Gold Turns Corrective After Monday's Gains

by Peter A. Grant

February 22, a.m.
(from USAGOLD.com) --

Gold corrected in overseas trading on Tuesday after surging to new 7-week highs in thin holiday trading on Monday. The escalation of violence in Libya increased safe haven flows into the dollar overnight and an increasingly hawkish tone from the ECB has made the euro more attractive on rate hike speculation.

Today Libyan strongman Muammar Qaddafi declared that he would not step down, vowing that the army and police would restore order tomorrow. The escalating situation in Libya, along with news that two Iranian naval vessels had traversed the Suez Canal and entered the Mediterranean Sea, have significantly ramped-up tensions in an already very tense region. Oil prices rose dramatically on Monday, corrected overseas and are now back on the rise, further stoking global inflation worries.

ECB Governing Council member Yves Mersch said today that a warning on upside inflation risk by the central bank could come as early as next week. Yesterday, the ECB's Bini Smaghi says higher-than-expected inflation is a "concern" and warned that food price increases may be permanent. The general rise in hawkish ECB rhetoric has the market pricing in a potential rate hike for Europe once again, which redirected some of the ongoing safe-haven flows to the euro today. However, with spreads still running quite high in periphery Europe, a hike to benchmark rates will likely raise borrowing costs in countries that can ill afford them.

German support for various plans to create a permanent bailout facility for Europe have waned in the wake of the crushing defeat suffered by Chancellor Merkel's CDU party in Hamburg. Ms. Merkel, apparently in reaction to push-back from German taxpayers, has come out against both joint EU bond sales and bond purchases through the ESM. This position was largely reiterated by outgoing Bundesbank President Axel Weber in an FT op-ed today, where he said, "this means the principles of subsidiarity, responsibility of individual member countries and no-bail-out remain essential for the EU."

Germany is the economic lynchpin of Europe and the Bundesbank is the lynchpin to the central banking system in Europe. If Germany is against expansion of the bailout fund, against bond purchases through the existing fund, against joint EU bond issuance and seemingly against further bailout, I'm not exactly sure what options that leaves the EU with to address the ongoing sovereign debt crisis. The situation strikes me as very reminiscent of post-bailout America. In the absence of political will for further bailouts, the Federal Reserve was forced into action, implementing their initial quantitative easing efforts. Might the ECB ultimately be forced to act similarly to prevent an EU collapse? And what might the implications be to the ECBs credibility, if rather than the rate hike that many now seem to be expecting, the ECB launches its own quantitative easing program?

Peter Grant is USAGOLD's resident economist and a well-known analyst globally in the forex and precious metals markets.

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