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Posts Tagged ‘money market’



   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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