HardAssetsInvestor

Written by Sumit Roy  |

November 08, 2011

Precious Metals Monitor: Do Not Buy Gold At $1800/oz

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The probability of a major financial shock in Europe has increased, but that’s not necessarily good for gold.

Precious metals surged over the past week. Gold led the charge as prices approached $1800/oz. — well above the $1600 level of only weeks ago and the $1532 intraday low put in during late September.

A perfect storm is responsible for this swift move. Those same European sovereign debt concerns are driving the rally, much like the case back in July and August when gold was also surging. But the two rallies also share another characteristic — strong investor demand.

Recent movements in gold ETF holdings — a proxy for investment demand — have mirrored the recent movements in gold prices, suggesting that investors or traders are fueling this rally. Stable financial markets are also a key ingredient. The S&P 500 is near multimonth highs, giving investors the confidence to buy gold. This is in contrast to September and October when gold got caught in panic liquidation amid broad-based selling across financial markets.

But can this situation last long enough to propel gold to new record highs above $1921/oz.? That depends on the evolution of the events in Europe. Currently, Italy is in focus, as interest rates on the country’s debt spiral to fresh euro-era records daily. Yields on 10-year Italian bonds spiked as high as 6.74 percent earlier today.

A loss of confidence that Italy can manage its €1.9 trillion ($2.6 trillion; 125 percent of GDP) worth of sovereign debt amid sluggish economic growth has driven these yields higher. But ironically, as yields increase, the country’s ability to manage its debt becomes increasingly difficult.

Italy may need to roll over €360 billion worth of debt next year. If interest rates stay at these levels or worse — increase further — the threat of default by the eurozone’s third-largest economy becomes a distinct possibility.

While Greece, Ireland and Portugal were bailed out by the European Financial Stability Facility, it remains to be seen whether even the enhanced bailout fund has enough firepower to staunch the bleeding in Italian bond markets. If confidence erodes significantly, it is unlikely that even the €1 trillion fund can prevent a worst-case scenario in the eurozone.

Keep in mind that Italian interest rates are spiking even in the face of substantial bond purchases by the European Central Bank on a weekly basis. Last week the central bank bought a whopping €9.52 billion worth of bonds, putting its total purchases since August at more than €100 billion.

The situation in Italy should be closely watched by precious metals investors. Our view remains unchanged from the last two editions of the Precious Metals Monitor. There are two possible scenarios for gold in the short term:

“… a scenario where Italian yields stay elevated but contained may be the best outcome for precious metals, as it represents a ‘kick the can down the road’ scenario. At the same time, financial markets will remain stable, giving investors confidence to deploy capital into risk assets such as gold and silver.”

The aforementioned scenario is ideal for gold and that’s what we’ve seen over the past few weeks in which gold has rallied strongly. But the situation in Italy looks increasingly precarious, leaving open the possibility of more bearish developments:

“… a continued deterioration in Europe will likely lead to selling in all risk assets, the precious metals duo included. The bottom line is that a major financial shock in Europe is unlikely to boost gold or silver and indeed, will probably lead to big losses in the metals — at least in the short and medium terms.”

At $1800, gold does not look nearly as compelling as it did only a few weeks ago and we would not be accumulating positions at these levels, especially given the elevated possibility of a major financial shock in Europe.

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