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Why Cyprus May Save the Gold Market

By Doug Ehrman - Apr 3, 2013 at 10:17AM

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The tiny island economy has the potential to have a sweeping impact on global matters.

While it may be too soon to fully gauge the lasting effects of the Cyprus crisis and subsequent bailout, one certainty is that the EU will forever handle these situations differently. The critical change that was a part of the Cyprus package, and that you should expect to see in any scenario that occurs in the future, is that large depositors will shoulder a portion of the loss as the failing banks receive supportive funds from abroad. The measure is designed to encourage increased financial responsibility on the part of countries with weakening banking systems, but an ancillary effect is to undermine the faith large depositors may have in EU banks across the board.

In the simplest terms, depositors with more than 100,000 euros in the affected banks will lose 10% of their deposits to help facilitate the bailout. To put the importance of the Cyprus economy in perspective, it accounts for 0.5% of the EU economy, and yet the ramifications of this decision may be severe. With significantly decreased comfort as to the safety of deposits, investors will be likely to – at least to an extent – flee to safety. When a flight to safety on a global scale occurs, the most obvious place for capital to flow is into gold.

So why is gold falling?
You might be wondering why gold continues to fall if the Cyprus situation is so negative for the global economy and so bullish for gold. There are several reasonable explanations that should be considered. First, given the tiny relative size of Cyprus, the risk of immediate contagion is limited. The real impact will be felt when the next country in the EU gets hit.

On Tuesday, contrarian investor Marc Faber told CNBC that he sees similar situations to the one in Cyprus occurring all over the world: "You have more people that vote for a living than work for a living. I think you have to be prepared to lose 20 to 30 percent. I think you're lucky if you don't lose your life." Leaving aside some of the obvious rhetoric, Faber's point is that these situations result in a massive wealth transfer from the rich to the government. When this type of redistribution happens, it has a lasting impact. As investors prepare to weather this storm, or at least protect against it, gold looks increasingly attractive.

Is it too soon to leap?
While the Cyprus bailout – which has been clearly explained as a model for future occurrences – poses significant risk to the global economy, shorter-term concerns are driving the market. A strengthening dollar is one of the primary culprits for the weakness being seen in the gold market. The SPDR Gold Trust (GLD -0.60%) is down roughly 6.5% on a year-to-date basis, while miners are down even more. Newmont Mining (NEM 0.75%) is down about 15% this year, but has several positive factors working for it. A strong growth profile is helping the stock to address the rising production costs facing the entire market. Kinross (KGC -0.87%), for example, faces the same pressure but pays half the dividend yield at 2%, relative to 4.1% for Newmont.

The immediate downward pressure on gold is too severe to warrant jumping in quite yet, but beware of the next EU economy to face problems. Additionally, as more investors and non-EU institutions get a handle on their EU exposure, gold has the potential to gain support. This is not the only factor driving gold, but it is one not to overlook.

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