HardAssetsInvestor

Written by Sumit Roy  |

November 22, 2011

Precious Metals Monitor: How Low Will Gold Go?

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There are two contrasting outcomes for the sovereign debt crisis in Europe, with major implications for gold prices.

As if Europe's sovereign debt worries weren't enough, U.S. debt worries resurfaced this week. The congressional debt committee that was formed during a last-minute compromise to raise the debt ceiling back in August — and which was charged with finding between $1.2 trillion and $1.5 trillion in budget savings — failed to reach a bipartisan compromise.

The deadline is Thanksgiving, but sources suggest that the partisan divide will not be overcome by then. Without a deal, $1.2 trillion in automatic spending cuts, evenly divided between defense and nondefense spending, will go into effect at the start of 2013. The repeated failure of the U.S. government to address the country's spiraling debt load has renewed credit-rating-downgrade fears and weighed on market confidence.

While sentiment has been negatively impacted by this second U.S. debt debacle, the impact on financial markets in the short term will be minimal. U.S. Treasury yields are near record lows as investors still consider the debt of the world’s largest economy a safe haven, particularly relatively to Europe.

Indeed, investors’ major concern remains the sovereign debt crisis in Europe, which continues to escalate. The two countries in focus, Italy and Spain, have both seen their borrowing costs stay at near-record levels at just under the critical 7 percent level despite the formation of new governments.

Yields on Italian and Spanish 10-year bonds last stood at 6.77 percent and 6.63 percent, respectively.

Meanwhile, the European Central Bank purchased another €7.9 billion worth of sovereign bonds last week, up from €4.5 billion the week before. That brings the ECB’s total purchases in its Securities Market program to €122.8 billion since the central bank resumed its buying back in August. Those purchases have primarily consisted of Italian and Spanish bonds.

As the potential for a catastrophic default and breakup of the eurozone grows, an increasing number of people are calling for the ECB to significantly increase its purchases to staunch the bleeding in debt markets and perhaps solve the crisis once and for all.

The central bank has so far refrained from getting more involved, saying that such action would be illegal and go against its sole mandate of price stability. The influential German government shares this view.

Some believe that the ECB and the Germans will be forced to reverse their stances as the possibility of a breakup of the eurozone becomes more apparent. Ironically, such a breakup would likely be the end of the ECB. Thus, the survival of the institution may hinge on whether it takes more decisive action or not.

Nevertheless, there is no free lunch. More vigorous action would likely take the form of a quantitative-easing program, much like that of the Fed in the U.S. and would potentially stoke inflation.

Moreover, ECB purchases of Italian and Spanish bonds are essentially subsidies—transfers of wealth from other eurozone members to those countries. Perhaps the central bank could purchase bonds of all members proportionally to avoid this, but in any case, if the ECB gets more involved in the sovereign debt crisis, it would likely spell a substantial quantitative-easing program in hundreds of billions of euros.

Such large-scale intervention would certainly bring down borrowing costs for Italy and Spain, but at the expense of the ECB’s inflation-fighting credibility. Risk asset prices would likely surge, with precious metals such as gold leading the charge as an inflation hedge.

The alternative scenario is much more dire, as we outlined last week. But a growing number of market observers are suggesting that the eurozone is a flawed union and that its demise is inevitable. If so, risk assets will suffer significantly in the transition period.

There is quite a dichotomy between these two potential outcomes for Europe. That contrast was evident in the gold market as well last week. On the one hand, gold ETF holdings surged to a fresh record high near 75.3 million troy ounces. But gold prices plunged below $1700/oz.