I had recently received a good and timely question in my inbox from one of my readers. This question is likely to be in the minds of a wider audience, so I am writing a new article about it to address his concern. Before I put his question forward, I would set the context for the question.
Gold serves as an inflation hedge as well as a medium of exchange in the times of financial instability. Hence gold will be of great value during the Weimar Republic era of hyperinflation or when your currency is facing rapid decline such as the situation with the Russian Ruble recently when it faced sanctions over Ukraine and also falling oil prices. Also, gold is normally priced in the USD as represented by the SPDR Gold Trust (NYSEARCA:GLD), but you might have your own favorite ETF or methods of gaining exposure to gold.
With the context of the question being set, we can move onto the question itself. The reader was confused as to whether he should buy gold over the political and economic uncertainty of Grexit. On one hand, there is the financial instability element that would justify the purchase of gold. However, the same financial instability would also cause the USD to rally and gold prices to fall. This is indeed a catch-22 situation.
Acknowledgment of USD Strength
I started out by acknowledging the strength of the USD. My take is that the USD would strengthen on its own fundamental and technical strength. Any Greek default would just add to it. This week is especially sensitive to the USD because the FOMC is going to meet and release a statement on June 17. The FOMC is likely to acknowledge the recovering US economy and set the stage for a September rates liftoff.
This is after the April data disappointed the market and caused the USD to be cautious about the better May data in the area of labor, housing and retail. In other words, there is this pent-up USD strength yet to be released on gold prices and we are likely to see it after the FOMC statement. If this is added with the mix of a Greek default, then the drive to safety will encourage funds to flee Europe and add to the USD strength.
Drivers of Gold Strength
My view is that the financial stability driver of gold strength had largely faded. This is because regulations that were put in place after the Great Recession has reduced the risk of a major banking failure. Systemically important European banks can no longer pick the most lax regulator and they are under the single purview of the European Central Bank (ECB). The ECB had also forced these banks to raise capital to act as a buffer against bad debts under rigorous stress test scenario.
One of the stress test scenarios would be the Greek default and the relevant authorities had 3 years since the first major Greek debt crisis started in 2012 to prepare for this eventuality. More specifically, ECB Governing Board Member and the Governor of the French Central Bank Christian Noyer had warned on May 26 that a Greek exit would have minimal impact on French bank according to this Reuters report. Of course, this could be just a negotiation technique, but it is unfathomable that the authorities would not take actions to reduce the impact of the Greek default and exit.
As long as the euro continues to be the legal tender of the land, it is unlikely that gold will go against the strengthening USD to appreciate. This is under the assumption that the EU would be able to contain the Greek default and subsequent exit. As long as the situation is contained within Europe and do not spark off a global crisis, the Greek crisis is considered to be contained. The most likely casualty would be the euro and it will wipe out previous gains due to the strengthening economy.
If you are a European reading this article, it would be wiser to exchange the euro for USD. Unless you expect your country to fall into anarchy, then it would be advisable to own physical gold. If you are an American reading this article, which is the most likely scenario, then you should be selling GLD.
Another factor that is pulling down gold is the subdued inflation environment. After the extraordinary actions by major central banks (with the exception of China) last year and early this year, the momentum for greater monetary easing had faded. This removes any basis for runaway inflation in the long term that would support gold prices. On the other hand, Central banks have accepted that they would have to wait for the medium for the 2% inflation target to be met. By medium term, it can range from 2-5 years. This would remove any incentive to own gold in the interim period.
Technical Chart Movements
Let us look at the price of gold from the perspective of XAU/USD. As the daily chart below shows, the greatest impact of Grexit actually occurred from December 2014 to January 2015 when it is clear that Syriza will form the next government. This is where the greatest fear of that the new government will renege on its loan and trigger off a domino effect. While there were a lot of heat from the next Greek government, default was never really on the cards. After all, the majority of Greeks want to stay under the protective umbrella of the EU, but they do not want the painful austerity measures.
Over the period of February to April, gold (as represented by forex ticker XAU) prices were more affected by the USD strength and the reduced risk of Grexit. We are currently in the red period where the technical trend points towards greater gold weakness.
Hence, even if Greece were to default by the end of the month, which is not unlikely given the poor current progress of negotiation, it would not reverse the bearish trend of gold prices.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.