Game Time: the European Elections

May 23 2014

Yesterday, both the Netherlands and Great Britain kicked off for the European elections. In the UK the anti-EU United Kingdom Independence Party (UKIP) made huge gains, acquiring between 25 and 30 percent of the votes (about 19 seats). In contrast, the Dutch election results were very fragmented, with the anti-euro PVV obtaining an estimated three seats, while the pro-EU D66 party came out on t

Game Time: the European Elections

Yesterday, both the Netherlands and Great Britain kicked off for the European elections. In the UK the anti-EU United Kingdom Independence Party (UKIP) made huge gains, acquiring between 25 and 30 percent of the votes (about 19 seats).

In contrast, the Dutch election results were very fragmented, with the anti-euro PVV obtaining an estimated three seats, while the pro-EU D66 party came out on top as the biggest party with just five seats. The remaining seats were divided between the other parties, which gained about three seats as well. Voter turnout was rather disappointing though: only one third of eligible voters actually voted.

Italian and Greek Elections Could Surprise

Greece's Alexis Tsipras and Italy’s Beppe Grillo — both opposed to the euro — might surprise on the upside in the upcoming elections. The popularity of these anti-euro politicians (who come in a wide variety) will undoubtedly have their effect on investors in the euro zone besides being a cause of worry for European policy makers. Any outcome that is better than expected for their anti-euro parties will have repercussions on the euro project and investor confidence.

The unsurprising gains of the British UKIP of Nigel Farage might inspire Greek and Italian voters to vote for euro-sceptic candidates as well. The popularity of Italian Prime Minister Matteo Renzi, who took office only recently, seems quite strong, but anti-euro sentiment is growing in Italy and a victory for Beppe Grillo might turn out to be the biggest surprise of this European election. It will mean a major setback for the Italian government and a possible trigger for euro turbulence.

Italians Have a Trick Up their Sleeves

The Italian finance deficit has structurally been above 3% since the inception of the euro. Italy has, since the euro, not once achieved a budget surplus. In the Maastricht Treaty, governments agreed to keep their budget deficits at all times within 3% when participating in the single European currency. Yet the Italians are not very pleased with this cap on government spending: it imposes fiscal discipline on reckless Italian politicians.

Yet the Italians have found a way to work around this problem. They will include as of 2014 illegal goods and services such as drugs, prostitution and smuggling to their GDP. As a result, their debt as % of GDP decreases in a flash, and the budget deficit as a % of GDP (to which the Italian government agreed) declines. Of course, nothing fundamentally changes. The Italian government is not cutting spending or raising taxes: they’re simply using an accounting trick to lower their debt ratios.

Of course, the inclusion of drugs and prostitution actually defies the purpose of a GDP measurement. GDP is measured through a questionnaire, and questionnaires cannot be send to producers that cannot be traced by the authorities. It leaves room for any estimate that is convenient to the Italian government. Italian authorities can justify any GDP figure. They measure the immeasurable, and that leaves plenty of slack to make up numbers along the way. It’s easy to figure out how Renzi aims to achieve the European 3% budget requirement.

European Bond Yields Creeping Up

After consistent declines in the 10 year yields of Spanish, Italian and other European public debt, it now seems a turning point has been reached. Italian yields are creeping up and are at 3.24%, after reaching an all-time low of 2.9% recently. Spanish bonds have acted in a similar fashion, with a low of 2.8% before moving up to 3.1%.

It seems investors are nervous about the anti-euro sentiment, especially in Italy. This nervosity might mean good news for gold, especially when the anti-euro parties in Italy and Greece garner support.

After the Elections: Monetary Easing by the ECB

As I’ve written before, my expectation was that the ECB would wait with easing until after the European elections. Further easing would be, especially in Germany, received with adversity. A policy change by the ECB earlier, could have possibly influenced the elections. In face of the European elections, the ECB didn’t want to attract any negative attention.

Yet the market already caught up and a majority of investors now expect further easing and lower interest rates at the next ECB meeting. I still expect a lower benchmark rate, although negative interest rates charged by the ECB on deposits held at the central bank was also widely discussed. My best guess is that Draghi will want to delay or avoid such unconventional measures. However, a looser policy by the ECB is, just as increasing bond yields, more good news for gold.

Nevertheless, further easing might just as well mean lower bond yields on European debt, offsetting any positive impact on the gold price of increasing interest rates. Voters sentiment, however, is very clear. Anti-euro movements are gaining momentum and, perhaps, we’ll see some unexpected surprises during the elections in countries such as Greece and Italy which upsets the euro zone and shakes investor confidence.

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