Eurozone credit crunch
With tax revenues decimated, not only is Spain's budget deficit forecast to be in the 7 per cent to 8 per cent range next year, but analysts at investment bank Barclays Capital estimate that the country's gross financing needs will be around E226bn, equivalent to over 20 per cent of gross domestic product (GDP). To compound matters, Spanish banks need to roll over E220bn of funding in 2011-12, of which E40bn is due in the first quarter of 2011. In other words, the combined first-quarter funding needs of the Spanish government (around E30bn) and the country's banks (E40bn) will total E70bn. In normal times tapping the bond markets would not be a problem, but we are clearly not in normal times right now, following the EU/IMF bail-out of Greece and Ireland.
Bond market investors are clearly worried about the ability of Spain to finance its borrowing, with the country's 10-year government bonds now yielding 5.7 per cent – a massive 170 basis point increase in the country's financing costs in the past two months. It is easy to understand this unease as total net borrowings in Spain already equates to 270 per cent of GDP even though, on the face of it, public sector debt (63 per cent of GDP) looks relatively modest.
Spain is not the only country facing a credit crunch as spreads on Portuguese sovereign debt (over German bunds) have ballooned to record levels in recent months and, at 7.3 per cent, are showing the same levels of distress that we saw in the run-up to the bail-out of Greece and Ireland. It's worth pointing out that Portugal's public and private debt is equivalent to 325 per cent of GDP, and importantly Portuguese banks are to all intents and purposes shut out of the capital markets, so are almost entirely reliant on funding from the European Central Bank (ECB). If the situation was not precarious enough, the country's current account deficit of 10 per cent of GDP requires a constant flow of overseas funding, too.
Credit rating agency Standard & Poor's (S&P) has already put the country's 'A-' long-term and 'A-2' short-term foreign and local currency sovereign credit ratings on credit watch and ominously notes: "The large stock of Portuguese debt that non-residents hold (54 per cent of GDP) has increased the government's vulnerability to rising real interest rates. This contributes to the country's large gross external financing needs and, we believe, raises the likelihood that Portugal will seek external assistance from the EU."
To compound the situation, it is estimated that Italy will require E300bn of aggregate funding in 2011 to meet the needs of its banks and public sector. A heady E100bn of this is needed in the first three months of 2011.
The monumental problem facing the eurozone, and one that will come to a head in the first quarter next year, is that the E750bn (£630bn) European Financial Stability Facility (EFSF) rescue fund created in May to act as a back stop for highly indebted countries, is simply not big enough to fund bail-outs for Portugal – which bond market vigilantes are now taking as a given – as well as Spain. William Buiter, a former member of the Bank of England's monetary policy committee, notes: "We argued before that the EFSF should be much larger (E2,000bn). Should Spain need assistance, it will stretch the resources of the EFSF, perhaps beyond its current limits. There may be some room to expand the size of the EFSF. But, in our view, once Spain needs assistance, the support of the ECB will be critical."
In the circumstances, it is hardly surprising that investors have been dumping the euro and seeking refuge in safe havens with the Swiss franc and the US dollar, the world's reserve currency, appreciating markedly in recent months against the single currency. It also makes a lot of sense for eurozone investors to buy gold, which is denominated in US dollars, as it acts as a natural hedge against further euro weakness and is likely to appreciate if the status of the euro is undermined any further by the contagion effect sweeping the weaker Mediterranean block.
Moreover, with bond market investors downgrading the credit of Spain and Portugal by significantly re-pricing the yield on their sovereign bonds, gold looks set fair to retain its safe haven status in the first half of next year.
Quantitative easing
There are a number of other factors that are also supportive of an upward trend in gold prices, including increasing uncertainty regarding the role of the US dollar within the international monetary system. In effect, the aim of the US Federal Reserve's second round of quantitative easing (QE2) – the central bank plans to buy $600bn (£385bn) of Treasury securities by the end of the second quarter of 2011 in an attempt to push down long-term interest rates – is to inflate asset prices and reverse the declining price pressures in the economy.
Moreover, by buying short-dated government bonds, the Fed is depressing the short end of the yield curve so the opportunity cost of holding gold has been reduced while the yellow metal also offers investors an alternative to fiat currencies as a store of value.
As I have previously pointed out ('', IC, 15 October 2010), it was no coincidence to see the gold price rise sharply during the Fed's first round of QE as investors became increasingly nervous over the role of the dollar as a reserve currency. This is hardly surprising given the massive increase in supply of the currency – the Fed's balance sheet has more than trebled to $2,500bn in the past two years. And the same forces are at work now; the gold price has risen 3 per cent to $1,388 an oz since the Fed announced QE2 on 4 November and is up 12 per cent in euro terms to a record high of E1,067 an oz during the same period.
Since the Federal Reserve had only completed a sixth of its $600bn Treasury purchase programme by 9 December, and as some of the cash from these purchases will be spent buying other assets including gold, then this is hugely supportive of the gold price.
Supply and demand
Gold may be trading close to an all-time high, but unlike in other industries where a price rises sharply, output has not ramped up to take advantage of this. In fact, mine production only rose 3 per cent year on year in the third quarter according to the World Gold Council. Instead, producers have unwound their legacy hedge books – Anglogold Ashanti and Norton Gold Fields have both completely unwound their hedge books in recent months – so that a high percentage of sales are now made at spot prices rather than at agreed forward rates.
Consequently, large producers increasingly have a vested interest in making sure that supply does not rise too sharply so as to maintain this tight supply/demand equilibrium and keep spot prices high. And with jewellery, industrial and particularly investment demand growing strongly in the third quarter – up 8 per cent, 13 per cent and 19 per cent, respectively, on the corresponding period in 2009 – then the demand side of the equation is also supportive of a strong gold price.
A perfect storm
Gold bugs will be salivating at the prospect of an escalation of sovereign credit worries in the eurozone and one that will most certainly come to a head early next year given the huge roll-over of debts required by the most vulnerable countries. Of course, the ECB may decide to take the nuclear option and attempt a massive buy-back programme to prop up the most beleaguered European bond markets, but this would only serve to underline the strong case for holding gold if the ECB in effect follows the Federal Reserve and embarks on a substantial programme of QE.
So with the gold market already tight, investment demand strong and the official sector net purchasers for the past six consecutive quarters, the gold price looks primed for a sharp upward move on any further deterioration in European credit markets. And that is before we factor in a safe haven premium in the price to compensate for the politically unstable situation in Korea.
