Gold Prices Tank as ECB Disappoints

NEW YORK (TheStreet ) -- Gold prices fell sharply on Thursday 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 for February delivery sunk $31.40 to close at $1,713.40 an ounce at the Comex division of the New York Mercantile Exchange. The gold price 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 prices lost $1.08 to close at $31.53 an ounce while the U.S. dollar index was rising 0.50% at $78.81.

It was a wild and crazy trading session. Gold was moving higher in early trades after the ECB lowered interest rates by 25 basis points to 1%, the previous low dating back to the Lehman Brothers crisis. President Mario Draghi said the eurozone economy faces "downside risk" and "substantial uncertainty."

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 kept its quantitative easing program at 275 billion pounds.

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But gold quickly reversed direction 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, which dragged on 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 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.

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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 the move is a de facto easing of 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 began Thursday with investors hoping to see a big bazooka plan whether that is 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, "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 the debt crisis will remain far from settled. "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 push gold to more than $2,000 an ounce.