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Posts Tagged ‘fx market and gold’



   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

This is clearly a week that calls for a historical perspective. In the United States, presidential historians are scrambling to find historical parallels to the tsunami of discontent that swept through the House of Representatives, undermining the policies of the current Chief Executive. Monetarist historians are trying to find any precedent similar to the Fed’s decision to expand its balance sheet in the order of $75bn per month (plus reinvested maturing mortgages). And dollar historians are now eyeing the greenbacks slide, seeking anchors beyond what looks on charts like a one-year long contour of a perfectly symmetric Swiss mountain. Henceforth, Mariana Trench anyone?

The combination of the feared legislative gridlock, monetary hyper-activism and the relentless dollar slide is making gold bugs licking their lips. This is the case in particular in countries whose currencies are pegged to the lameduck dollar and possibly among investors in countries whose authorities have decided to step up intervention into their capital account. Brazilians, Koreans, Indians, Canadians and Chinese are certainly a lot more excited about gold’s renewed attempt to break nominal records. And you may excuse Australians, Europeans, the Swiss, the Japanese, Scandinavians and South Africans for not sharing much of this effervescence.

We are touching here, in fact, a two-fold issue. First is the way in which gold’s local gains depend largely on the relative value expectations formulated by the fx market. Secondly, it raises the perennial question of the universality of the product.

For as long as the developed economies represented 75% of the global GDP, this did not quite matter. But as the first decade of the new century has seen their contribution shrunk by a third (in PPP terms), what ‘others’ can gain from a particularly fungible form of investment is a highly relevant question. Cultural and regulatory differences abound – from the ultra-sensitivity of Vietnamese savers, who use gold shops as a proxy for black market hard currency hedges to countries where private ownership of gold is still not permitted.

Gold bugs would like you to believe that there is something uniquely ‘universal’ about gold’s attractiveness. As any absolutist claim, this betrays poor knowledge of history. There is nothing deterministic about the appearance of gold coinage in the first place. The country which popularized gold coinage was Lydia in western Asia Minor. The reason was the relative availability of electrum (a natural alloy of gold and silver) found in local river Pactolus. Lydia happened to be located near the juncture of important trade routes and the combination of scarcity with low annual fluctuation of output made (gold) coinage a more attractive form of value exchange than grain or barter. But at the same time that Lydians were putting their ‘staters’ into circulation, Mesopotamia used copper ingots and China used proto-coinage made of bronze. These developments occurred between 9th c and 6th c B.C. and go some way to deny the validity of universalist claims of gold’s “eternal” value.

The myth of gold’s universal value is widespread. Every Latin American populist, from Guatemala to the Andes, runs on a platform of historical victimhood, branding the educated (white) elite as the direct descendants of Spaniards who “took our gold and gave us pieces of glass”. The fact that such trade did take place at the beginning of the 16th c proves the point that the attractiveness of gold pales in comparison to products or assets whose availability, at a given time, is even less constrained. Just ask any rare earth trader.

When Placer Pacific’s explorers penetrated Papua in the 1930s, they were stunned to see how little interest the Highlanders had in alluvial gold. Prospectors’ camps did not even have to guard the inventory of naturally occurring gold. This and other stories should remind us that there is nothing deterministic about the gold’s value.

This is a tough statement to make on a day when the yellow metal is, again, hitting a (US dollar) nominal high. But the travails of the global monetary system and the attempts of the Federal Reserve to reflate the world’s economy will bring solace to gold investors only in some parts of the world. The relative size of the winners’ capital and its propensity to leak into alternative assets will determine how high gold can go against the basket of currencies, not just in the dollar and the Renminbi.

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   Posted by: Mr. Gold    in Uncategorized

Last night, Premier Wen Jiabao sent EU packing, rebuffing any attempts to “pressure” China over its inflexible currency policy. It is well-known that Beijing holds EU institutions in disdain, partly because Brussels does not command anything like the 7th Fleet, and partly because of Europeans’ own failure to craft a properly articulated, common foreign policy.

Yet, hubris may yet prove to be China’s undoing. Beijing’s propaganda regards international clamor over its mercantilist policies as a sort of a dark conspiracy, a view expressed already in last year’s bestseller, Song Hongbing’s “Currency Wars”. And indeed, think tanks around the world are beginning to roll out less accommodative strategies. To be effective, they may require Heinz Guderian-style skills transposed into capital markets, rather than Charles Schumer-like cheap populism. Until some solution is found to Beijing’s intransigence, gold has a ball.

This is a tough time to be optimistic about the peaceful, orderly solution to competitive devaluations and uncoordinated liquidity injections. Yet, one remains hopeful that the world’s biggest trader will blink in the face of its inability to redeploy the earned dollars into Treasuries overseas (a credible threat to this effect is one tool the developed markets have at its disposal). As Naoto Kan stated last month, there is something perverse in a global system, in which China is allowed to buy JGBs, but Japan cannot purchase Chinese Treasury bonds.

What would a coordinated approach mean for the gold market? Unlike unilateral interventions occasionally adopted by Tokyo, most multilateral efforts in support of specific currencies had lasting effects on the FX market and, by extension, on gold prices. The magnitude of these effects depended on the depth of the negative correlation between gold and trade-weighted dollar, a measure which is currently back at its strongest level since April.

The most clear-cut cases of direct influence on gold market can be traced to the hallmark agreements of the 1980s. In the year following the Plaza Accord of September 1985, dollar weakened 35% against the Yen. Eerily, gold (in dollars) strengthened by exactly the same rate. The negative DXY/gold correlation was very strong, at -0.76. The February 1987 Louvre Accord, organized to stem dollar losses, was famously unsuccessful when Germany raised interest rates. Remarkably, over the following year, the dollar lost a further 16% to the Yen, while gold gained 14.5% in dollar terms. The negative correlation between the trade-weighted dollar and gold was still strong (negative -0.47).

The effects of the interventions in the following decade were less straightforward. Between January and April 1995, Japan and US coordinated efforts to stop Yen’s strengthening. Over the following year, the dollar gained 35% to the Yen, but gold performed better than expected and remained flat, in dollar terms, at 394/oz. In fact, by early 1996, gold’s correlation to the dollar reversed and stayed in positive territory for several months. The opposite intervention in June 1998, aimed at strengthening the Yen, did send the dollar down by almost 20% over the following year. This time gold did not enjoy the party. Saddled by legacy sales from central banks, the yellow metal fell 9% over the period. Finally, the joint intervention in support of the Euro, in September 2000, helped the common currency to gain over 8% during the following 12 months. Again, gold did not benefit from this effective dollar weakening, and the correlation between the two reversed to positive by June 2001.

What are the lessons of history for the optimists who still expect Beijing to relent and enter a global debate on a more orderly currency system? First, the dollar gold price seems to shadow the dollar depreciation when the intervention is publicly known – regardless of its ultimate success. Secondly, the initial conditions count. A very strong negative correlation between dollar and gold represents a risk of (low probability, but high impact) reversals, such as those in early 2009 and in Spring 2010. This could still be good news for European and Japanese investors, but not for dollar-gold holders. Finally, assuming the correlations do hold, gold’s response in the first days after the intervention is likely to evolve into a trend over the mid-term.

Yet in the context of the collapse of Brussels-Beijing negotiations this week, a more plausible scenario today is one of partly closed capital accounts. In such a world, to keep long term yields low, central banks may need to continue or even increase the purchase of domestic Treasuries to palliate against the disappearance of Chinese demand. Maybe global capitalism needs to take this step back in order to ‘advance’ in a less disorderly fashion. How gold performs in this ocean of liquidity will depend on how successfully sterilized the interventions would be.

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