Euro break-up should be a game-changer for gold
• We expect the exit of one or more countries from the euro-zone to drive the price of gold significantly higher. For now, the precious metal is losing out to other safe havens, notably the US dollar and highgrade government bonds. But this is unlikely to last as the crisis in Europe escalates.
• Gold has not performed badly this year - the price has risen by around 2% in dollar terms and 8% in euros - nor has it done as well as we had anticipated given the uncertainty about the global economy and the turmoil in the euro-zone. This partly reflects gold-specific factors: in particular, demand from India has been undermined by tax increases, rupee weakness and a poor monsoon. But the main headwind has been the return of confidence in the dollar. Over the past twelve months, gold's sluggishness has coincided with a gradual recovery in the US currency across the board. (See Chart 1.)
• However, the price of gold could still rebound even if, as we expect, the dollar continues to strengthen against other currencies. There have already been periods in the recent past when gold has risen while the dollar has been firm. In particular, the dollar price of gold rose by more than 10% in the first five months of 2010, despite a 7% appreciation in the value of the dollar against other major currencies. Perhaps significantly, this was when the markets first began to focus on the problems in Greece.
• What's more, there is no reason in principle why the dollar cannot be one of the strongest of the paper (or "fiat") currencies, and still under-perform gold. Indeed, this appears to us to be the most likely outcome in the event of the break-up of the euro-zone. For now the markets still seem to regard the crisis in Europe largely as a problem of failing economies and the need for debt restructuring in the periphery, the direct impact of which on the US economy and financial system should be limited. As it happens, they may ultimately be proved right. However, the uncertainty triggered by the exit of one or more countries from the euro-zone would lift the crisis to a whole new level. Our working assumption is that Greece departs first, followed by Ireland and Portugal.
• Doubts over the future of the euro itself would then surely raise concerns about the impact on the rest of the world. The US recovery has already faltered in part because of the impact of the crisis in Europe on business and consumer confidence. The widespread defaults that would follow euro exit are also likely to revive concerns about the sustainability of the US debt position, especially with the "fiscal cliff" looming ever larger. This should all be positive for the price of gold, an asset whose value is not dependent on the creditworthiness of any particular government or financial institution.
• Finally, the impact of euro break-up on the US economy and financial system would almost certainly prompt the Fed to loosen monetary policy further. We are not as sure as some about the relationship between the dollar price of gold and the size of the US monetary base. Prior to the global financial crisis there was barely any relationship at all. (See Chart 2.) Nonetheless, renewed talk of QE3 should still lift the price of gold, as should additional easing by other major central banks.
• The upshot is that we still expect the price of gold to climb to a new high of $2,000 per ounce before the end of the year, lifted by renewed fears about the global fall-out from the break-up of the euro.
Friday August 3, 2012 by