16 Sep 2011


Although the trading day is still early, varying factors are pushing gold in opposing directions but the downside has so far been the stronghold. The metal fell about $40 overnight and early this morning to its current trading value of $1,775/oz. What was the cause of this drop?
Two major releases came out today which are likely pressuring the price of gold: US inflation data and an announcement of dollar liquidity financing to the European Central Bank.
ECB, SNB, BoE, BoJ to Provide Dollar Funding
First, what surprised most investors, was gold fell even as dollar stimulus measures were announced out of the ECB. Europe’s unified bank issued plans to provide dollar liquidity operations to those participating in their repo (repurchase agreement) system. The move is likely being done to stem any fall out from a likely Greek default and/or continued banking troubles arising from other troubled nations in the periphery of Europe. Similar actions are also being taken by the Bank of England, the Bank of Japan and the Swiss National Bank to contain any fallout.
On June 29th the Federal Reserve announced a continuation of swap lines with the above central banks in anticipation of an event like this where they would be required. The lines provide dollar credit to foreign central banks in exchange for the borrowing banks local currency serving as collateral. During the height of the financial crisis in 2009, as much $600 billion in credit was outstanding from these liquidity swaps. Since use of the swap lines means dollar liquidity will flood markets and quell demand for dollars, many expected that the announcement of this move would be a positive for gold prices. The fall today in gold amidst this release by the ECB is likely the result of another balancing force: US inflation data and QE3 expectations.
CPI Higher Than Expected
Today, the consumer price index (CPI) was released and showed growth at a faster than expected pace, indicating recent high inflation was not the transitory phenomenon the Federal Reserve predicted. The year over year growth rate was 3.8% for the 12 months leading into the release, which puts the year’s price increases almost twice as high as the Fed’s 2% target. The major implication to be drawn from the data relates to Fed policy and whether or not another major easing program can be expected from the Fed.
Initially, the Fed led us to believe that inflation would need to be “dangerously low”, bridging on deflation, before another round of quantitative easing could take place. This mentality was largely abandoned, however, as growth greatly disappointed the Fed’s expectations in the first half of the year and their focus then shifted. As a result, the Fed began to give indications that if growth were to falter in the second half of the year more stimulus would be necessary. With August’s jobs report showing no job growth and other indicators turning sour, the market expectations for more Fed stimulus before the year’s end grew.
Today’s very high inflation reading, however, may have shifted the Fed once again. The Fed has long been selling markets on atransitory story for inflation, blaming high inflation on temporary factors from mid-east revolutions to weather disruptions. So far this picture has not involved and, in fact, is moving in the opposite direction. With the Fed’s inflation expectations being disappointed, there is a chance they are more timid when it comes to stimulating growth. The effect of this policy expectation shift on gold is generally negative, as the metal’s price growth relies on the negative yields and inflationary trends produced by the Fed and their stimulative policies.
This is likely the major factor forcing gold prices down today. More clarity on the issue may be given at the upcoming Fed policy meeting next week with a statement being released on September 21.
Bottom Line
The reason CPI data outweighed the release of stimulus measures out of Europe is somewhat complicated. For one, the swap lines to be utilized by the ECB are only being done so with a three month maturity when they may unwind. While there is a good chance the credit is rolled over, the size and temporary nature of the borrowing likely pales compared to what was expected from another quantitative and/or qualitative easing from the Fed. QE2 was well over a trillion large, for example. Moreover, the ECB signalling that dollar shortages might develop in Europe can also be seen as a temporarily negative sign for gold. A short term spike in the price of the dollar, should the ECB fail to mitigate the demand influx, could drive down commodity prices including gold.
In all, the fundamentals for gold are unaffected by these short term moves to dollars though and are actually a positive influence in the end. Any demand drive to dollars will wane but often some of the dollars printed in the intermediary will overhang after the fact, keeping metal prices even higher in the long term. Also, expectations for the Fed avoiding stimulus policy in light of higher inflation underestimates the need for the Fed to keep expanding their balance sheet and continue deluding themselves to the real nature of inflation. We can almost certainly expect the Fed to continue blaming inflation on transitory factors and the arrival of QE3 and/or other forms of easing is only a matter of time. In this sense, buying dips like today if you are a long term gold buyer is probably the correct strategy.

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