Gold Rallies During "Risk-On" Trading

Why did the Dow Jones Industrial Average soar 162 points yesterday? And why is it rocketing another 300 points this morning?

Was it because Consumer Confidence for October plummeted from 46.0 to 39.8…or was it because the number of Americans who signed contracts to buy homes fell for the third straight month?

Consumer Confidence Index

Neither, according to the newswires. The market is rallying because the deadlocked euro rescue plan became UN-deadlocked. Adding to the euphoria was a rumor that the Chinese would buy some of the European debt that would finance the rescue.

Bravo for that.

“After more than eight hours of hard-nosed talks between European heads of state, the International Monetary Fund and bankers,” the Associated Press reports, “the [rescue] deal foresees a recapitalization of hard-hit European lenders and a leveraging of the bloc’s rescue fund to give it firepower of 1.0 trillion euros ($1.4 trillion).”

This news kicked off a monstrous rally in Europe that vaulted most of the major stock indices 5% to 6% higher. We Yankees joined the celebration by bidding our homegrown stocks higher as well.

So for the moment, investing is fun again. But as your editor’s mother used to say, “It’s all fun and games until someone gets hurt.”

Today’s knee-jerk rally is fun indeed. But we’ve seen this show before…or at least a version of it.

Today’s European summit was the 14th such powwow in the last 21 months. And nearly all of them produced some kind of “breakthrough agreement” that thrilled investors for a day or two. But each of these relief rallies proved fleeting, as the “breakthroughs” yielded to deadlocks and bickering about the details of the supposed breakthrough.

The process of unifying 17 countries — while also unifying a variety of disgruntled, self-interested constituents inside each of those 17 countries — has made the rescue process a little bit like herding cats — or more like herding cats, chimpanzees, rhinos and rattlesnakes…all at the same time.

This time around may be different…but it may not. For starters, the breakthrough arrived only after German Chancellor Angela and French President Nicolas Sarkozy coerced European banks into accepting a “voluntary” 50% haircut on their Greek bond positions.

Around midnight in Europe, the European Banks’ representative at the summit, Charles Dallara, fired off an email stating categorically, “There is no agreement on any element of a deal.” But shortly thereafter, according to the AP, “Sarkozy said the bankers were escorted in ‘not to negotiate, but to inform them on decisions taken by the 17 and then they themselves went on to think and work on it.’ Luxembourg Prime Minister Jean-Claude Juncker said the banks’ resistance was broken by a threat ‘to move toward a scenario of total insolvency of Greece, which would have cost states a lot of money and which would have ruined the banks.’

Armed with this “voluntary” agreement, the rescue plan was good to go…and the markets were sprung to rally. So for now, it’s all smiles and high-fives.

Whatever the actual prospects for an enduring rescue package — “enduring” being something longer than a week — investors are growing tired of fear. So they are shifting into “risk-on” mode. Treasuries are selling off; the dollar is dropping; stocks are rallying. This is classic “risk-on” trading action — meaning that market participants are becoming slightly less skittish and slightly more eager to take some chances.

But here’s a curious data point: During the most recent phase of the risk-on trade, gold has also rallied. In so doing, gold has broken ranks with its “risk-off” companion: Treasury bonds.

Ever since the credit crisis of 2008, investors have flocked to both gold and Treasurys whenever macroeconomic conditions started looking a little dicey — i.e., “risk off.” As such, both assets tended to rise or fall at the same time. But during the last few weeks, when the risk-on trade was gaining traction once again, gold also rallied. Treasurys did not. Something has changed here. We’re not sure what it is but, as usual, we have a guess.

Precious Metals Prices Move Higher While Treasury Bond Prices Move Lower

First, a little background…

Throughout most of the last four decades, the price of gold and the price of Treasurys traded inversely from one another. Whenever gold rallied, Treasurys fell, and vice versa. This “inverse correlation” as professionals call it, stemmed from the fact that T-bonds tended to thrive during deflationary periods, while gold tended to thrive during inflationary periods.

But after the credit crisis of 2008 — when neither deflation nor inflation were the anxiety du jour — these two asset classes started tracking each other much more closely than usual. They became “flight-to-safety” assets, more than anything else. While very dissimilar, both assets satisfied a particular appetite for risk aversion — much the same way that Eggs Benedict and a bran muffin, though different, both satisfy an appetite for breakfast.

So what does the recent gold rally mean, given the fact that Treasurys are falling? Perhaps it means that investors are starting to brace for a different sort of risk. Perhaps it means that investors are beginning to anticipate a sustained inflationary response to the euro crisis — whether or not that response succeeds — or just a crisis.

In other words, either the governments of Europe rescue the euro with a massive inflationary effort or they fail, in which case the euro breaks apart and the most reliable money around would becomes the ancient money: gold.

That’s what you call, “Heads, I win; tails, you lose.”

Eric Fry
for The Daily Reckoning

The Daily Reckoning