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   Posted by: Mr. Gold   in Uncategorized

It is hard to fathom the rationale behind Barrick’s juicy premium for EQN. It was only 18 months ago that Barrick, with much fanfare, “left Africa”, leaving behind a limping offshoot (African Barrick), unloved by the London market, deprived of any growth story, plagued with 70% overhang on the stock, hemorrhaging talent and serving few fund managers except those seeking a proxy for “Tanzania risk”.

So now, Barrick is back on the black continent and in search of copper (well, much is being said about copper, but there is uranium there too). Barrick’s Zaldivar and Cerro Casale projects provide a significant copper element to the stable, even though the impact is less visible than in the case of, say, Newcrest or even Newmont. But Lumwana? Granted, EQN will increase production from its flagship operation by about 100kt of copper between now and 2014, but the new owner will have to throw in $0.5bn in capex over and above the $7bn plus in cash splurged on the Australian/Canadian listed producer. Barrick also gets access to the dubious charms of Jabal Sayid – a 60ktpa early stage development project in Saudi Arabia. One wonders if Barrick’s portfolio risk is not getting a little too exposed to a region plagued by uncertainty and (at least perceptions of) instability. The company is already involved in Reko Diq project in Pakistan – sharing the burden with the most unlikely of guests, Chile’s Antofagasta.

True, EQN will spit out $1.3bn in Ebitda as early as 2013, assuming the nominal copper prices around $4/lb. Should the USD continue on its trajectory post FOMC meeting in June, this looks like a great USD hedge, but the real value of the red metal may not shine so brightly for anyone whose wealth is denominated in stronger currencies than the USD.

This rationale is probably the only common thread between the gold and copper markets. The red metal is driven by a completely different set of drivers, some of which are of discretionary, administrative nature. One could even argue that after years of guesswork on central banks’ intentions regarding gold reserves, it is now copper that suffers from increased opacity. Any attempts to penetrate the great wall of secrecy regarding copper hoarding at China’s State Reserve Bureau are bound to be frustrated. And even the estimates of unregistered stocks in bonded warehouses range from 0.5mt to over a million tonnes – a significant range in a 19mtpa market. Barrick’s move represents therefore a leap of faith, as no meaningful due diligence can be made regarding the distant future of the copper market, beside the well worn (and still valid) argument of China’s copper deficiency. But industrial metal demand growth rates could be past their peak and it is illustrative that no base metal producer tried to dislodge Minmetals’ original bid.

Andrew Michelmore – Minmetals’ CEO had seen worse times at OZ Minerals and it is difficult to disagree that walking away was the most rational of options. But from a broader perspective, this adventure amounts to yet another failure of a Chinese-funded entity to secure a stake in a Western-operated mining venture. In certain quarters of Chinese metal value chain, belligerent calls intensify. China’s steel association’s vociferous attacks on Western governments’ (!) monopoly in iron ore production is an unfortunate example of just how political the quest for “equity” participation in offshore commodity production has become. Chinese entities are still light years behind the hugely successful, long-term metal bets Mitsubishi and other Japanese shosha companies engineered in Australia and South America four decades ago.

This leaves us with the Barrick’s murky rationale (the sale could not possible premeditated on doing in the hapless African Barrick, there are cheaper ways to do this). The company’s speedy due diligence may reflect as much its nimble approach to growth as an unwelcome rashness. Or maybe Peter Tomsett – EQN’s chairman had ulterior motives? Here’s the guy to six years ago successfully brought Placer Dome’s history to its end. When Barrick made the initial approach, Tomsett remained open to an alternative bid. Newmont and AngloGold Ashanti embarked on an in-depth due diligence of PDG’s assets, until AngloGold’s visit to Porgera went badly wrong. Barrick digested Placer Dome awright and has thrived since.

Smell a revenge?

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   Posted by: Mr. Gold   in Uncategorized

Only verdant gold market observers would claim that high level of headline inflation is correlated with higher gold prices. When food and energy prices rise in response to supply constraints, consumers’ disposable income is initially reduced. Until the price pressure seeps into core inflation, household’s ratio of consumption and investment to savings is more likely to slow down than increase. The PPI/CPI ratio, if accurately measured, provides some solace as a guide to show how quickly the demand conditions allow producers to pass on higher input prices. Until then, deceleration in the rate of growth of gold demand (as well as demand for other products with significant retail component) should be expected.

But there is no denying that gold remains the most sensitive of assets in the rush to offset the expected reflationary cycle. One of the unfalsifiable correlations is between nominal gold prices and the growth of money supply as measured by M2. In the US, M2 is “held” by individuals in terms of cash, deposits and in the money market. Although over the long term, gold’s trajectory correlates strongly with M2 trend line, in certain periods, gold tends to outperform it.

For example, the aggregate has doubled over the last decade, from $4.5 trillion in 2000 to some $9.0 trillion currently. Over this period, gold’s nominal price in US dollars has more than quintupled. On the other hand, in 1971-72, when the gold market became untethered, M2 crept by 13% per annum, but gold jumped 46%. In the following two years, while the money supply fell to single digits, gold’s gains continued, at nearly 70% annually.

Much of the acceleration in M2 growth in the US during the market dislocations of 2008-2009 was bound to offset the spectacular collapse in shadow money aggregates (estimated by CS as outstanding securities market less repo haircut in percentage terms). Even though the rationale for these offsets has now abated, another source of money supply growth has come from the side of an economy which back in the 1970s had hardly anything to offer bar little red books.

Whatever our view on the real economic growth in the People’s Republic, it is difficult not to be awed by the growth in money supply in the recent years. China’s M2, which covers cash in circulation and all deposits, grew at 17% last year. The accumulated stock was worth 73.61 trillion RMB or $11.24 trillion. This is a quarter more than the M2 of the US economy, which continues to be 3 times larger than China’s. To the extent that Chinese currency remains pegged to the US dollar and that some of its monetary supply leaks to the global market, this rapid rise in M2 matters for the rest of us, and it matters for gold too.

The question remains how big the cross-border flows are? Chinese state, in the guise of “improving people’s lives” has been pretty efficient in controlling the capital account outflows (as opposed to inflows – which amplify upward pressure on the Renminbi). With $500bn worth of trade, $60bn in overseas FDI, $110bn of overseas loans provided by EXIM Bank and China Development Bank, whatever foreign investments made by SAFE and CIC, and of course the massive purchase of US, European and Japanese Treasuries, China’s wealth does leak massively through the Great Renminbi Wall over and above the gamblers’ collateralized punts in Macao. By comparison, the Hong Kong/China gold imports’ contribution to offset the trade surpluses is tiny, but the statistics here are unreliable, given the secretive nature of the flows in what remains the world’s largest gold mining country.

And so, any deceleration in the growth of money supply in China will have an impact on monetary conditions globally. There are reasons to believe that M2 growth, which clicks at double the GDP growth in China will, indeed, slow down. First, the aggregate is already showing signs of cooling – it rose 15.7% year on year (February data), still impressive, but much slower than a year ago. Secondly, Chinese trade surplus has fallen by over 35% in the last two years, largely due to higher (and sustained) commodity prices. Over time, this could mean buying less dollars to buy from exporters. Third, the narrower M1 – advocated by some in China as a policy target – is decelerating even faster than M2.

In the meantime, tightening credit conditions in China are beginning to affect not only mortgage discounts and flows to local UDICs, but have also laid bare the stockpiling of certain commodities as collateral for loans. With PPI growth outpacing (the statistically re-jigged) CPI, there is now a danger that the lack of meaningful monetary, tax and credit reforms may force the stewards of this supply-driven economy to focus on value chain control. Failure in this endeavor may force some Chinese wealth to leak overseas in search of better, inflation-adjusted returns. However, it is unlikely that this process will offset the mighty impact of official outflows, which have so far helped us keep low long-term interest rates and thus facilitated the monetization of public debt in the West. Much of the continued gold story depends on how long this trend can be sustained.

(due to heavy, intercontinental travel schedule, the posts will appear with less regularity, until further notice)

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   Posted by: Mr. Gold   in Uncategorized

One of the common misconceptions about gold prices is that they correlated tightly with CPI numbers. Any such trade is doomed to fail, as much as an equally mono-dimensional bet on long term yields on the back of a central bank’s interest rate decision. Both relations fail to factor in the market anticipation ex ante, the way these expectations have already been priced in (“is the interest rate decision chasing runaway price pressure” vs “is the interest rate hike offsetting future price pressures”) and the time lag. In fact, over years, gold prices have exhibited a much tighter (inverse) correlation to M2 growth – which takes into account both visible and shadow money creation (growth of money creation through expanding collateral acceptance). Gold is telling us much more about a broad-based purchasing AND investing power of specific currencies, rather than some adjustable, narrow consumption index with all its comparative intricacies between “core” and “headline”.

In this light, the price action since the beginning of the year has been particularly demonstrative. While the spread between regular treasuries and inflation-protected bonds in most countries points to increasing inflation expectations, gold has relinquished some of the last year’s gains. Those gains had come in two large waves. First around the Greek crisis in May – in anticipation of a near term monetary response offsetting the longer term grind of disinflationary austerity measures. The second wave was triggered by Bernanke’s speech in August and subsequent QE2 anticipation from September onwards. As we noted last week, the price impact of this event on the economically inert gold has been less pronounced than the appreciation in many other commodities, including base metals and agros.

Yet last year’s flight to quality was also characterized by a consistent rush into the perceived safety of ever-lower yielding sovereigns, most notably the Bund. The actual advent of QE coincided with the peak of that Bund rush. Yields have now mostly rebounded from their cyclical lows. And gold has recently been affected by ETF redemptions. A more granular analysis across various currencies is necessary to understand to what extent the leading indicator of inflationary pressures has now largely fulfilled its role.

We do this by comparing the differential in yield increase between regular Treasuries and inflation-protected bonds among the 10 economies which offer such products. Not surprisingly, we find that among the developed economies it is the UK which has registered the highest jump in yield spread between gilts and inflation protected securities (21bp, as of last Tuesday). The Eurozone bond markets are far from uniform (Germany 19bp, Italy 13bp and France 11bp). Australia has seen a 13bp increase in yield spread, US 5bp and Canada only 2bp.

It appears that much of these trends are mirrored by the way in which the FX market treats the respective gold (or losses) for investors whose wealth is denominated in the main currencies. In fact, as of last Tuesday, gold in UK pounds has lost most since the beginning of the year (-7.21%), followed by losses in Euro (-5.65%), US dollar (-3.60%), Australian dollar (-3.32%) and Canadian dollar (-3.43%). In other words, the “dollar” currencies have been the weakest performers vis-à-vis gold. It also appears that these economies’ increase in real yields happens to mirror real economic activity, rather than increased inflationary pressures.

Some scoff at GBP’s renewed strength – possibly predicated on the expectation of further increase rate hikes in future. Others point to China’s relentless upward (buying) pressure on deeper bond markets outside the dollar zone. The fact of the matter remains that the FX market is beginning to do the job of the gold investor both in the UK and in the Eurozone, bidding up the currencies whose monetary authorities may be forced to adopt a more hawkish position. The reduced risk aversion may even further accelerate the yield rebound in Germany.

But there is one outlier – where inflationary pressures do not cause the market to bid up the currency. The Australian dollar – eternally affected by the Japanese money flows – is currently suffering from China’s own growth trajectory jitters. Aussie’s relative weakness ensured that gold price losses down under have been limited since the beginning of the year, despite the fact that the 8bp rise in 10 year (inflation-protected) yields has been outpaced by the 21bp jump in regular treasuries. This positions the Aussie somewhere around the equally inflation-prone Italy, which however is being protected from stronger price pressures (and imported inflation) by a robust Euro. Should the emerging market (and China bearishness) prevail in the near future, and RBA continue with its counter-cyclical interest rate policy enshrined since the days of Governor Macfarlane, then Australian commodity producers could soon reap big benefits in terms of weaker (nominal) currency and concomitant margin expansion. Sooner or later, the gap between the nominal and real value of the currency will close – but in the near term, the Aussies may be in a sweet spot.

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   Posted by: Mr. Gold   in Uncategorized

The turmoil in Egypt and its open-ended character have obviously not stemmed the market’s relentless slide towards ebullience. While some oil trading may betray anxiety over the unrest spreading to crude producing nations, OPEC’s spare capacity will most likely put a damper on any signs of panic. But it’s the broader commodity complex that is showing signs of exuberance. With copper at all time highs, unprecedented pre-planting tightness in cotton market and an ominous cyclone threatening to level Queensland’s sugar cane long before Brazil’s crushing season, it is understandable that gold has been on a back burner of late.

In fact, a more careful analysis of the commodities’ relative performance reveals that the seeds of the yellow metal’s poor showing were planted in the summer of 2010. Since August, silver, corn, wheat, cotton, coffee and later soybeans have all registered significant gains over gold. It is easy to intuit from the charts that what slowed down this process prior to the QE2 announcement was the Greek shock last May. This picture emerges from gold’s underperformance in comparison to industrial metals, the less successful of which (lead, zinc and aluminum) are now closing the spread which gold opened last May. Meanwhile, other metals are towering above the precious metal for reasons ranging from structural supply constraints (tin) to fund bullishness (nickel).

From the macro-economic perspective, we are heading back to the 2006-2008 setting. During this period, most commodities registered record spreads over gold. Copper, aluminum, zinc and sugar triumphed in 2006, followed by lead, nickel and cocoa in 2007, while platinum, tin, the grains (corn, soybeans, wheat) and the energy complex (oil and coal) in 2008. Palladium is an outlier, still anchored on the squeeze peak in 2001.

The financial crisis reversed this trend in 2009 and 2010. Gold’s spread over other commodities peaked first over its sister precious metals (platinum and silver) towards the end of 2008, followed by industrial metals in 2009 and agricultural commodities around summer 2010. Each of these peaks represented the highest relative gains that gold has registered over competing commodities since the beginning of the century. However, the pendulum never swung into gold favor with the vehemence recorded by some of the product specific bubbles observed previously – zinc in 2006, nickel in 2007, wheat and coal in 2008. The fall from these peaks was a lot more painful than whatever slow burn that gold was subject to on a pullback.

It appears that gold’s low volatility and its inert character as an economic input positions it just as well to detect currency debasement as it does to illustrate market overconfidence with respect to specific commodities. Most analysts watch spreads such as oil to gold, copper to gold, silver to gold or platinum to gold. But the broader set of comparisons reveals some intriguing trends, given that gold is uniquely non-mean reverting (I leave eternal arguments about silver aside). As gold lacks the ɳ to measure the return to trend, it serves as a useful benchmark to measure wealth, with many other commodities mean-reverting to gold’s value along the leverage cycles.

How is this lesson relevant now? In some metal/gold ratios there is currently no spread at all – it is therefore difficult to bet on direction. Chances are that further PMI improvements could push aluminum and oil above gold in the near term. But other commodities are beginning to show signs of unprecedented exuberance. Ratio of silver to gold hit a multi-decade high at the beginning of this year, but has ebbed since. Currently it is coffee and cotton whose ratios are at multi-year highs over gold. The cotton boom has been many years in the making and shortage eventually developed in May 2010. It is true that wet weather hampered harvesting in China and that higher oil prices are making substitutes (such as polyester) pricey. Yet both Australia and Brazil have now both expanded acreage devoted to cotton and by the second quarter of this year the speculative phase of this boom may be over. Coffee is another interesting example. Although we are in Brazil’s “off-year”, the country’s crop is expected to be strong. It will not, however, entirely offset the losses in the northern Andes where unusually heavy rains left the crops afflicted by fungus.

But coffee showcases another interesting feature. In fact, its two-year Rsq to gold is the highest among commodities after precious metals (higher even than copper) and so is coffee-to-gold beta. Do people sip coffee while handling gold jewelry? With the exception of the Greek episode, the overall correlation between the two commodities has been surprisingly high throughout 2010. Since more tightness reappeared in copper’s front contracts, coffee now also constitutes the only major commodity with a front contango and deep backwardation afterwards. And now the aromatic drink is registering a record spread over gold. Would it mean that the spread will begin to tighten again in gold’s favor?

But the one commodity to watch is sugar. We are still far away from sweety’s record high over gold in 2006 (which was unimpressive by agro standards). Sugar has had a good run since last summer and has closed on gold’s spread. If, therefore, we use gold as a litmus test, then sugar is not yet overheated. For the next two months, the market is almost entirely dependent on Indian exports. And let us not forget that last month the demonstrators in Algeria protested against sugar prices. There could be more to come. The sweet taste of democracy?

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   Posted by: Mr. Gold   in Uncategorized

What a mournful January it has been for gold bugs. The misery of this seasonally slow period has been compounded by the crass underperformance of XAUEUR. Gold in Euro terms has lost 11.36%. While the robust Euro, bolstered by hawkish ECB comments and record interest in bailout EFSF bonds registered record gains over high growth proxies (such as AUD), gold, which usually benefits from strong EURUSD performance, has languished, elbowed away from the pedestal by the ever more radical ETF redemptions.

Much of the real (as opposed to nominal) gold losses can be attributed to the newfound optimism concerning the interest rate trajectory and a possible reduction in liquidity injections in the West. But while the transatlantic hawk/dove rhetorical discrepancy has reached 1987 levels (by itself hardly a bullish signal for the raging stock markets), few gold market observers have paid attention to the travails of PBOC in Beijing. There, the regulator, frustrated by the ineffectiveness of lending quotas, slapped an initially yawn-inducing seventh increase in reserve requirement ratio.

This poorly timed, pre-holiday tightening has created liquidity havoc at a time where most Chinese withdraw cash in order to purchase gifts for the family and train tickets to head home for a week of bonding and home food feasting. Remarkably, after repo rates rocketed, the central bank had to conduct reverse repos and briefly disengage from open market bill selling. Instead of addressing the underlying problems of inflation, the actions rocked the money market. But why did PBOC act in such an untimely fashion?

The answer lies in the system’s deepening inability to deal with structural inflation. With minimum wage increases rising more than 20% in the main cities, China’s low marginal costs and its output gap are now unlikely to protect the country against price pressures. Nowhere is it more evident than in the food sector, where spare capacity has been the slimmest to start with. For several months now the system has exhibited two basic characteristics of overheating: rising overconfidence and booming credit.

China is experiencing a massive discrepancy between asset appreciation and hitherto suppressed inflation of goods and services and the resolution of this tension can only occur in a binary fashion. Either asset (including home prices) deflate or goods and services increase in price. Which path will China choose and what it will mean for gold?

In the US, where the focus of the monetary authorities is exclusively on core inflation, it was the asset price deflation that closed this gap, with huge costs. Although most banks survived, the country is now saddled with a broken housing market, structural unemployment and severe political polarization. In China – asset deflation would mean a significant loss of wealth for realtors and other clients of the communist party officialdom. High inflation could potentially mean social unrest.

Beijing will only act when all other options to kick the can down the road have been exhausted. In a normal world they should pick the former (i.e. asset deflation) and then offset a resulting NPL crisis by injecting capital (including from overseas – similar to the floating of Ag Bank last year). But the authorities have been vacillating to act on interest rates because too much personal wealth of decision makers has been tied up in property and because with higher interest rates the sterilization costs would make their foreign reserve management very costly. So instead, Beijing is resorting to raft of new ‘anti-inflationary’ measures: generous statistical inventiveness, soviet style price controls, ban on usage of corn for ethanol (in case feedstock prices affect negatively pork supply) and periodic release of commodities from “strategic” inventories. All this is being combined with an even stronger grip on dissent (the government spends $78bn on ‘weiwen’ stability maintenance, which is smaller only than the official military budget of $81bn). An almost perfect control of electronic media thus precludes a Tunisian-style scenario.

A serious asset price deflation would deliver a shock which would be deeply commodity-unfriendly. Although industrial metals and steel would suffer most, gold would not be spared in the sell-off. A clean-up would offer another gold buying opportunity as the impact of the burst bubble would most likely slow down the interest rate cycle in the developed economies dealing most of which have to grapple with their own refinancing woes in 2012-2014.

But contrary to a widely held opinion, possibly based on an optimistic reading of Engel’s Law, a rising inflation of goods and services does not bode well for gold, and particularly so in the emerging countries. Should inflation really accelerate, the economies particularly sensitive to food prices (like China) or energy prices (like India) may not yet be wealthy enough to offset cost increases if they advance faster than the growth in disposable incomes. Gold’s performance has benefited hugely from M2 explosion in the developed economies and more recently in China. An onset of liquidity revenge may not be its best friend.

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   Posted by: Mr. Gold   in Uncategorized

On a day when Freeport announces its quarterly results, it is probably a good opportunity to reflect on the question I have recently received from a successful option trader in the city. It came with an anaphora (“gold is a bubble and copper has real demand”), and so “isn’t it time to short gold and go long copper”. Indeed, this week again, copper hit an all-time high in dollar terms, leaving gold behind with its most recent record notched several weeks ago now.

Freeport’s numbers later today may serve as a good starting point to discuss this issue. After all, we know from the company’s guidance that as copper volumes would have fallen in 4Q, while its gold production would now return to annualized 1.5moz. In other words, Grasberg remains, by far, the largest gold mine in the world and nothing on the horizon appears to challenge the Indonesian producer’s leadership (the biggest upcoming kid on the gold block is Barrick/Goldcorp’s Pueblo Viejo in the Dominican Republic, which expects 1.2moz p.a. production). Grasberg represents the stunning 2% of the entire global gold mining production and since it is not mined specifically for its yellow by-product, its sizable swings in the precious metal’s output have a considerable impact on total gold supply data.

Despite Grasberg’s pit widening and the impending transition to block caving, Freeport remains one of the key players in the copper universe, which in 2010 experienced again multiple disruptions and production disappointments. In the last 5 years, despite comfortable margins, the global copper mining production has increased barely by 1% per annum. By comparison, provisional data for 2010 point to a nearly 10% increase in global gold mining production. Global copper deficit estimates for 2011 range between 400kt to 650kt. So the question returns – is this the time to long the red and short the yellow?

The story of copper, however fundamentally sound, has been with us for several years now: tight elasticity of supply, deep BRIC deficiency, falling grades, few new SXEW finds, slow decay of the largest producers (e.g. Escondida). The fact that China’s secretive Strategic Reserve Bureau considers copper a “strategic asset” has added to the allure. SRB, whose only officially confirmed purchase goes back almost two years now, is believed to be holding between 0.5mt and 1.5mt of copper and is rumored to have targeted a 2mt worth of copper war shield by 2015. There is no denying that the underlying demand – from the power sector and construction – is sound, even though most analysts have now learned to infer China’s restocking and de-stocking cycles from the discrepancy between end-user data and the so-called apparent demand (production plus net imports +/- change in Shanghai stocks).

Yet, in the short term, there are some clouds over the red horizon.

First, after significant restocking in the rest of the world throughout 2010, in the near term the market will be over-dependent on one crucial market – i.e. China, increasing the concentration risk.

Secondly with changes to VAT regime for bonded warehouses in China, it is now entirely plausible that the arbitrage between London and Shanghai prices may function both ways – including shorting LME and long SME.

Third, with the new copper ETF products coming on line this year, it is entirely imaginable as these new products gain liquidity, arbitrage opportunity could emerge between copper futures and ETFs whenever the forward curve goes into backwardation.

Fourth, a seasonal increase in Chinese imports in 1Q may reflect more the record liquidity conditions generated by Chinese banks this month and some delayed delivery of last year’s orders than the actual demand growth in this key market, sending a misleadingly bullish signal to overseas traders.

Finally, if the LME curve flattens into contango, it is not entirely impossible that some producers may engage in selective locking in of the current record prices.

Some other market indicators also invite caution. Copper’s 3m implied volatility lies in low stasis, diverging from the spot metal price and forming a spread from where the underlying usually corrects. Bizarrely, near term 25 delta puts have recently had a volatility premium vis-à-vis at-the-money option. And last but not least, the copper/gold spread has turned positive.

This has only happened for the second time since the heyday of June 2008 commodity peak, and when it did (in April 2010), it did not last. Indeed, such is the precariousness of the global order that any glitch – EFSF discord in Europe, more forceful inflation-busting in China, another flare-up in North Korea – may quickly reverse the new trend. Any volatility inducing event will lead to losses in red copper/short gold trade. In fact, the opposite trade could be treated as debit spread betting on volatility returning to both metals, yet in an asymmetric fashion.

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   Posted by: Mr. Gold   in Uncategorized

Hot on the heels of yet another missed lending quota, the first quarter of 2011 begins like any other in China – by a huge liquidity binge. The archaic banking system pushes as many loans as possible early in the year to earn the near-full interest within the calendar year, which in China corresponds to fiscal year. These developments were of marginal interest to the world when China was merely an ambitious ‘emerging market’. It is more vital to the global economy, and indeed to gold prices, now that the country’s M2 is nearing $11 trillion, or a stunning 26% higher than the US whose economy is still three times China’s size.

As the QE2 detractors know well in the US, money creation is a good friend of the gold prices, or indeed of many other commodities as well. This year is unlikely to avert further inflationary pressures in China, where food prices are running at 20% pa – four times faster than the usually underreported corresponding figure in the United States. Exhortation against “food price speculation” and price controls are unlikely to resolve the problem of China’s excessive liquidity. All this leaves 300 million Chinese consumers and investors in a bind. Inflation expectations are now entrenched and self-fulfilling. Yet a Chinese citizen can do precious little to protect him/herself against the flood of money. After placing overseas the maximum of $50’000 per year through the narrow crack of QDII (“Qualified Domestic Institutional Investor”) scheme, a Chinese saver has only domestic assets to choose to fend off inflationary embrace – stocks, property and precious metals.

Shanghai stock market has been in a sorry state for three and half years. The relentless ride up to 2007, which hiked the emerging market indices globally, now looks like an isolated Matterhorn peak, ever more distant on the chart. Property investments, on the other hand, have paid off handsomely for those who could enter early. Nationwide, prices march on with double-digit annual gains, but in 2009 the city of Wenzhou registered an average annual gain of 845% year on year. Such appreciation means that despite the commitment of savings of three generations, a young Chinese man is finding it increasingly difficult to pay western rates per sq ft and thus fully satisfy his future bride’s parents.

And so, the saver is left with one last inflationary hedge: gold. Gold jewelry demand may have been lackluster, but the trading volumes at Shanghai Gold Exchange have jumped up considerably in the recent weeks. Meanwhile, Lion Fund Management has raised domestically nearly $0.5bn to manage money via overseas gold ETF exposure (I have not seen the prospectus, but if the QDII quotas are observed, Lion must have gathered an army of 1 million retail investors). In Hong Kong, China-destined HK now claim a hefty retail premium at around $3/oz. No doubt, the GFMS/WGC’s “China investment” figures are bound to look good.

But here comes the caveat. If gold constitutes this one last avenue towards savings security, any change to capital account regulations, and QDII in particular, could damage this fast growing market. Most emerging markets are now struggling with excessive liquidity, “speculative” capital inflows and renminbi competition. Stronger EM currencies have led to current account deficits in India, Brazil and Turkey. Increasingly, a panacea is sought in encouraged capital outflows, in addition to limiting inflows. Thailand has now eliminated limits on overseas investment and lending to foreign entities. Who would have thought back in 1997?

China experimented with such schemes before, only to backpedal after witnessing instant damage to Shanghai stock market. It seems that any crevice in the capital account fortress leads to capital flight. Opening this floodgate could actually solve the problem of foreign reserve accumulation.

Except that China’s mercantilist leaders and their military brethren are not seeing “accumulation” of foreign reserves as evil any more than hoarding of “strategic reserves” of various commodities, even though such war chests are inherently inflationary (as is war itself). It is therefore fascinating to observe the new pilot project for relaxed QDII quotas emanating out of… Wenzhou. The great city of Wenzhou, whose denizens are known to have enjoyed an unprecedented appreciation in real estate values. And who also gave Italy its largest sweatshops.

The move is destined to cool the real estate bonanza a bit. But should this pilot project become more successful than the previous ones, the recent growth rate in gold investment on the mainland may soon fade into the oft-rewritten “5000 years” of history.

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   Posted by: Mr. Gold   in Uncategorized

After yet another year of risk-on/risk-off trading, it is a bold investor who seeks commodity differentiation. Barring freaky weather events which impact Australian metcoal, Russian wheat or Ivoirian cocoa, these days most commodities tend to move in synch, with fundamentals playing a screechy second fiddle. But then, how do you make an old-school fundamental judgment on say, lead, when the LME stocks are at their highest in 15 years and yet the metal is in backwardation…

Yet this week, some attention is brought to the differentiating fortunes of materials, energy and agros and this courtesy index rebalancing. Gold is present in these indexes and last year the allocations were reduced in the two largest indexes: S&P-GSCI and DJ-UBS. The latter index is contrarian within subsectors and silver’s amazing run throughout 2010 will this time shelter gold from losing its part in the pool. In fact, gold will enjoy some 0.8moz of fresh buying from around January 10th, equivalent to some 2% of open interest on Comex. Despite the nearly 30% upswing in the previous year, it will join the relative laggards – natural gas and zinc – among the winners. The impact from S&P-GSCI will be less significant, with 828 contracts sold. In the context of both indexes, silver will join coffee, cotton and wheat as the most aggressively pruned commodity (4% of the open interest).

For most of us, this is now old news. But what are other inter-commodity movements that could affect gold throughout the next twelve months? From the macroeconomic perspective, two big themes are in pole position: China’s trade account and oil prices.

It is now commonly recognized that China’s sense of insecurity regarding the global trade system is leading the country to plough enormous resources into exploration and development of materials necessary for its further growth. In 2009, the country spent nearly $4bn on metal exploration. Yet until these endeavors prove successful, until the recycling business reaches maturity, or until Chinese state owned enterprises show some operational mettle overseas, China remains at the mercy of an iron ore oligopoly and the fickle markets still dominated by foreign devils. It is therefore a sign of insecurity, rather than strength, that the country is currently sitting on 70kt of iron stockpiles, some 2mt of (unreported) copper inventory and its list of “strategic materials” is being extended.

Until the day China reaches a satisfying level of self-sufficiency in the key inputs into its building binge, its current account will reflect cyclical swings in inventory build-up. Copper imports offer a reliable litmus test to these patterns, as they usually peak between March and May. It is also around this time that the accelerated imports of raw materials tend to tip the current account balance, reducing somewhat its structural surplus. In short, China really imports only three types of products – commodities, advance machinery to reverse-engineer it over time and high value added components for assembly and re-export. If we assume, ceteris paribus, that other sources of capital inflow remain constant during this period, then State Administration of Foreign Exchange will enjoy a less hectic period of managing dollar inflows. The mechanism can be detected by following the volume of short term bills sold by PBOC domestically. More importantly, the rebalancing of the reserves away from the dollar ebbs, strengthens in its wake the US dollar and weakens other currencies, most notably the euro. Unless gold experiences a stint of FX correlation reversal during this period, the metal’s gains will be thus constrained by the dollar’s strength. This is a fairly safe bet, given that commodities’ (and gold’s) strength has been associated with dollar’s weakness in 18 out of the last 22 quarters.

The second big theme relates to the oil prices. Here, the US economy still remains dominant, although most demand growth is now coming from the emerging markets (Asia alone was responsible for nearly 70% of the global demand growth in 2010). Regardless, this $4 trillion worth of output is invoiced in the US currency. Historically, whenever oil prices increased, the supply of dollars also rose – both in absolute terms and in relation to other currencies. The inflow of dollars into the oil producers’ economies generates new demand, only a fraction of which will be realized with the US currency. Despite the global importance of US exporters (Boeing, Honeywell, Caterpillar, Eaton, Emerson Electric, 3M, Cummins), their European and Japanese competitors offer equally viable products and services for which oil exporters need Euros and Yen.

This phenomenon is non-linear and therefore all the more important when the oil prices rise. A 1% rise in the price of oil from the current base of $94 weakens the dollar more than a similar percentage off a base of $65 a couple of months ago. With inflation hawks dominating the ECB’s board, one could expect that the supply of Euros could also diminish with stronger oil prices, further helping the dollar-denominated gold prices.

All this would indicate plain-sailing this year, were it not for the fact that the FX volatility may increase in the coming months – marked by the debt refinancing schedule of the European periphery and the recurrent rumors surrounding the Lisbon Treaty re-negotiation. Yet, at the current prices, the commodity markets’ impact on the dominant currencies can no longer be dismissed. And this is an important lesson to heed for those who watch the most successful long-term currency of all.

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   Posted by: Mr. Gold   in Uncategorized

Despite the lackluster performance of Brazilian and Chinese stock markets this year, most of us – the aging dwellers of the decaying West – are still in the throes of the emerging markets’ “opportunity”. The relentless media pounding about the growth momentum among the Brics, the public awe at China’s new missiles, aircraft carriers and their “digested” technology of Japanese speed trains, the reverie caused by the seemingly boundless wealth of the Tatas, the Ambanis, the Deripaskas and the Slims – all generate countless metaphors of the changing pecking order on this planet. And the global statistics of capital flows support this increasingly common perception, showing a capital surplus of $0.5 trillion directed at the fertile grounds of EM.

Yet for each lucky winner who happened to hold his wealth on the Sri Lankan or Peruvian stock market this year, there are just as many stories of laggards and failures. Although the warning bells are ringing in most eagerly watched emerging markets (food prices in China, interest rates in Turkey, current account deficit in Brazil, high inflation in India unchecked even by a good monsoon), some peripheral countries are showing signs of advanced disease.

Nowhere is it more salient than in Vietnam. And what happens in Vietnam is of particular significance to any gold watcher. After all, Vietnam is the world leading per capita consumer of gold and imports the metal at a clip between 800tpa and 1000tpa. Vietnam’s gold investment demand powers on at 25% per year and in the third quarter it notched 45% of the volumes purchased by the more populous markets in India and China. What drives this gold fever in Vietnam? The short answer is – macroeconomic mismanagement.

Vietnam has had several chances to straighten its act. But the communist party’s eternal power struggle led to a stop-go approach to economic liberalization. Fifteen years after Vietnam closed its doors again to foreign investors (and then held it ajar), it is now plagued with a current account deficit, a 9% fiscal deficit, double-digit inflation, rising interest rates, mere $16bn in foreign reserves, a fragile banking system, SOE defaults and falling pledges from international donors.

In mid-2008, in an effort to narrow the trade deficit, the central bank tightened controls on gold imports. This led scarcity in the domestic market and opened a widening spread between domestic and international (or Thai) gold prices. Smugglers sought to capture an arbitrage opportunity by buying dollars to purchase gold abroad and bring into the country illegally. In response, Vietnamese consumers sold dong en masse to buy (dollar in order to purchase) gold with $26 premium over the global market price. This generated a strong demand for dollars with the widening gap between the official and unofficial exchange rates. Banks often need to pay a 20% premium for dollars and go to unofficial market to obtain the greenback, putting further pressure on the dong exchange rate and forcing devaluations whenever dong falls through the 3% to 5% managed float range.

Some of the gold import restrictions were lifted when the dong was devalued and in October 2010 the central bank announced it would consider granting permits (timed quotas) for gold imports if prices in the domestic market rose “unreasonably high”. Traders in South East Asia claim that re-opening of the officially sanctioned channels has historically proven to be a price-supportive signal for the physical market in the region.

However, by now the vicious circle has been established. Typically, the authorities’ first reaction to tackle the gold import pressure is by expanding the quotas for several additional tonnes. Should the global gold prices continue to rise and the price-taking importing country continue to hemorrhage foreign exchange, the next step is devaluation (which occurred three times between November 2009 and November 2010) and an inflation-stemming interest rate rise. The former increases further the attractiveness of gold as an alternative currency and an inflation hedge.

The weak currency and entrenched inflation mean that few people are willing to use the dong to make payments. This is particularly true for term payments, not just daily staples. Common to the bubbly conditions in some other Asian cities, apartment prices in Ho Chi Minh City grow by 30-40% year on year. Gold (rather than dollars) is used to purchase big ticket items such as real estate and gold shops double up with the function as foreign exchange counters. The ban on gold exchanges in March this year has led to anarchic gold market conditions, with a palliative of an “official gold exchange” now sought by one state-owned bank.

As of January 1st, Vietnam is imposing yet another slew of administrative curbs on gold, this time in the form of 10% export tax. This could be little more than an attempt to capture more revenue (Vietnam exports nearly $3bn worth of precious metals annually), but will be of no help if the prices stabilize.

Capricious policymaking and administrative unpredictability are at the root of gold’s dubious “success” in the context of the Vietnamese morass. This could be the most important lesson yet for those Washington and European politicians whose populist agendas aim at undermining of central banks’ independence.

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   Posted by: Mr. Gold   in Uncategorized

As the 2010 is nearing its inevitable calendar demise, gold investors may be excused for looking back with a smirk of complacency. From the directional perspective, the market performed very well, even though it trailed the market darlings: cotton, coffee, sugar, silver, palladium, Peruvian or Sri Lankan stock exchanges. Yet it’s still somewhere up there, next to Matterhorn-solid Swiss Franc as the last sentinel of security. This party will end one day too, but the continued explosion of liquidity in China, interbank problems and persistent output gap in the developed economies may conspire in favor of gold-plated capital preservation a while longer.

So rather than focusing on self-congratulatory hindsight, let us have a peek into the other side of the gold market in 2010. What did it bring to volatility traders? Famously, gold is among the least volatile of commodities. Yet this statement alone does not reveal what an analysis of implied and historical volatility could provide. We are focusing here on the front contract, looking back all the way to January 2010.

The ranges, divergence or convergence between the volatility implied by the market price of the option contract and the annualized standard deviation of returns reveal as many as seven different stages throughout the past 12 months.

In February, implied volatility (IV) peaked for the year at above 28, pulling up in its wake the 30-day historical volatility. Naturally, this would have been a classic opportunity for delta-neutral long volatility traders and – as it later transpired – with few other such openings for the remainder of the year. As is the case in generic equity markets, the jump was associated with the fall in the gold price to the year low of $1058/oz.

In mid-March historical volatility retraced in synch with implied vol, which never again returned to the February levels. The gold price found a floor around $1100/oz, with at that time few signs of the European drama which was to befall us in the second quarter.

It’s the Greek troubles which seemed to be behind the implied and realized volatility gapping higher in May. This is, interestingly, exactly the same vol pattern that was revealed by the Irish conundrum in mid-October and November. But by late June historical volatility diverged from IV as if an imminent turn was in the offing. It was a safer period for a directional (and uniquely bearish, in the context of the entire year) strategy.

Accordingly, as July saw the gold prices fall back below $1200/oz, the implied volatility slid, while historical vol remained flat. From here to late December, you’d be on the right side staying short vol.

The next chapter opened in late August, with the seasonally stronger gold prices, steady IV and a historical volatility falling off the cliff to as low as 7 in early September. As a consequence, the strong Aug/Sep gold market consensus saw the biggest (13 point!) divergence between IV and historical vol.

The subsequent, steady gold price run until a new record in mid-October saw a strong recovery in 30-day volatility and occasional IV spikes – as mentioned above – a pattern reminiscent of the May chart.

It was only in mid-November that the chart reversed for the first time, with historical vol tracing a “mesa” above the implied volatility. This would normally indicate that the market unpredictability ebbed a bit around the time a new price record was established. The question remains why implied volatility was crushed, reaching eventually the year-low of 15.7, before recovering. Most likely, arbitrageurs forced the options prices lower to capture gamma and theta in the process. It must have been a tough moment for long-volatility market makers.

What an interesting year it was… Some regular seasonality, several short-termed yet strong USD/EUR correlation reversals, unusual volatility divergence… With 200t of open market IMF sales now depleted, I would be less bearish vol in 2011 and bullish on the direction.

Let’s revisit the chart in a year from now.

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