bonds. The longer term inflation risk is being overridden by demand for a short term safe haven.
Conclusion: Bearish On The Euro And Ramifications
In short, over the coming months, we still are short the EUR, and thus long the USD, gold, and US Treasuries.
We’re bullish on the USD as a direct play against the EUR. As noted above, the two usually move in opposite directions.
We’re bullish on gold as another play on the falling EUR and the demand to hedge its value via gold.
We’re bullish on US Treasuries because inflation threat is low for the coming months as price and wage growth will be subdued, and the EU is likely to continue to keep demand for safe haven assets brisk.
We would be long gold as another play on fears about the value of the EUR, not because we’re worried about inflation.
The EUR Has More Downside Ahead
The same factors pressuring the EUR remain in place and are not going away anytime soon. Prime among them include:
- There is real doubt that the current EU/IMF package can be implemented or enforced. Greece is already attempting to negotiate concessions regarding cuts to pensions, and there is already real parliamentary opposition to austerity measures required by the EU/IMF plan. The Spanish parliament just passed its latest austerity measures by only one vote. Given the pain the rescue plan imposes on both lender and borrower nations, the plan is unpopular and its long-term sustainability is questionable. A breakdown in commitment to this plan, however, would bring the EU and the world back to the brink of another crisis of threatened sovereign defaults, banking crises, market crashes.
- There is still no plan for enforcing compliance with the terms of the plan
- Unclear EU Members Willing To Sacrifice Their Sovereignty: There is still no plan for correcting the inherent structural problems of the EU, particularly the contradictory nature of having a united currency combined with national independence in spending. This allows one or more mismanaged economies like Greece to bring about a crisis for the EU and devaluation of the EUR. That implies a need for virtual EU control over individual national budgets – which would mean an end to the sovereignty of the member states.
- The EU and EU banks are in worse shape than generally realized. This is an entire topic by itself. See Reggie Middleton’s extensive and superb series here.
There are others too, see my prior articles on the topic.
Disclosure: No Positions
