Global Uncertainty and the Trajectory of Precious Metals

Tanushree Mazumdar, Senior Economist and Vice President- Knowledge Management, NCDEX

Gold, silver and other precious metals are traditionally considered as ‘safe haven’ assets which serve as flight-to-safety for investors when there is global turbulence and uncertainty. The advantage of these assets is that because of their tangible nature they serve as a ready store of value and investors are able to readily identify with them. Of them all, gold is a commodity that is most easily understood as it has stood the test of time as a medium of exchange and a store of value. As an investment asset gold enjoys a distinct advantage as it has a weak correlation with stocks and bonds adding to the breadth of an investment portfolio.
In the last few months the role of gold as a ‘safe haven’ asset has come to the fore thanks to the global uncertainty caused by debt problems in the euro zone and the US. The main problem plaguing the euro zone for more than a year now has been that of the Greek debt. Very simply put the Greek debt problem is nothing but a case of a country having lived beyond its means and having to bridge this gap between income and expenditure through borrowings which it has to then repay. This borrowing or debt became a burden for Greece as it stood at almost 160 per cent of its GDP!
Why does indebtedness become a problem? For markets and financial institutions the threat of a sovereign credit rating downgrade by credit rating agencies is enough to send them into a nervous frenzy. A downgrade makes it difficult for business in a country to raise money from overseas markets and puts a stress on its banking sector and those of banks in other countries as they have exposure to this government debt which could simply end up being on their books as non-performing assets thus eating into their capital.
At the time of writing this, debt concerns in both the US and the euro zone have been allayed to an extent as at the 11th hour lawmakers in the US agreed to cut its deficit by $2.1 trillion and raising the debt ceiling to enable US to pay its bills till November 2010. The resolution came after weeks of political theatre which saw the Republicans and Democrats engaged in a bitter struggle to arrive at a consensus to raise US’s debt level (effectively its ability to borrow) as well as cutting deficit (curtailing expenditure). There was respite on the euro zone front as well with the new package in place for Greece. The new package will mean that Greece will get additional support of € 160 billion (i.e. over and above the support of € 110 billion that it had received in 2010). How does all the above affect gold? Through two channels: currency and investment. The latest announcement of the Greek rescue package saw the euro appreciate against the dollar by close to 2 per cent on a single day! As most commodities including gold are denominated in dollar, a stronger euro (and a weaker dollar) makes commodities cheaper. An additional factor is at work in the case of gold: that of a safe-haven asset. As the uncertainties regarding the euro zone have not completely dissipated and the markets have yet to digest the full import of the debt deal in the US, perceived riskiness would increase the appetite for gold investment. This has been proven with gold crossing the $ 1620 per ounce mark at the time of writing. What about silver and other precious metals? Unlike gold, these metals are not stubborn ‘safe haven’ investment and are often subject to unexplained volatility. Silver, for example, recently has seen a rally and touching new records. Markets believe that silver follows gold or more importantly its ratio to gold in price. Currently the gold to silver ratio is about 40. The norm in the past several years is for the gold-silver ratio to hover between 55 and 60 i.e. the price of an ounce of gold was 55 to 60 greater than the price of an ounce of silver. The very long-term gold- silver ratio is said to be around 16.
What would be the outlook for precious metals in the unfolding global scenario? To a great extent this would depend on how the market finally thinks the resolution of the debt ceiling through spending cuts (without any plan to raise taxes) will affect the growth in the US. The Federal Reserve’s response too will determine the market sentiment. If a threat to growth seems imminent, markets moving to a ‘risk on’ mode cannot be ruled out which could lead increased investment in gold. If the Fed responds by increasing money supply (QE 3) to prop up growth then the quantum of dollar flow would decide the exchange rate vis-à-vis other currencies, especially the euro. And, of course, finally all will depend on how much the markets believe in government’s and central bank’s ability to deliver their countries from the throes of debt and put them on the path of sustainable recovery! In markets, perception is everything!

Aug 2011

Source : Bullion Bulletin

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