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Archive for January, 2011



   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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