Gold Falls as Euro Survives Crisis, EC Props Up Its Banks

by: Jonathan Bernstein
Here's why I think gold pulled back from its June 21 high of $1,266.50 per ounce to its July 7 low of 1,185. Traders began to realize that the euro just isn't dead yet.
In May and early June, Europeans who thought the euro was finished, dumped euros and bought gold. Then the EC and the European Central Bank (ECB) signaled that they will protect the euro and the European banks or die trying. The ECB's secondary market purchases of PIIGS sovereign bonds, which began in May, helped send this message.
And so, at least some traders who bought gold because they feared the end of the euro, sold gold and bought euros back.
While traders were skeptical about the initial announcement of the Greek rescue, the ECB may have moved the markets as much if not more. Despite the impressive $955 billion headline number for the Greek rescue package that the EC announced May 9, the euro kept falling and gold kept making new highs.
As the ECB continued its PIIGS sovereign bond purchases every week, though, it became clear that these purchases are ongoing, not a one time event. The euro bottomed on June 7. Furthermore, gold, which made an intermediate high of $1,254.50 on June 7, can now be seen to have struggled since then, and finally sold off July 1.
While the ECB purchases may have punished gold holders recently, they should push gold prices higher 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. These things 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. Some analysts suspect the Euro’s bounce means that the risk trade is back on, and maybe it is for at least a little bit, given last week’s corresponding bounce in stocks.

Europe's Moves Toward Bank Bailouts Also Prop Up the euro

The European bank stress tests also demonstrate Europe’s determination to save the euro by propping up European commercial banks as well as the 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.

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 (NYSE: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.

What Gold Investors Should Do

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 contrary indicator, and calls it a buy signal. 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: GLD, SGOL