Gold tanks as ECB disappoints

By Alix Steel

Updated at 5:21 p.m. ET

Gold prices tumbled as the European Central Bank cut interest rates to 1% and pumped more money into European banks but failed to ramp up bond buying.

Gold (-GC) for February delivery was sinking $31.40 at $1,713.40 an ounce at the Comex division of the New York Mercantile Exchange. Gold has traded as high as $1,760.50 and as low as $1,707.80 an ounce, while the spot price was down $34, according to Kitco's gold index.

Silver (-SI) finished down $1.08 at $31.53 an ounce while the U.S. dollar index was rising 0.5% at $78.81.

Gold has had a wild and crazy trading session. The metal was moving higher as the ECB lowered interest rates by 25 basis points to 1%, the previous low achieved after the Lehman Brothers crisis. President Mario Draghi said the eurozone economy faces "downside risk" and "substantial uncertainty."

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The ECB also announced longer-term financing operations of 36 months, which means banks can borrow more money for a longer period of time at a fixed rate. Collateral requirements were expanded as well. The move, in essence, underscored the fact that the ECB is the lender of last resort for banks, not just governments. The Bank of England left interest rates unchanged at 0.5%, and maintained its quantitative easing program at 275 billion pounds.

After early gains, however, gold quickly reversed directions after Draghi said that sovereign bond purchases would be limited and that he was surprised that the market thought the ECB would act more aggressively if certain fiscal union conditions were met by the eurozone. The euro tanked on the news, boosting the dollar and dragging down gold.

A rate cut in and of itself is confusing to gold. Typically low rates are good for the hard asset as the cut devalues the paper currency, but the euro and gold have been moving together of late in opposition to the U.S. dollar. If the rate cut is seen as helping the eurozone, gold could rise with the euro, but if it is seen as devaluing the currency, both assets could head lower. This tug-of-war could keep gold trapped in its trading range.

Another confusing factor for gold was the news that the ECB lent almost $51 billion to European banks for 84 days by swapping euros for dollars with the Federal Reserve. This was part of the massive central bank intervention launched last Wednesday. Accessing the swap lines means that the Fed's balance sheet has expanded and is de facto easing its policy, according to UBS. "This represents a touch more than 8% of the balance sheet expansion seen during the Fed's second quantitative easing program."

James Steel, analyst at HSBC Securities, says "to the degree that heavy U.S. dollar funding is evidence of U.S. dollar shortages in the European banking system and a sign of stress, the demand is gold-bullish." On the flip side, Steel points out that if gold is lent in exchange for U.S. dollars, in face of this liquidity crunch, then it increases the short-term supply of gold in the market, which is a bearish indicator.

The spotlight now turns to Europe's two-day summit, which begins today, with investors hoping to see a big bazooka plan -- whether that is some form of fiscal union, a leveraged bailout fund or more intervention from the International Monetary Fund.

"Fingers crossed they will sort it out," says Mark O'Byrne, executive director at GoldCore, a bullion dealer, adding, "if they don't sort it out then that would create massive volatility in the markets again and I think gold could react quite positively, particularly in euro terms."

If there is some kind of success declared in Europe on Friday, O'Byrne says it might result in gold prices falling in the short term, but he adds that longer term any action won't solve the debt crisis. "I think (that will mean) kicking the can down the road because the fundamental issues won't be solved." O'Byrne thinks gold could rise another 20% in 2012, which would push gold to more than $2,000 an ounce.

The SPDR Gold Shares (GLD) shed just over 2 tons of gold Wednesday. Over the past 10 years gold on average has rallied 1.8% in December; so far prices are down 0.6% this month.

"What you typically tend to see at the end of the year is people balancing portfolios largely for tax reasons," says Will Rhind, head of U.S. operations for ETF Securities. "The last two months of 2010 were actually our second and third strongest months for inflows in the U.S. exchange traded funds . . . so we could see some money moving around from now until year end."

O'Byrne echoes this sentiment. "Last year there was a small increase in the price of gold in November and a small increase in December and then there was quite a sharp fall in January . . . I think it's possible we may see the same thing again." Gold tanked 5.5% in January of this year but since then has rallied 31% and is up 23% for the year while the S&P 500 ($INX) is flat.

This leaves hedge funds and traders either selling gold to book profits for the year or buying gold to show clients that they own an asset whose performance is beating the S&P.

Gold mining stocks tanked Thursday along with broader equities. Barrick Gold (ABX) closed down 3.1% at $49.59, while Newmont Mining (NEM) fell 2.4% to $66.06. Goldcorp (GG) dropped 3% to $50.40, and NovaGold (NG) shed 2.8% to finish at $10.55.