There is a real sense of the calm before the storm in markets globally. Complacency reigns, despite signs that the sovereign debt crisis in Europe is deepening and that Japanese and US bond markets also look very vulnerable due to rising inflation, very large deficits and massive public debt. 

Gold
Gold in Japanese Yen - 6 Months (Daily)

The unfortunately named PIIGS have seen their bond yields rise sharply again in recent days. Greek, Irish and Portuguese bonds in particular have come under pressure on concerns of deepening economic contractions and possible defaults.

Greek bonds fell for a ninth day after a report showed the nation's economy shrank for a 10th consecutive quarter. In less than 2 weeks, the yield on the Greek 10-year has risen sharply from 10.804% to 11.750%.

Greek
Greek 10 Year Bond Yield - 1 Year (Daily)

Irish two-year notes fell sharply this morning, pushing the yield to the highest since the introduction of the euro in 1999. The yield increased 10 basis points to 7.26 percent in London after jumping as high as 7.56 percent. The Irish 10-year yield rose three basis points to 9.26 percent.

Peripheral sovereign bonds remain under pressure despite considerable support and outright purchases by the ECB.

http://www.goldcore.com/images/mu/goldcore_bloomberg_chart3_16-02-11.PNG
Ireland Government Bond 10 Year - 1 Year (Daily)

Sovereign debt issues are not confined to the eurozone and there is a real risk of the contagion spreading to other large debtor nations, including Japan and the US.

A Japanese minister denied overnight that there was any chance of a Japanese default on their massive government debt (see News). Japanese bond prices came under selling pressure with the yield on the 10 year rising to 1.36% and gold prices in Japanese yen rising to JPY 115,000 near the recent nominal record of JPY 118,000 seen in December (see charts above and below).

Gold in yen terms is still more than 25% below the nominal high of 30 years ago which should give those calling gold a bubble pause for thought.

Gold
Gold in Japanese Yen - 40 Year (Quarterly)

US Treasuries have been sold by some of the largest investors (both private and sovereign) in the world recently (see news). These include large creditor nations Russia and China but also PIMCO, the largest bond fund in the world.

The estimated cost to service the US National Debt of $14.09 trillion is $240 billion for fiscal year 2011 alone. The US national debt now equals the value of the entire US economy in GDP terms.

This is making investors nervous and they are rightly demanding and will continue to demand higher interest rates for the increased risk of financing the US' unsustainable fiscal and monetary policies.

The Obama administration's budget is seen by many as being optimistic in the extreme based as it is on the hope of rapid economic growth after two years of sluggish growth. The unpartisan Congressional Budget Office however does not share that optimism and thinks that the economy will continue to struggle.

A global sovereign debt crisis is now quite possible. At the very least, we are likely to have a long period of rising interest rates which will depress economic growth.

Contrary to some misguided commentary, rising interest rates will benefit gold as was seen when interest rates rose sharply in the 1970s. It was only towards the end of the interest rate tightening cycle in 1980, when interest rates were higher than inflation, that gold prices began to fall.

Gold's importance as financial insurance and the fact that it cannot go bankrupt or default will also be increasingly important in the years ahead.

As ever, it is best to be optimistic but realistic and to hope for the best but be prepared for less benign scenarios by diversifying accordingly.

Gold

 

Gold is trading at $1,372.00/oz, €1,015.62/oz and £854.62/oz.

Silver

 

Silver is trading at $30.72/oz, €22.74/oz and £19.14/oz.

Platinum Group Metals

Platinum is trading at $1,372.00/oz, palladium at $835.00/oz and rhodium at $2,400/oz.

News

(Bloomberg) -- Yosano Says Japan Debt Appeal Points to Zero Default
Japan's bond market will find support from domestic investors even as government debt swells because they lack better alternatives, Economic and Fiscal Policy Minister Kaoru Yosano said.

I see zero chance of Japanese government bonds nosediving at the moment, Yosano, 72, said in an interview in Tokyo today, responding to calls from opposition lawmakers to prepare for a collapse in government finances. Investor still believe that the government, to a certain extent, is pursuing fiscal discipline.

Members of the Liberal Democratic Party met today to discuss emergency measures the government needs to take should the nation's bond market collapse, underscoring growing concern about public finances since Standard & Poor's downgraded Japan's credit rating for the first time in nine years. A former finance minister, Yosano has advocated raising taxes to pare debt and increase the sustainability of government finances.

Long-term bond yields have been contained at incredibly low levels due to a lack of promising domestic investment opportunities, Yosano said. Investors within the country also are able to absorb government debt, he said.

More than 90 percent of the nation's government debt is held domestically. Japan accumulated a 17.1 trillion yen ($203 billion) current-account surplus in 2010 and is also the world's second-largest holder of foreign reserves.

(...)

Yosano reiterated the government's support for the U.S. dollar as the world's key reserve currency. Officials of Group of 20 economies have said they will discuss the global currency system when they gather this week in Paris.

It's very important that the value of the dollar is maintained because Japan has many dollar-denominated assets and is a major exporter, he said. The U.S. hasn't given up on its fundamental view that a strong dollar is in their national interest, he said.

(Bloomberg) -- Gold Rises to Highest in Almost Four Weeks on Inflation Concern
Gold futures climbed to the highest in almost four weeks as rising consumer prices boosted demand for the precious metal as a hedge against inflation.

In January, China's inflation accelerated as costs excluding food rose the most in at least six years, and U.K. consumer prices rose the most in more than two years. Billionaire investor George Soros increased his SPDR Gold Trust holdings by 0.5 percent in the fourth quarter, and John Paulson kept his investment unchanged.

With inflation concerns heating up and the metals underpinned by a mix of physical and investment demand, it looks as if further gains are in the pipeline, James Moore, an analyst at TheBullionDesk.com in London, said in a report.

(...)

Surging food prices have spurred protests in North Africa and the Middle East, while Brent crude oil, a global benchmark, closed yesterday at the highest since September 2008.

(Financial Times) -- China and Russia sell US Treasuries
China has sold billions of dollars in US Treasury bills for the second month in a row, even as strong buying from other foreign investors countered Beijing's move to reduce its holdings.

A Treasury report on Tuesday showed net foreign demand for long-term US securities, including bonds and equities, was $41.8bn in December, versus $64.5bn in November. Monthly net Treasury International Capital flows rose to $48.2bn in December, up from $35.6bn in November and $17.2bn in October. The rise was driven by private investors, while official accounts, or foreign central banks, sold US assets for the second successive month.

Foreign private investor demand for US long-dated government debt remained solid in December and US Treasuries with maturities of more than a year recorded inflows of $55bn. But, short-term bills suffered a $37bn fall, after November's $32bn drop.

(...)

(Financial Times) -- China pull-back paints unsettling rate picture
It is no secret that China's appetite for Treasuries has been waning. Official figures now bear out Beijing's stated desire to diversify away from US government debt.

The market impact is likely to be muted for now, given the Federal Reserve's bond-buying under its quantitative easing programme. But what happens when QE2 ends in June? Beijing's pull-back may then become noticeable.

The US Treasury market occupies the centre of the global financial system. It is the deepest and most liquid bond market in the world, and demand from central banks and institutional investors, including private sector banks and hedge funds, has allowed the American government to finance its multibillion-dollar budget deficits.

Indeed, the US is more dependent than other countries on foreign investors buying its debt. The UK, Italy and Japan are largely funded by domestic investors. So far, robust demand for Treasuries from the UK and, to a lesser extent, Japan and US domestic investors has helped offset China's waning appetite over the past year. The Fed effect has been supportive, too. The US central bank has become the largest single holder of Treasuries, with $1,160bn, as it continues buying securities.

(...)

(Financial Times) -- Bank lays ground for interest rate rises
The Bank of England said monetary policy would need to be tightened to bring medium-term inflation back on track, confirming market expectations that interest rates would start rising in May.

In a letter to the chancellor George Osborne that was triggered by a 4 per cent increase in consumer prices last month on the back of surging food and petrol costs, Mervyn King said inflation was likely to return to the Bank's official 2 per cent target on the assumption that [the] Bank rate increases in line with market expectations.

Mr King's comments confirmed investor expectations of a series of quarter-point hikes in interest rates, beginning in May. Mortgage lenders have already withdrawn or repriced fixed rate deals in the expectation of higher interest rates.

(...)

In response, Mr Balls said the government's value added tax increase had made it harder for the Bank to set interest rates. The problem is that if you've got too fast spending cuts and a VAT rise but inflation is going up too, it really is putting the Bank in a very difficult position, he said.

(Bloomberg) -- Greek, Irish Banks Force ECB to Print More Money: Euro Credit
The European Central Bank is being forced to print money to bolster banks in bailed-out Greece and Ireland, leaving the region's taxpayers on the hook as the final guarantors of those nations' debts.

Greek and Irish banks have issued at least 70 billion euros ($95 billion) of bonds to create the collateral required to get cash from the ECB, according to the International Monetary Fund and regulatory filings, a figure that may rise to 100 billion euros after Greece said Feb. 11 it may extend another 30 billion euros of guarantees to its banks.

What you have here is micro-quantitative easing, or money printing, said Cathal O'Leary, head of fixed-income sales at NCB Stockbrokers in Dublin. The banks are issuing unsecured loans to themselves.

The ECB has vowed to eschew the type of monetary policy implemented by the Federal Reserve, whose bond-buying to boost growth has left it owning more Treasuries than are held by China, the biggest foreign buyer of U.S. debt. By granting loans against bank debt, the ECB is adding to the monetary base and would be out of pocket were the guarantors to renege.

The yield premium investors demand to hold Irish 10-year bonds rather than German securities is 593 basis points, up from 153 basis points a year ago. The spread between Greek and German 10-year bonds is 852 basis points, up from 305 basis points a year ago.

'Stressed Market Conditions'
Ireland's banks have issued at least 17.4 billion euros of notes backed by government guarantees, with 9.2 billion euros going to Bank of Ireland alone. The program amounts to 11 percent of Ireland's 2009 gross domestic product.

Access to ECB operations allows the banks in question to obtain funding that is not currently available in the continued stressed market conditions, the Irish central bank said in an e-mailed response to questions.

Greece's current state-guaranteed liquidity program is 55 billion euros, according to the IMF country report, equivalent to more than 20 percent of the nation's $330 billion output in 2009. That's on top of the 8 billion euros of zero-coupon bonds Greece has lent to the banks and 15 billion euros of direct capital injections, according to John Raymond, an analyst at CreditSights Inc. in London.

'Huge Credit Exposures'
To a very significant extent, the ECB is taking the place of capital markets, said Alan Dukes, the former Irish finance minister who is now chairman of Anglo Irish Bank Corp., which posted Ireland's biggest-ever loss in 2010. The ECB is no longer in a position to pursue a clear monetary policy because it is running huge credit exposures, he said in a speech last week.

(...)

'Difficult to Distinguish'
Monetary growth in the euro area, as measured by M3 money supply which the ECB uses as a gauge for future inflation, turned positive in June and reached a 15-month high of 2.1 percent in November.

The ECB is calling on governments to step up efforts to restore confidence, to allow sovereigns and their banks to regain access to the capital markets.

It's difficult to distinguish banking and sovereign risk, said Nicolas Veron, senior fellow at Bruegel, the Brussels-based economics research group. What happens if there's a default? Everyone would like to avoid testing that out in real life. Governments are really scared of the consequences of an actual restructuring.