Two weeks ago, I argued on these pages that the respite from the Greek panic would offer an opportunity to go long Euro and long gold. After the street recently banked some $8bn on short Euro trade last week, this hope for a “rebound” now feels a bit like a crowded trade. And yet, this mid-term opportunity remains in place. The more the street gets nostalgic about “another ERM” type of trade, the bigger the expected return for patient investors. Alas, the timing is everything.
There are two interrelated issues to consider. First we need to consider the scenarios for solutions to the Greek dilemma and how they may affect global risk aversion. The second is the nature of Euro – gold correlation in the coming weeks.
First, the threat of Greek “default”. There is ample evidence to show that anytime the Street gets excited about the possibility of Greece “leaving the Euro”, “defaulting” or its sovereign paper no longer being accepted as collateral for liquidity operations – the Euro gets pounded, and the commodities are caught in the downdrift, including gold. The “stocks down-US yield down-dollar up-gold down” reaction has been a common feature of these bouts of Greek drama since early December (with similar consequences to the height of Dubai panic). Many of my friends on Wall St are convinced that the end is near and that, under market pressure, the Greek equivalents of Mr Lamont, Mr Major and Mr Hazeltine will eventually throw in a towel just as the Bank of England did in 1992. Yet the stakes are today completely different and the participation in the 10-year old currency union is an entirely different matter if compared to a theoretical 10% trading band imposed on ERM participants two decades ago. For one, there is no mechanism for Greece, or any other country, to simply “exit” the Eurozone. The costs of such a move would be incommensurably higher than the costs of fiscal retrenchment the country is facing now. For starters, Greek Euro-denominated debt would become foreign debt, the spreads would rocket, it would become nigh on impossible to raise new funds, and even if “drachma-2” were to lose the 30% of its value, it would take time for tourism, shipping and retirement industry to reap the benefits from the depreciation. Meanwhile, inflation would jump, debt costs rise and frictional trade costs with EU partners would be reintroduced. However tortuous and painstaking, the help from Frankfurt, Brussels and Paris will come in some form or another – loans, aid with conditionality, joint Euro bond issuance, technical assistance, you name it. Market pressure on Greek spreads and CDS is a good thing to focus the bureaucrats’ minds a bit. But an exit from Euro? You gotta be kiddin’
So in this overwhelmingly Euro-bearish spell, gold and other commodities have taken a breather. In some cases the sell-off has been driven by product-specific sentiment but there is no denying that much of the trade was largely chained to dollar’s renewed strength. We should therefore focus on the second big issue – i.e. the probability that gold would recover from the current support level (or even from 1035/oz) in a convincing fashion should the EUR/USD exchange rate stabilize.
We looked at several historical precedents of strong gold price momentum (in USD) and its relation to the behavior of EURUSD pair. We picked the four quarters during which gold flirted with nominal $1000/oz and subsequently retreated, as well as the quarter during which this resistance level was finally broken, as well as the period during which the metal hit an all time high, over two months ago. In each case, the table below illustrates the preceding month’s returns for gold, EUR/USD, as well as the characteristics of that period daily correlation between the two markets. Finally we compare these months’ volatility and coefficient of determination, and set them against corresponding annual figures (for the 12 months preceding the gold price spike).
First thing that does not surprise anyone with at least a 12 month memory is the unprecedented move in gold in 1Q09, when the physical and ETF interest offset the dollar strength. The market behavior during this period remains an outlier. Only in two cases (Mar 08 and Sep 09), the correlation peaked on the day gold price hit a high, but in both cases the beta between the two markets had radically fallen off over the preceding month, as compared to the preceding year. In other words, the high correlation between momentum-driven gold price swings was accompanied by the fall in the volatility of gold price movements in relation to EUR/USD. Note that overall, long term beta was considerably lower in 2009 than in 2008, which is not surprising, given the uniqueness of market events in 2008.
Where does this all leave us now? Both the long term beta and coefficient of determination have picked up strongly again for Gold vs EUR/USD, but with a tendency for the correlation to ease over the last month (from 0.63 to 0.017). Without a pent-up demand for physical gold (as in 1Q09), this easing of the daily correlation did not bode well for gold returns. In other words, the height of gold – Euro correlation (in late November, early December) was a dangerous place to be, leaving little upside for the market sentiment, short of another Central Bank purchase. But luckily the market has cooled quite a bit since.
The correlation is unlikely to weaken for much longer. What this analysis is telling us is that should a positive signal reverse the current EUR –USD trend, the pick-up in gold momentum may be more akin to moves in 2008, or Spring – Summer 2009, than the relentless run towards the end of last year. Now it’s up to Germans to warm up to Greek shores again.
Tags: beta, correlations, euro, Greek default, momentum