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Friday, May 4, 2012

Eurozone breakup: how would this affect precious metals?


2012-MAY-04

Warning sign As funding pressures and economic distress increase in Spain, talk of a potential breakup of the eurozone has returned. There has been debate as to whether this would be a deflationary or inflationary event, and how it would affect the precious metals markets.


In the event of a breakup, investors need to be prepared for a period of extreme volatility, characterised by chaotic trading conditions in all markets. Similar to 2008 a financial shock such as the failure of the eurozone would likely be met by trading that is more characteristic of panic/liquidation decision-making than fundamentally sound trading. Remember that after the collapse of Lehman Brothers gold traded almost as low as $700 after previously being above $1,000 all while an historic expansion of the Federal Reserve's balance sheet was getting underway. So it will be important to distinguish between short term trading noise and longer-term fundamentals.

With increasing debt burdens and little evidence of a plan to effectively address them, a look around the globe shows few safe havens remaining. Where would capital flee in the event of a eurozone breakup?

The dollar and the US Treasury have long played such a safe haven role, but with continued US economic weakness, an expanded Fed balance sheet, and little progress towards addressing government spending that status is being challenged. Now with sanctions against Iran leading to the development of an oil for gold barter market, and with China and its trading partners continuing to seek out non-dollar payment settlement mechanisms, the possibility of an end of the dollar as the international reserve standard continues to increase.

In response to the public spectacle around last summer’s debate about the raising of the debt ceiling in the United States, capital flowed to the Swiss franc until their central bank effectively pegged the franc to the euro. While China has recently allowed for more flexibility in the trading band of the renminbi, its past track record combined with weakness in their economy makes further accommodative policy likely. Interestingly one factor that is providing strength for the renminbi is the Chinese appetite for gold. If China’s currency were to appreciate considerably, it could be in part because of recognition of the monetary significance of Beijing’s growing gold hoard.

Meanwhile, further east, Japanese Finance Minister Jun Azumi has repeatedly intervened to weaken the yen, at one point even stating that he will, “continue to intervene until I am satisfied.” Rhetoric aside, the policy actions to date over the past 20 years continue to leave the yen as a poor choice as a store of value. And while some of the BRIC nations don’t have the same extreme debt burdens as the western world, there do not appear to be any potential candidates that seem prepared to assume the reserve currency/safe haven role.

It’s also worth noting that as the flaws in the current monetary system become harder to ignore, it’s possible that the whole system will reach a tipping point. So far the bond vigilantes have focused on Europe, but upon seeing a collapse of the eurozone it’s possible that US or Japanese bond investors will see the similarities of the paper they are holding and realise that the differences between these sovereigns are not that great.

Taking a broader view and reflecting over the events of the past five years often helps to remove the short-term trading noise and remind investors that the conditions driving the precious metals bull market have not changed. When gold is being measured in dollars or any other fiat currency and the supply of the currency increases then the price of hard assets increases as measured in those currencies. The short-term volatility serves as a reminder of the risk of buying on margin or using other forms of leverage, but for long term investors who already believe in the fundamentals of precious metals, the potential breakup of the eurozone merely adds to the long term case for owning precious metals.

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