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Posts Tagged ‘China’

24
Nov

SHOULD GOLD BUGS CHEER KIM JONG-EUN?

   Posted by: Mr. Gold    in Uncategorized

Stupor, bewilderment, anxiety, shock and anger meet yet another provocation dished out by Pyongyang on its southern neighbor. These are the feelings expressed by those directly and indirectly affected, those still married to the post-war, UN-regulated order, the naïve bunch that has not quite grasped to what extent the rules of the game have shifted. Despite years of international sanctions, North Korea, an entity born out of sweat and blood of Mao Tse Tung’s troops, has now happily turned into a China’s bad boy testing ground. Assessing the patience of neighbors, fraying at the global resolve to cap the mercurial ambitions of the ruling family, helping Pyongyang to run its businesses and obtain more uranium for enrichment… The “global community”, if there was ever one, can’t stop it because Kim’s backers are today full of liquidity-oiled hubris and see no interest in hemming in the wayward behavior. Behavior that may well be channeled through the tensions with the immediate neighbor to the South, but ultimately is aimed at Beijing’s traditional enemies and rivals in the region – Japan and the US. After all, China invited Kim Jong-il when his navy killed 45 South Koreans in Cheonan incident last March. From Burma to North Korea, the neo-imperial Middle Kingdom revels in this sort of archaic clientelism. One just gets tired of the press mantra about Beijing’s concern about “refugees flooding into PRC”. China is managing the ‘refugee’ problem all right, stuffing stacks of banknotes into the pockets of every Manchurian who spots and denounces a non-fluent Chinese speaker in the backyard of the chilly Jilin Province. A police state does not need a private militia to protect its flank. Amnok River is no Rio Grande.

But there is a group of excited investors who, while may not exactly cheer Kim Jong Il’s (and now possibly Kim Jong-eun’s) aggressive antics, are anxious to see instability as a litmus test for further gains in the safe haven asset par excellence: gold, geum, huangjin – or whatever else it the 79th element on Mendeleev’s table could be called in that troubled region.

And the oxymoronically sobering news is – there is actually something to get excited about. In a simplistic, single-variable overview, gold’s usual response to Pyongyang’s ultimately unpredictable actions is positive and not necessarily short-lived.

We looked at 9 incidents caused by the North over the last 5 years, ranging from missile launches, to nuclear tests to warship clashes and bombing campaigns. We added to this any reports concerning dramatic changes at the top of the state’s structure (Kim family issues). We then compared the performance of the gold market in the ensuing period. It appears that gold in dollar terms is lifted by an average 0.09% in the day after an incident. In only two cases (reports on Kim Jong Il’s stroke in September 2008 and the second nuclear test in May 2009) did the gold price actually fall on the news. More surprising yet is the fact that in the week following the events, gold gains an average 2.31%, and a month later it is still higher by 5.36%, in dollar terms.

Of course, this is a single variable extracted from a wealth of other macro- and gold-specific influences. What is stunning is the regularity of the metal’s behavior, possibly coincidental and certainly orthogonal but regular nonetheless. Importantly however, in only one case (May 09) did the subsequent trading reverse the pre-existing trend. In all other instances, gold’s trajectory simply amplified or extended the trend. Remarkably, Korean incidents have a peculiar feature of not occurring during occasional gold market pullbacks.

One hypothesis could be that any posturing or outright aggression induces Asians to actually purchase more gold. This would require further research into historical demand data, but it is an intriguing thought. Just as most Westerners seem resigned to the swell of Asian juggernauts, locals may be a little more aware of the precarious state of liquidity-driven property boom, unresolved territorial disputes, ultra-nationalistic educational systems and the premature demographic peak. Contrary to Norman Angell’s hopeful students, there are reasons to believe a war in a region run by unreformed dictatorships is not becoming any less likely just because many of its inhabitants have now become wealthier.

Nor should the conclusion be any different if you are a South Korean resident and most your wealth is Won-denominated. Not only have you suffered from your central bank’s ongoing intervention to keep the currency competitive against the undervalued Renminbi, but now the Kims up north are doing this job just as efficiently. You may have little choice but to hold gold as an insurance against sudden falls in the value of your currency. On the basis of the 9 peninsular incidents, it turns out that your wallet’s one-day gold price sensitivity is seven (!) times higher than for dollar-denominated gold investors.

For all other gold investors the solution lies elsewhere. For as long as the North Korean forays remain low frequency events (on average every 7 months over the last 5 years, but with significant variance), the option market may not adequately price in the probability of such idiosyncratic shocks. When things quiet down a bit, the lingering uncertainty left by the 60-year long positioning in the region may in fact give the advantage to investors paying for long vol on a regular basis. To all those who retort that this could sound like a bet against traditional Korean concept of kibun (interpersonal harmony), here’s a quick refresher. Although peace and security are the objectives of kibun, flare-ups and hostility occur if it is not observed. The frustrated, exaggerated reactions to the perceived lack of harmony can be observed anywhere in this cultural context – from violent students’ demonstrations to fistfights by upset clients on Korean Air flights. Betting against kibun with option volatility assumptions slightly above the ‘implied’ number on the screen could yet be one way to derive value from the fat boy’s ascendancy into a Beijing-backed loose cannon.

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18
Mar

WHAT DOES THE FORWARD CURVE PORTEND?

   Posted by: Mr. Gold    in Uncategorized

As the London Bullion Market Association has opened negotiations with London Metal Exchange to distribute its new gold forward curve, the question of the relationship between gold and base metals is again beginning to haunt investors’ minds.

The relative liquidity of the copper contracts, and the presence of this metal on COMEX means that the gold-to-copper ratio is the most frequently quoted comparable between the precious and base metal sectors. And although many gold-rich epithermal systems are found around large copper porphyries, the geological relationship between the two metals does not necessarily extend into the markets. For one, as expounded before on these pages, gold seasonality is quite strongly tilted towards strength in the second half of the year. On the other hand, base metals – and in particular aluminum, zinc and copper – are known to enjoy stronger demand in (northern) Spring, although falling merchant premia since the Chinese New Year seem to suggest that it may not necessarily be the case this year.

Of course, the most notable difference between gold and the base metals has for years lain in the shape of the forward curve. Gold resides in a permanent contango (forward prices higher than spot prices), owing to its abundant liquidity and the fact that storage costs outweigh convenience yield. Base metals, on the other hand, were historically characterized by entrenched backwardation (spot prices higher than forward prices). Until the middle of the past decade, the backwardated forward curve offered fairly predictable gains in the futures market. An investor could buy a futures contract 2 months before expiration and then sell it to avoid physical delivery, while buying another one with later expiration. The price difference offered by the backwardation is commonly referred to as roll yield. Between 1959-2004 investors could earn this way over 10% excess return over risk free rate.

However, just around the time this passive strategy was heralded for its low correlation with the rest of the portfolio, money poured into commodity index funds, increasing the level of offsetting inventories and leading to prolonged periods of contango. Although the interest in the commodity space was initially triggered by the structural shifts in the physical demand, engendered largely by the construction boom in the emerging markets, the appearance of the contango also reflected low financing and storage costs. The problem for investors was that contango left the aforementioned passive futures strategy with a negative roll yield (essentially, what you bought after selling your previous contract was more expensive). This development proved to be particularly damaging at the front end of the curve, which is more volatile and – as in copper – more amenable to twists into a contango.

The base metals experienced rising prices along stock surpluses for the first time between July 2005 and March 2006. Much to the surprise of gold investors, some market participants began to consider copper (rather than gold) as a “hedge against inflation”. In the process, the market cap of the major mining companies for the first time reached levels previously reserved exclusively for oil majors. In May 2006 copper hit an all time high of $8800/t. Later that year the copper/gold copper ratio rose to a record 1.7x (it subsequently collapsed to 0.4x in December 2008). The second “surplus investment” period began in 2009, this time driven by Chinese merchants’, dealers’ and investors’ unprecedented level of stockpiling. For many of these players the red metal constituted a hedge against inflation, broadly anticipated in the credit-swamped economy. And, as in the heyday of gold miners’ hedging, forward sales by the holders of physical inventory could negatively affect the prices. However, long positions accumulated in commodity index funds now significantly outweigh these hedges.

Nowhere is this situation more striking than in aluminum. Between 75% and 90% of aluminum stocks are now tied in financial arbitrage deals, facilitated by low 3-month Libor and low storage costs. The metal is not instantly available for physical consumption and will only be freed either when the forward curve flattens or when the prices go up enough to offset the cost of breaking the warehousing contracts. As in gold, or in early stages of the silver cycle, this “investment” demand is now being associated with stock surplus, not with the deficit.

If the contango persists, it could encourage further over-production, most easily achieved in aluminum and zinc markets. But this is only sustainable for as long as interest rates are low and Chinese “speculators” continue to enjoy access to easy credit. Metal financing deals won’t suffer from a small rise in interest rates because the cost base is very low. Importantly, the $200bn stack of unused corporate loans in China would indicate that the party could go on for longer, regardless of PBOC’s interest rate decisions. The optimistic view is that even if the contango in aluminum disappears, it will take up to 3 years to reduce the stocks currently tied up in financing deals.

How significant are these developments for gold investors? First, regardless of the surplus stock building, the base metals are still a far cry from the investment-related inventory levels supporting the gold contango. Even counting all the exchange stocks, smelter and merchant inventories, Japanese port inventories, physical investment, China’s strategic reserves and whatever generous statistics we can offer to the rumored private stocks of the base metals, they mostly amount to around 15% of annual market. Meanwhile, just the gold ETFs and Comex net long positions correspond to nearly 70% of the size of the annual gold market, and as we know there are many other sources of liquidity, potentially available to this market. In other words, base metals cannot “replace” precious metals as an inflation hedge, not least because the resulting price level would actually feed back into inflation expectations and eventually a higher PPI.

But the eventual disappearance of the contango in base metals could dent investor sentiment vis-à-vis the commodity markets. This is not insignificant for gold, given the level of gold allocation in the main commodity indices – 2.8% in GSCI index and 9.15% in DJ-UBS index. This allocation is only marginally lower than in 2009 and gold retains some sensitivity to broader commodity sentiment.

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