The Euro Versus Gold
Ever since the Swiss franc was pegged to the euro, gold became the only safe haven investment in times of crisis. Here is a system to profit from the next crisis.
The value of gold has been subject to intense debate for centuries. London financier Nathan Rothschild once commented that he only knew of two men who really understood the true value of gold, an obscure clerk in the basement vault of the Banque de Paris and one of the directors of the Bank of England. And unfortunately, they disagreed.
Gold is a precious metal with many faces and multiple personalities, and trying to evaluate its intrinsic value can be difficult, since it can switch focus very quickly. When a crisis occurs, fear becomes the predominant factor, driving gold prices higher, eclipsing all other correlations.
In Figure 1, I calculated the yearly correlation between gold and various related assets. You can see that gold had been moving in lockstep with equities and the whole commodity complex until a major change occurred in 2011. The correlation with the CRB index from a strong positive turned negative, while the correlation with equities from a moderate positive went to a strong negative. Even the traditional correlation with the gold mining group broke down and the negative correlation with the dollar weakened dramatically.
In the summer of 2011, gold rose to multiyear highs as concerns about the European debt crisis and the risk of contagion pushed gold’s safe-haven asset and currency hedge status to the front. Note the correlation with European banks for the Dow Jones Eurostoxx bank futures (FESB) and Italy’s Unicredit Bank, which rose to a strong -0.90 in 2011. At the end of October 2011, European leaders agreed on a plan to stem the debt crisis by expanding the European Financial Stability Facility (EFSF) to €1 trillion, recapitalizing banks and prompting bondholders to accept a 50% haircut on Greek debt.
FIGURE 1: YEARLY CORRELATION BETWEEN GOLD AND RELATED ASSET CLASSES. A value of +1 indicates a perfect positive and a value of -1, a perfect negative relationship. A correlation coefficient of zero means that there is no linear relationship between the variables. Values in between indicate the degree of correlation of the variables under consideration. Symbols used are SPX (S&P-500), VIX (CBOE volatility index), TNX (10-year Treasury yield index), XAU (Philadelphia Gold/Silver Index), SLV (silver (cash), DXY (dollar index), FESB (Dow Jones Eurostoxx Bank continuous futures contract), UCG (Italy’s Unicredit Bank), and MZM (liquid zero maturity money supply, which includes all money in M2 less time deposits). All correlations were calculated using daily data except for the MZM. Correlation for 2011 included data up to 10/21/11. All rows depict yearly correlations except the first, which is the total for the 10-year period from 2001 to 2011. The last row is the standard deviation of yearly correlations.
I write this after the European Union (EU) leaders unveiled the ambitious plan, and it appears as if investors are not convinced as Italian bond yields are rising to new highs (see Figure 2). The country’s €1.9 trillion debt is equal to 120% of its gross domestic debt and the Italians must repay €298 billion of debt next year, more than Spain, France, or any other euro-zone member.