Sovereign debt crisis

“Buy Treasuries, they are risk-free”, the pundits said. “Governments cannot go bankrupt, they can always print the money to cover their debts”, they explained. Boy, they have been wrong! Just ask the Greeks. Indeed, the European sovereign debt crisis revealed that for all to see.

The sovereign debt crisis occurs when a country is unable to meet its debt obligations. There are several major fundamental causes underlying each crisis. One of them is unsound fiscal policy, i.e. excessive spending and persistent fiscal deficits. Another one is market interpretation of the monetary policy: this is the case of the famed bond vigilantes showing up and forcing the central bank’s hand. However, the macroeconomic imbalances turn into crises only when investors lose confidence in the country’s solvency. When this happens, they demand higher yields on the government bonds. But the higher the interest rates, the more it costs the country to refinance its sovereign debt. Sometimes, the debt servicing costs rise so much that the government has no choice but to default.

Sovereign Debt Crisis and Gold

The sovereign debt crisis should be positive for gold, right? After all, gold is a hedge against the crisis. Not so fast. Gold is a safe-haven asset, but so is the US dollar. Hence, the impact on gold depends on the country is perceived as going bankrupt. Let’s take Argentina. Its government defaulted on its foreign debt multiple times, but these bankruptcies did not cause the rally in gold prices. Actually, the Latin America debt crisis, which covered several other countries from the region, occurred in the 1980s, when gold was in the bear market. Similarly, the Asian financial crisis, during which several Asian economies defaulted, happened in the 1990s and did not pull gold from the paws of bears.

The reason for such gold’s behavior is the debt crisis in emerging countries are often associated with the strong US dollar. The appreciation of the greenback is both the reason – stronger dollar implies that the country needs to turn more of its local currency into dollars on order to pay off the dollar-denominated debts – and the result is the debt crisis, as investors shift their capital away from emerging markets to the US. The only partial exception might be European sovereign debt crisis.

European Sovereign Debt Crisis and Gold

The European sovereign debt crisis was the direct result of the Great Recession. In a response to the economic crisis, some of the European governments bailed out their commercial banks. Doing that, they invited trouble upon themselves. To compound their woes, please remember that individual nation states of the eurozone have lost their ability to print money, to devalue: they have lost monetary sovereignty and the benefits of a freely-floating exchange rate. With the euro, it’s one size fits all.

Other countries were just plain fiscally irresponsible. The best example is Greece, which announced in 2009 that its actual budget deficit was 12.9 percent of the GDP. Contrast that with their financial books adjustments (for lack of a better term) and presentation in order to be allowed into the euro club in the first place. There’s no free lunch in the form of advantageous credit rating or a strong currency for the less than stellar borrowers. Artificially high exchange rates hollow out the manufacturing base (just ask Italy). Staying internationally competitive has the exchange rate aspect to it, too. As a result of its 2009 admission, the credit rating agencies slashed the Greece’s rating, while the yields jumped. The Greek debt crisis very soon spread to other countries which invested in Greek bonds or had also very high public debt. The PIIGS crisis was born.

The chart below reveals that the European sovereign debt crisis was very positive for gold. The yields on long-term Greek Treasuries soared from less than 5 percent in 2009 to almost 30 percent in early 2012. Since then, thanks to the international bailout of Greece, they started to decline – together with the gold prices.

Chart 1: Gold prices (left axis, yellow line, London P.M. Fix, in $) and the yields on the 10-year Greek government bonds (right line, right axis, in %) from January 2008 to December 2018.

Sovereign debt crisis and gold chart

But let’s take a closer look. The gold prices peaked in 2011, when Europe still struggled with the debt crisis. Why? Let’s analyze the second chart, which overlays the gold prices and the EUR/USD exchange rate. This solves the riddle.

Chart 2: Gold prices (left axis, yellow line, London P.M. Fix, in $) and the EUR/USD exchange rate (right line, right axis, in %) from January 2008 to December 2018.

Sovereign debt crisis and gold EURUSD chart

As one can see, the price of gold reached its peak in 2011, shortly after the euro started to depreciate against the US dollar. In other words, the currency channel started to dominate the safe-haven demand for gold. Or, to put it differently, initially, the risk aversion rose, which pushed investors toward gold. But when the worries receded (as can be seen in credit default swaps for the PIIGS countries), the gold prices started to follow the direction of euro against the US dollar.