ECB HOLDS THE KEY TO NEXT GOLD RALLY / THE FINANCIAL TIMES ( VERY HIGHLY RECOMMENDED READING )

Note from the editor

ECB holds the key to next gold rally

By Jack Farchy in London

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Gold has been a conundrum in the last couple of months. For its most ardent fans, it has been a downright disappointment. Despite the rising sense of alarm in Europe, regular sell-offs in the bond markets and relentless headlines about the demise of the single currency, gold – supposedly a “safe haven” against such turmoil, has been mundanely rangebound in a $1,600-$1,800, or €1,200-€1,300, band.
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The next leg of the gold rally may not be far away, however. If Mario Draghi, president of the European Central Bank, follows through on a hint last week that the ECB may step up bond buying activities, he could trigger a new rush for physical gold among conservative Swiss and German investors.
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A look at the history of the eurozone debt crisis shows why. For all the fear that it has caused in the debt, equity and currency markets, the eurozone crisis has only seriously impinged on the gold market twice. The two instances have one thing in common: the ECB.
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The first time was in May 2010, when European leaders succumbed to the necessity of bailing out the eurozone’s peripheral countries. Gold, denominated in euros, rose 11.5 per cent in the month. It also hit new records in dollar terms.
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Of critical importance to the surge of gold buying was a policy U-turn by the ECB, which agreed to start buying eurozone bonds. German TV broadcast footage of Germany during the hyperinflation of the 1920s, and coin dealers in Germany and Switzerland were sold out for weeks.
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The second key moment in the eurozone crisis – at least from the perspective of the gold market – came this August. Again the ECB was central. Following an escalation of the crisis the central bank announced it would start buying Italian and Spanish bonds for the first time.
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Again, gold’s reaction was electric. It jumped 8.7 per cent in euro terms, and 7.8 per cent in dollar terms, in the three days following the ECB announcement. Of course, the ECB and the eurozone crisis are not the only factors driving the gold market. But they have contributed to two of the most dramatic surges higher in recent years.
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For the thing that most terrifies German and Swiss investors – holders of much of the wealth in Europe – is not a breakup of the single currency bloc per se, but uncontrollable inflation. As that footage of Weimar Germany demonstrates, the fear of hyperinflation runs deep.
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Indeed, a look at the gold price (especially in euro terms), German coin and bar demand, and the ECB’s bond buying activities shows a remarkably tight correlation. In the second quarter of 2010, the ECB expanded its “securities held for monetary policy purposes” by some €75bn.
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German coin and bar demand, according to the World Gold Council/GFMS, jumped by 167 per cent to 49.6 tonnes. And the euro gold price rose 23.2 per cent. The third quarter of 2011 witnessed the ECB’s most aggressive bond buying to date: an increase of about €85bn in “securities held for monetary policy purposes”. German coin and bar purchases leapt 162 per cent to 59.3 tonnes, and the euro-denominated gold price rallied 17.3 per cent.
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The lesson? Gold investors should pay little heed to “Merkozy” and Monti. The crucial player over the coming week is the other Mario sitting in Frankfurt.