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The threat of deflation in the Eurozone is an issue that continues to
plague the ECB. The current easing measures have failed to drive inflation
above 0.3%, which is far short of the 2% inflation target that the ECB is
mandated to reach. This has led ECB President Mario Draghi to begin the
discussion of further QE to stimulate prices in the region. Just last week
Draghi commented that:
“We consider the APP [asset-purchase programme] to be a powerful and
flexible instrument, as it can be adjusted in terms of size, composition or
duration to achieve a more expansionary policy stance… We will do what we
must to raise inflation as quickly as possible. That is what our price
stability mandate requires of us.”
Dovish remarks such as these signal the markets that more QE is coming
from the ECB. Following the GFC, massive quantitative easing from the Fed
drove gold prices to new all-time highs, yet similar sized programs,
including those of the ECB, have failed to fuel a bull market in gold. Here
we will discuss why an increase in the ECB’s easing measures now will not
just fail to be bullish for the metal, but will in fact be likely to drive
gold prices lower.
The Currency Argument
New QE from the ECB will see the Euro weaken relative to the USD. The
chart below clearly shows that since the ECB first began discussion of new
easing measures in mid-2014, the Euro has fallen significantly. We believe
that this decline is likely to continue as we approach the launch of fresh
easing from the ECB.
In the US the Fed is moving ever closer to the beginning of a new
tightening cycle. Increasingly hawkish statements from the Fed and
speculation that the first hike will come this December has led to the USD
reaching 10 year highs. This strength has also been a product of the monetary
policy of other central banks moving in the opposite direction. Case in
point, the ECB introducing more quantitative easing.
Now consider the effect of a stronger US dollar on gold. Historically as
the US dollar has rallied gold has fallen in US dollar terms, and vice versa.
Therefore, if the US dollar strengthens then one would expect gold to
decline. Given that the US dollar and Euro often have an inverse
relationship, it is clear that if the Euro weakens, then gold could follow
suit. Accordingly, we reach the conclusion that from a currency standpoint
alone, gold will fall if the ECB increases their monetary easing programs.
Why ECB QE Will Not Be Bullish For Gold
Many gold bulls in 2014 called that the introduction of new QE would
re-ignite the bull market and drive the yellow metal to new all-time highs.
The reasoning was simple, QE from the Fed had fuelled the gold bull market
for years, so why should QE from the ECB be any different?
The answer to this is simple, ECB QE has had a different effect on gold,
because it is a different type of program. The measures used by the Fed
during QE1 and QE2 were broad based programs. Their goal was to stimulate the
economy by keeping interest rates low. To do this the Fed targeted buying
long term Treasuries to push the price of that debt higher and the yields
lower.
However, this has not been the goal of the ECB. Long term interest rates
are already at all-time lows, so instead the ECB’s QE programs target Asset
Backed Securities (ABS) to incentivize bank lending. An ABS is a financial
security backed by a loan, lease or receivables against assets other than
real estate and mortgage-backed securities. This means that the ECB’s QE
program was similar in nature to QE3 from the Fed, which targeted Mortgage
Backed Securities (MBS).
Given that the ECB is already using targeted QE and that targeted QE has
been successfully used in the US, it’s logical that the ECB will again use
targeted QE. This means that they will not use the broad based measures
similar to QE1 and QE2 that drove gold higher. Therefore we do not expect
that new easing from the ECB will drive gold higher.
ECB QE Will Be Directly Bearish
Targeted programs will be used when the ECB increases their easing
measures. We have established that these will not have a bullish effect on
gold as they differ subtly but significantly from the easing programs that
fuelled the gold bull market. However, we are yet to cover why new measures
in Europe will drive gold lower, rather than simply not push the metal
higher.
In the US QE3 was successfully used to stimulate growth and improve the
health of the employment sector. While the employment sector has not
recovered to full strength, shown by a lack of significant wage inflation,
jobs growth has been considerable. Therefore, although employment has not
reached its full potential, QE3 has resulted in an economy that is ready for
higher rates and tighter monetary policy. This means that targeted measures
can be effectively used to improve long term economic health.
If this conclusion extends beyond the US, which we and most economists
agree it does, then targeted QE can be used to increase inflationary
pressures in Europe and avoid the threat of deflation. From this we can see
that if the ECB’s new QE programs are successful, then over the long term
inflation and economic health in the Eurozone will rise.
This means that further measures are unlikely to be necessary, and that in
fact over the longer term monetary policy will begin to tighten, which will
be highly bearish for gold. This view will likely be priced in to markets as
the ECB’s QE is shown to succeed, which means that gold is likely to be sold
off as the new measures take effect.
As the economic health of the Eurozone increases we are also likely to see
gold sold off as a safe haven asset. Improvements in the economy generally
lead to investors becoming less risk averse, as the probability of a
significant downturn is decreased. This means the "risky" assets,
such as stocks, become more favourable than safe haven assets, such as gold.
Therefore gold is likely to be sold as the economy improves simply because it
is a safe haven asset.
Accordingly, we believe that fresh QE from the ECB will be directly
bearish for gold, rather than just non-bullish.
What If the New Measures Don’t Work?
The argument can be made that the current measures from the ECB have
failed, as these now need to be increased to combat the still weak inflation
outlook, and that because they have failed all future programs will also
fail. We believe that this argument is flawed for a two key reasons.
Firstly, the view that just because the most recently announced easing
programs from the ECB have been unsuccessful, all future attempts will also
be futile is naive. In the US, QE3 was the third round of easing from the Fed
under the quantitative easing banner, and even QE3 was initially considered
unsuccessful. After being announced in September 2012 the Fed increased QE3
at their December meeting that year. This shows that the initial program may
not achieve all of the desired targets, but can still be successful when
increased or adjusted.
Secondly, although the inflation situation in Europe is poor, it has not
severely weakened. In fact, core inflation has improved in the region with a
print of 1.1% in October. While this appears soft on the surface, it is worth
noting that in the US core inflation is only 1.9% and the Fed is approaching
a rate hike. This means that although the current ECB measures are not
enough, they are on the right track. Therefore it is likely that an increase
in ECB QE would be effective in the same way that the increase in QE3 was.
When we consider the effect on gold prices, the key factor is the markets
perception of the programs. It matters little whether one personally believes
that the current measures have worked, as the markets hold the view that they
will work over the long term. This means that the long term effect of gold
being lower due to higher interest rates will likely be priced in while the
programs are in place. This is true regardless of whether they are effective
at that time, as markets believe that the ECB’s action will eventually drive
growth in the region, which will necessitate higher rates.
How to Trade Gold from Here
We hold the view that more QE from the ECB will be bearish for gold
prices. Additionally, we believe that the Fed will hike this December and
that this action will drive gold lower. Together these actions are likely
drive the US dollar higher and gold consequently lower. Therefore, we clearly
believe the right trade is to be short gold, but when is now the right time
to open new shorts?
Gold has fallen around $100 since mid-October when the Fed signalled that
they would hike in December if data remained steady. This selloff has led to
the yellow metal becoming oversold, as shown by the RSI, which is currently
at 32.92. The MACD is also poised for a sub-zero bullish crossover. These
crosses have often signalled a rise in bullish momentum and at least a small
rally higher. Therefore gold has the technical potential to move higher from
here.
The $1080 level is likely to impede this, but gold has failed to break
significantly beneath the level. This indicates that the resistance is yet to
be fully broken, and therefore is unlikely to fully stop a rally higher if
gold breaks to the upside.
Although we hold the view that the fundamentals are highly bearish for
gold, we admit that the current technicals show that the metal has the
potential to move higher in the near term. Therefore we would not look to add
new gold shorts at this stage. Whilst we are maintaining a core short, we
intend to wait until gold approaches resistance at $1150 before adding new
short trades. This would ensure that these positions are opened at optimal
levels to take advantage of the bearish effects of new ECB QE.
We will signal our subscribers when we open these positions, providing
them with the exact trades that we open in our own portfolio. We will also be
publishing our regular market updates with further analysis of the effects of
new ECB QE, the Fed meeting this December, and how we are trading gold to our
subscribers only. If you wish to become a subscriber, you may do so via
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