Inflation Angst Drives Commodities

Hopes for a further crisis response by the European Central Bank (ECB) cheered the markets yesterday, with a declining dollar giving support to rallies in commodities and precious metals prices.

Though discounted and criticised by the German Bundesbank, the market continues to be optimistic that the ECB will soon act to cap peripheral bond yields. These hopes might in part be attributed to the growing dissent between the Bundesbank and the ECB, as it looks increasingly likely that the Bundesbank will be left standing when push comes to shove. A clear hint could be seen in the publically voiced support for the ECB’s bond purchases by the German member of the ECB board Asmussen, while it is well known that the head of the Bundesbank Weidmann has been strictly opposed toward any such programs.

Good For The Euro
Bond purchases by central banks are of course an extension of the bank’s balance sheet, which devalues the currency by electronically creating new currency units in exchange for those bonds. According to the quantity theory of money, this would lead to a declining value of the euro. However the market has already priced in the possibility of a euro-zone break-up. Therefore, any decisive actions by the ECB aimed at backing the cohesion of the monetary union will lower this default risk. With that in mind, it wasn't surprising to see yesterday's euro rally as it gained about 1% against the dollar to close at $1.2473. Subsequently the U.S. dollar index (USDX) came under pressure and declined by 0.67% to 81.91.

As usual, when the dollar loses ground, commodities and precious metals, which are traditionally priced in terms of dollars, are on the rise. The December gold contract gained almost $20 (1.2%) and closed at $1,642.90 per ounce, reaching its highest level in three months. Silver fared even better with a gain of 83.5 cents (2.9%) in the front-month contract, which settled at $29.428. The return of inflationary expectations also manifested themselves in oil prices, with WTI flirting with the magical $100 mark again, last seen in early May of this year.

As senior market strategist Adam Klopfenstein said in the WSJ, "It's starting to seep into investors' minds that you have inflationary prices going on. You're going to have a situation in Europe that's going to require some kind of currency debasement".

When this change in sentiment really takes hold of the stricken gold and silver markets, we could be in for some explosive fireworks.