How Gold Traders are Reacting to a Weaker Euro
The interconnectedness of the financial markets features many opposing forces!
Gold is first and foremost a safe haven commodity. Investors are more likely to be drawn to gold during times of economic and political uncertainty. During the course of 2014, various crises enveloped the markets. The civil war in Syria, the Ukraine crisis, the Gaza/Israel war and the growing terrorist threats posed by ISIS have rocked the global landscape. In the midst of the chaos, gold has managed to gain 5% during 2014.
Are you looking for fast-news, hot-tips and market analysis? Sign-up for the Invezz newsletter, today.
However, the demand for gold is not merely based on uncertainty. There are a multitude of other important monetary, fiscal and other considerations coming into play. For example, gold is a precious metal that is closely correlated with the US dollar. This is true because the gold price is dollar-denominated. Therefore, when the US dollar strengthens or weakens, this has a direct impact on the price of gold, and therefore the demand for this commodity.
If we consider the case of the EUR/USD currency pair, several interesting points can be gleaned from recent developments. Just before the ECBs announcements on Thursday, 4 September, €1 fetched $1.31481; however by the time Mario Draghi announced monetary easing policies, the euro had weakened to $1.29370. There is direct connection between relative currency values with major pairs like the EUR/USD.
Consider a gold price of approximately $1,265 an ounce. The price of an ounce of gold on Wednesday would have been €962.11. That same ounce of gold just one day later would cost €977.81. Fluctuations in the price of commodities like gold are nothing new. But, when policy changes have been put in place to intentionally weaken the European currency, in an effort to stimulate the economy of the 18 nation bloc, the overall impact on gold demand is more pronounced.
What Impact will Mario Draghi’s Policies Have on Gold?
First off, it’s important to understand that any tinkering with exchange rates, interest rates and money supply has positive and negative effects on commodities like gold. The fact of the matter is that gold is closely tied to uncertainty in the markets, is dollar-denominated and is affected by supply and demand factors. Investors may initially feel that the uncertainty created by the weakened euro would result in a spike in gold demand. Conversely, there is an opinion that the relatively more expensive gold price for Europeans would lead to a reduction in demand.
Mario Draghi’s policies had a profound effect on the markets, and weakened the euro to its lowest level against the greenback in 14 months. When news breaks of accommodative measures in monetary policy, the gold market typically blossoms since there is more money supply in the economy. The opportunity cost of purchasing gold diminishes since there is very little to be gained by keeping your money in savings accounts and fixed interest-bearing accounts. The ECB’s policies resulted in marginal lending facility rates being cut to 0.3%; the main refinancing operation was cut to 0.05%, and the deposit facility was reduced to -0.20%. Additionally, the ECB announced quantitative easing policies which could be as high as €1 trillion.
The question therefore is why the gold markets have not reacted more strongly to these accommodative policies? It should be borne in mind that the cross currency exchange rates will likely have a bigger impact on the gold price then the accommodative measures alone. Another factor that is equally important is that of quantitative easing in the US. Recall that the US government had enacted a gradual tapering of its quantitative easing policy in 2014. The US Federal reserve bank is expected to end its QE programme by October 2014.
There has historically been a positive correlation between the price of gold and the European currency. If further pressure is exerted on the Euro, it will not bode well for the gold price. As a case in point, spot gold peaked at $1276.50, but dropped 0.4% to $1263.66 per ounce on 4 September. Gold trading volumes on the US COMEX for December gold futures were 20% higher than the 30 day moving average, according to Reuters reports. In tandem with weaker currency cross rates with the USD, the Euro also moved lower against the Swiss franc.
Why the European Central Bank Cut Rates Further
Deflationary fears in the Eurozone were a major consideration in cutting interest rates by 10 basis points. The European Central Bank has targeted an inflation rate of two percentage points. This is in line with the US and the UK inflationary targets. Presently, the inflation rate in the European Union is hovering around one percent. This brings with it a unique set of challenges including falling prices across the EU. Deflation is associated with low interest rates, and a less than optimal velocity flow of money. By adopting a quantitative easing programme, the European Central Bank is hoping to increase investment spending, boost the European stock exchanges and raise economic activity.
Other factors that directly affect the gold price are jobs reports in the US. The ADP private jobs report revealed that some 204,000 jobs were created during August. While this figure is only marginally lower than the forecast, it still bodes well for analysts as it surpassed the 200,000 level. Added to that was the ISM report which also provided better than expected data. Banc De Binary analysts alluded to a month of heavy trading in gold, albeit choppy at times. While European monetary policy is an important determinant of overall gold demand, US monetary policy is more important. The US dollar index has been trading higher of late, and this bodes well for the price of gold, less so for European countries relying on the weakened euro for gold trading. The jury is still out on whether a weakened euro and monetary policy accommodations vis-a-vis the Federal Reserve Bank will impact positively or negatively on the buying of gold.
Surprisingly, it’s not the Europeans who purchase the biggest volumes of physical gold stores – it’s the Asians. Emerging market economies have a gluttonous appetite for gold, as evidenced by China’s gold reserves and the Shanghai premiums which are now at a $3-$5 discount. Most of the global economy’s liquidity is based around what happens with the US dollar, and the European central bank will likely fall in line.