Flight to quality

illustration: gold

(19.07.2011) Persistent concerns regarding sovereign debt and the lack of a solution for both the euro zone and the USA bolstered a flight to safety yesterday. The Swiss franc reached new records against the euro, while gold prices climbed to a record high.

By Maren Romstad, Analyst at DNB Markets

Global stock markets lost ground on Monday, dragged down by the banking sector. However, there are still great uncertainties and frustration about how both the euro zone and the USA will solve their debt problems, which also weigh on financial markets. Debt fears kept up the pressure on non-core European government bonds, while yields on German bunds and US Treasuries fell somewhat.

One important event that will receive much attention this week is the planned summit among euro zone leaders on Thursday. The goal of this meeting is to agree on a new rescue package for Greece and the participation amongst private investors. Already four days ahead of the meeting it’s affecting financial markets. Yesterday Germany's Prime Minister Angela Merkel threatened to be absent from the meeting if they wouldn’t agree on a solution. The Germans want private investors to contribute in the second rescue package and the more the better.

This was probably a contributing factor why European stocks fell from Monday morning, despite that the much talked about stress tests were better than feared. The euro has strengthened during the Asian session.
 
One currency that has benefitted from the uncertainty surrounding a Greek solution and fears that the most serious problems will spread to larger European countries is the Swiss franc. Since the beginning of July, the Swiss currency has strengthened about 6 per cent against both the euro and the Norwegian krone. The reason for the record-strong franc is the currency's status as a safe haven. Due to relatively large financial markets and a very strong international net investment position the currency has gained such characterization.

No solution to the Greek problem contributes to great uncertainties in financial markets and thus makes the Swiss franc very attractive. As long as euro zone leaders fail to agree on a solution, the Swiss currency is likely to remain strong with the risk of further strengthening. However, when a permanent solution is in place, our main view is that the Swiss currency will weaken on a broad basis. Even if a Greek default is the final result.

The Swiss central bank has previously intervened in the foreign exchange market (sold CHF) to prevent further appreciation pressure on the currency, and with today's record strong franc the speculations are growing. The situation today is quite different than the last time the SNB intervened. The economic development has improved significantly and even if inflation is low, deflation fear is subdued. SNB expects an average inflation rate of 0.8 per cent this year and that inflation gradually will increase and reach the target of 2.0 per cent in 2013.

As a consequence of last week’s turbulence, gold price has increased rapidly. As of yesterday, spot price increased to 1.600 dollar per ounce, which implies that the sequence of days with price increases has extended to eleven. Several factors explain this development. Alongside turbulent Euro zone debt markets, disagreements between democrats and republicans and how they will increase the US debt limit, has been a contributing factor.

While negotiations have been more or less stuck, news from yesterday reported that the Congress is currently working on an alternative solution where President Obama will be authorized to raise the debt limit which was reached already in May. Our view is that the Americans probably will succeed in raising the debt limit before the deadline at August 2. If they do not succeed the country will impose a sovereign debt crisis, as they will fail to either finance ongoing expenditure or their current debt obligations.

Nonetheless, whether President Obama is authorized to raise the debt limit without having to vote in House of Representatives, the underlying need for contraction is still evident. This is closely tied to the budget deficit, and if they only raise the debt, the US faces a risk of downgraded credit rating. S&P has been very clear on the requirement for a credible plan on how they will undertake a reduction in the budget deficit. However, financial markets do not show noticeable signs of worry for an American downgrade.