With the euro having dropped substantially from a high of around $1.51 to less than $1.40 in the span of a few short months, it has sent gold buyers looking for cover, mostly as a function of the linear (and at times sigmoidal) inverse correlation between gold prices and the DXY which throughout 2009 has held surprisingly strong. Yet will a dollar scramble prove that the recent flight to gold has been premature? BofA believes that while the near-term implications for gold are as of yet undecided, relying on both € (bearish) and risk (bullish) signals, the long-term drivers for gold should be price supportive, especially for EUR-based investors. Proper positioning can be adopted using OTM gold calls, which are not only no longer as rich as they were a mere month ago, but would benefit substantially should Greece indeed follow through with an actual default and result in a flaring of all risk indicators, further precipitating a flight to euro alternatives, among which the dollar, and gold, are dominant.
Bank of America suggests:
In the case of an actual default, even an orderly one, increased systemic risk is likely to support gold prices as investors look for a safe haven. The more disorderly the default turns out to be, the more upside we see on gold. However, if Greece just muddled through the crisis or ends up being bailed out, gold may not fare that well. If the Greek problem does not spread to other countries in the Euro area, gold prices are likely to suffer due to a weaker EUR against the USD.
[T]he long-term consequences of Greece’s debt crisis for gold prices are clearly constructive, in our view. Emerging Market central banks are ever more aware that gold is one of the few viable alternatives to the USD. A deterioration of Greece’s creditworthiness, even if bad for the EUR, should support gold prices in the long run, in our view.
The main question, as discussed previously, is how will EM central banks decide to allocate their trade surplus FX reserves. Contrary to some gold-bearish perceptions, it is very likely that an increasingly deteriorating Greek situation, will force EM CBs not only to unwind € holdings and use the resulting capital to purchase dollars, but to augment their gold reserves as well. Thus the price determining factor will be decided in the marginal scramble for dollars versus gold.
Emerging market central banks (EM CB) are ever more aware that gold is really one of the few viable alternatives to the USD. Top holders of currency reserves like China, Russia or India will likely need to increase their exposure to gold over the coming months and years as the value of fiat currency reserve holdings like the USD or the EUR comes into question. The obvious problem with diversification is that there is simply not enough gold to go around. So a deterioration of Greece’s creditworthiness, even if negative for the EUR, should be supportive of gold prices in the long run, in our view.
And with gold prices still, presumably, reflective of a dollar-destruction rampage courtesy of the Federal Reserve, what would be the proper way to express a cheap bullish bias toward a spike in gold prices should a risk-flaring episode come back once again? BofA suggests that clients look to gold OTM calls, which are no longer a ripoff compared to ATM calls. In fact the call skew in gold, which still bullish, is half as expensive as it was on November 20, 2009. Yet investors most likely to benefit from such appreciation would likely not be USD-based speculators but those found in a EUR regime.
In our view, gold OTM calls look appealing for investors willing to play a potential Greek default through the gold market. Volatility levels have been declining and 3M ATM implied vols are now trading at levels last seen in late 2007. While the gold options market continues to price in appreciation, together with the CNY and the JPY, the call skews in gold have become less pronounced. That is, OTM calls are no longer as rich as they used to be when compared to ATM calls. In the event of a default, gold prices and volatility are likely to spike. If Greece’s problems are contained and the EUR (and gold prices) suffers, investors are protected on the downside. USD-based investors may find gold to be an ineffective hedge in this event. However, EUR-based investors could, in our view, hedge by buying gold calls in EUR, as the price of gold in EUR terms should remain well supported.
The biggest concern for outright gold longs will be whether the transfer in mentality from one of continuous dollar debasement in which the demand would come from traditional USD-based investors seeking to hedge and capture stock gains by allocating increasing capital to gold, to a perspective of gold as an increasing investment allocation for central banks, who seek to abandon the euro as a capital flow and pursue less risky exposure. Should this increased central bank demand be coupled with lack of incremental selling by those who already are in possession of Gold spot and future positions, and the probability for increasing gains in the fiat-alternative seem to accelerate. Lastly, for some additional insight into the crystallizing plight of the German government vis-a-vis Greece, as well as the increasingly torn fabric of the European Monetary Union, we strongly recommend the latest piece by Evans-Pritchard, "Should Germany bail out Club Med or leave the Euro altogether?"