In early May of this year, with the euro hovering in the $1.46-$1.48 range, I disagreed vehemently with euro bulls such as portfolio manager Axel Merk who argued that the common currency was no longer vulnerable to a sell-off (see Merk's May 11 FT article titled 'Dollar in graver danger than the euro' and my counter arguments here, here, and here).
Merk's argument was basically that in 2010, when the euro sank to a low of $1.18, the currency served as a proxy for the sovereign debt crisis. Now, however, investors were shorting sovereign debt directly and, according to Merk, recognized that it is a lot harder for the ECB to print euros than it is for the Fed to print dollars.
For awhile, as you can see from the below chart, it appeared that Merk perhaps had made a good point. From May the euro has shown remarkable resilience; for the last six months one sovereign after another has white knuckled its way through uncertain debt auctions and ever higher interest expense. Meanwhile the ECB kept its 'bazooka' semi-holstered with purchases of sovereign debt apparently capped at €20 billion per week. While the euro did soften from mid-May onwards, it was able to keep its head above the $1.40 mark for the summer and a good chunk of autumn.
Click to enlarge:
In the last three months, however, the dreaded head-and-shoulders chart pattern has formed and today the euro risked crashing through the psychologically important $1.30 level for the first time since January. What's driving this deterioration?
European Bank Run
The quiet bank run which has been rolling its way through Europe for some time now appears to be accelerating. According to the central bank Greece has lost 20% of its deposits in 2011, with a €6.8 billion decline in October compared to September's previous record €5.5 billion euro outflow. By last count Ireland has lost 40% of its deposits. I'm also hearing the occasional anecdotal report from friends and family, including an Italian uncle in-law who recently bought property in London (a common strategy among Europe's monied elite I'm told). And while not occurring within the eurozone itself photos of recent bank runs in Latvia splashed across the news paint a vivid picture in the imagination of citizens in countries where tactical plans for leaving the eurozone are now in the open.
Another factor weighing on the euro is the clear weakness in core-Europe's banks. Belgium's Dexia required a bailout (again), and recently it was reported that Germany is contemplating the nationalization of Commerzbank (also again). French banks have been battling persistent rumors of undercapitalization and too much exposure to Italian and other European periphery debt. These are just some of the more well-publicized problems as there is zero transparency on which European banks have been tapping the ECB's dollar swap lines with the New York Fed.
The euro is also suffering from an apparent shift in momentum. Credit rating agencies are ratcheting up their concerns with S&P recently announcing that it was considering downgrading every eurozone country, including Germany. And the lack of any more feel-good EU summits on the horizon has left the common currency somewhat adrift.
Why Isn't Gold Rocketing?
While it's perhaps no mystery why the euro has finally rolled over, a somewhat more puzzling question is why hasn't gold responded more favorably to eurozone events?
In early August I made a bullish call at the $1700/oz level and gold went on a tear, shooting up over the $1900/oz mark shortly thereafter. It then dropped and has traded roughly between $1600/oz and $1800/oz. While the tumble from $1900/oz was dramatic, it still left gold up close to 20% on the year.
So to answer this question part of the reason for gold's lukewarm response to the latest developments in Europe is the fact that gold has already rocketed up quite a bit in 2011. The other factor working against gold is the renewed strength and demand for the U.S. dollar. You may recall that during the height of the 2008 financial crisis, gold experienced a sharp selloff as the world scrambled for scarce U.S. dollars. The drying up of liquidity in the European banking system has again set off a demand for dollars, which central banks from around the world recently responded to with coordinated policy action.
Dollar strength has traditionally correlated with a weakening in the price of gold, and this relationship appears to have reestablished itself recently. But will this continue? The short answer is no and the reason is that I have zero doubt that the Ben Bernanke Fed will crank up the printing press to ride to Europe's rescue if things really get out of hand, which they almost certainly will.
Further, as I noted in August, so long as three key fundamental forces persist the long-term rise in the price of gold will continue unabated. Those forces are:
Low interest rates, a hallmark of the current program of financial repression, which is only just getting started and should extend for many years to come.
More money printing, which we've seen in spades of late with Italian and Spanish bond buying by the ECB, Bank of Japan and Swiss National Bank currency intervention, and the Fed's rumored QE3.
The bottom-line: Volatility in the price of gold can be expected and further declines may even be in store over the short-to-medium term. But gold remains the preferred long-term safe harbor during what will remain stormy monetary times for the foreseeable future. Take advantage of the dips in price but be sure to position yourself so that you can manage short-term volatility.