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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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This entry was posted on Thursday, January 6th, 2011 at 8:05 am and is filed under Uncategorized. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.

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