EuroTARP to the Rescue

06/07/2010 12:01 am EST

Focus: GLOBAL

David Coffin

Editor, Hard Rock Analyst

Efforts to prop up European bonds could end up adding to gold's shine, write David and Eric Coffin of the Hard Rock Analyst.

The European Commission brought out the big guns. In a move intentionally reminiscent of the US TARP (Troubled Asset Relief Program), leaders of the continent’s major economies promised to keep throwing money at the problem in bulk until some of it stuck. 

It’s not a pretty picture overall, but the drop in yields in the past two weeks points to at least grudging acceptance of EuroTARP by bond vigilantes. Like the reaction to the US program 18 months ago, this might simply reflect a belief that it doesn’t pay to bet against a trader that can print its own money.

That is pretty much the mindset EuroTARP was created to instill. Stripping away the dogma on both sides of the trade, bond yields are really about trust. Traders either believe a government, or a committee of governments in this case, is willing and able to support the market or they don’t. The 750-billion-euro package had enough shock and awe to calm the bond markets a bit, but yields are still high and unlikely to be back to “normal” for the foreseeable future. Rising LIBOR rates and a large drop in the amount of bank and commercial credit issuance in Europe is also worrisome if it continues.

It will take months for the market to know if the plan is working. Until then, markets will be more risk averse and will discount lower growth in the euro region as austerity programs start to bite. This in turn is leading to fears of knock-on effects in other markets, particularly the BRICs (Brazil, Russia, India, and China).

That is especially apparent in the base metal space and the Shanghai stock exchange, which has dropped about 20% in the past month or so. Longer-term wagers will continue to be made on the survival of the euro itself. Anyone who has looked at a euro/dollar chart lately knows which way those bets have been running.

The euro is getting pummeled, having been knocked down 20% in the past six months, and there is no sign the selling is about to end. All of the southern euro zone countries have become significantly less competitive against Germany through the past decade. This is not due to pay rates, which are much higher in Germany, but to productivity. Germany is famous for productivity growth and cost control. It's one reason it’s the world’s most successful exporter.  

Some of the PIIGS have a long way to go to get competitive and generate growth in incomes. It’s easy to make a case that some of these countries may be forced to leave the euro and that, really, it would be the best thing for them. That, however, is not the same as saying the euro as a currency would “fall apart.”

The collective debts of Greece, Ireland, and Portugal would not exceed the damage the Lehman Brothers bankruptcy created even in the case of a 100% write-off. If the contagion effects can be addressed, the fund for buying Club Med debts now being set up should be adequate. At that level, the market is over-reacting, but it won’t calm down unless traders decide larger economies won’t be sucked into the same black hole.

All this uncertainty has been working in gold’s favor. In our view, gold is trading more and more as an independent currency. The list of countries starting up the printing presses continues to grow. The ECB is now planning to embark on a campaign of quantitative easing, something it insisted would never happen [until recently]. As more people view the fiat currency race to the bottom as back on, more funds have moved into gold.

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