Gold, the euro and Operation Twist

2011-SEP-23

At first sight it is puzzling that systemic uncertainties are escalating rapidly in the eurozone and that the gold price is subdued. And if the press is to be believed, the euro might even disintegrate.

There is no doubt that Europe’s difficulties are a good reason to take out some insurance, but to argue that the fall-out from the euro crisis should increase demand for gold much beyond that is to misunderstand what gold is about. Yes, it is an effective temporary refuge from paper money in uncertain times, but the real reason for the price to rise is to be found in monetary inflation.

In managing the euro, the European Central Bank has done well to resist calls for substantial monetary easing, and by standing firm politicians have generally stopped badgering the ECB to do so. This has given some support to the euro and restricted flight from it to manageable quantities. True, the euro has fallen about 6% against the dollar, but then the dollar was overdue for a bounce. There is on-going panic in the eurozone, but all things considered there has not been much of a panic over the euro itself.

All this suggests that the fringe money that has gone out of the euro and into gold is for the central banks a containable problem. And if anyone has a deposit at say, a French bank, and is worried about it, it is far easier to move it to another too-big-to-fail bank elsewhere than to take a more difficult decision, such as “Do I buy some gold, even though the euro price has risen five-fold in the last eleven years?”

Meanwhile, there are far better reasons to sell the dollar and buy gold, even though the market’s initial response to the Federal Open Market Committee statement on Wednesday was to mark down precious metals along with everything else. Operation Twist disappointed those that were hoping for QE3, but realistically the headline focus was always going to shift to bank credit. Few commentators have picked up on this, but they should do in the coming weeks.

Put simply, the Fed is going to sell short-dated US Treasury stock and buy maturities of 6-30 years. The short-dated stock will most probably be bought by funds gearing up through the repo market, which will shift excess bank credit from the Fed balance-sheet into the banking system. This is consistent with the announcement last month, that funding rates will be held at current rates for the next two years.

While the Fed claims this will benefit the economy by lowering long-term rates, the true beneficiary is the Treasury, which gains an improved maturity profile at a ridiculously low cost. This is actually highly inflationary, as bank credit will expand to finance government borrowing through the repo market, and room will be created on the Fed’s balance sheet for up to $400bn of new money to be issued.

So not only do we have QE3 of $400bn, but we have an expansion of bank credit to match: now that is monetary inflation. What price will gold be when people actually wake up to what is going on?