Monday, April 15, 2013

Gold is re-linking to commodities


This is a followup to my post last Friday, in which I explained why gold's second great rally had ended, and gold's downside risk loomed large. Gold today is down over 11%, to $1350/oz. as I write this. At 11%, that's the biggest one-day decline in over 30 years. The chart above is a good guide to how much downside is left. In short, it looks like gold is on its way to re-linking to commodity prices, with a likely price target of $900-1000/oz.

To summarize my argument of last week, in late 2008 gold began to overshoot commodity prices. Call it an "end of the world as we know it" trade. Gold was reacting to fears that the world's central banks were engaged in a massive money printing scheme that would result in hyperinflation, and/or a global currency collapse. Gold was also propelled higher by the Eurozone sovereign debt crisis, which many thought would lead to the demise of the Euro, and by fears of exploding sovereign deficits that might inevitably be resolved by a big increase of inflation.

Back in January I had a post that offered yet another explanation for why gold rose so much and was headed for a fall: "Developments in China explain the end of gold's rise." It's worth reviewing and updating, because I think the argument has at least some validity, and because we have fresh data today on China's GDP growth and foreign reserves. What follows is a revised and updated version of my January post.

Arguably, there have been only a handful of major developments in the global economy in the past 10-12 years: 1) the Chinese economy enjoyed an unprecedented 10% annual economic growth rate, on average, for most of the past decade, but growth has now slowed to 7-8%; 2) beginning in 2000, China's foreign exchange reserves soared from $170 billion to now $3.4 trillion, and the growth of reserves has now slowed to a crawl; and 3) the price of gold soared 642% from 2001 to 2011, but it has since retreated by almost 30%. It's likely that all three of these developments are related, and that they help explain the recent decline in gold.



China's decision in early 1994 to peg the yuan to the dollar was a key factor driving China's growth, since it brought Chinese inflation rapidly down to the level of the U.S., where it has remained ever since. The prospect of a strong and relatively stable currency not only reduced inflation and its multiple distortions, it also increased the market's confidence in China and that in turn helped boost investment in the country. Indeed, since the yuan has only appreciated against the dollar since 1994, foreign investors benefited from strong Chinese growth and yuan gains. China was the boomtown of the century.

As the first of the two charts above shows, the huge capital inflows that helped China grow needed to be sterilized or accommodated by the Bank of China, otherwise they would have caused the yuan to soar, and that could have short-circuited China's ability to grow. Massive inflows of foreign capital seeking to benefit from rapid Chinese development essentially forced the Bank of China to buy over $3 trillion of foreign exchange, with a commensurate increase in the Chinese money supply. Converting capital inflows into yuan is the only way foreign capital could actually enter the economy, because you can't build a factory or hire workers with dollars—the dollars need to be converted to yuan, and it is the proper role of the BoC to buy those dollars and issue new yuan in the process. Yet despite massive forex purchases, which relieved pressure on the yuan to appreciate, the BoC still had to allow the yuan to float irregularly upwards, in recognition of China's declining relative cost advantage that in turn was a function of huge increases in worker productivity. At the same time, a stronger yuan helped to keep the inflationary pressures of rapid growth under control.


As I explained in this post, it now appears that this process of huge forex purchases and continual yuan appreciation is at or nearing an end. This is a big deal. China's foreign exchange reserves have not increased materially for the last two years, and the yuan has risen less than 1% against the dollar over past five months. Capital flows and trade flows appear to be reaching some kind of equilibrium, just as Chinese and U.S. inflation have converged. Moreover, China's growth rate has slowed significantly in recent years, as shown in the chart above. China is now growing at rates similar to what we saw prior to golds' surge.


The above chart compares the rise in China's forex reserves with the rise in the dollar price of gold, both of which have been impressive over most of the past 10-12 years. China's central bank started buying up capital inflows in earnest in early 2001, right about the time that gold was hitting a multi-year low. This came to an end in early 2011, as net capital inflows to China approached zero, and shortly thereafter gold peaked. Both forex purchases and the price of gold increased by many orders of magnitude over roughly the same period. Now, about 18 months after China's reserves have been relatively stable and 20 months after gold hit its peak of $1900, gold has dropped sharply.

Is there a plausible explanation for the strong correlation between these disparate variables? I think there is, but I can't say so with authority.

Gold bugs like to argue that gold rose because both the Fed and the BoC were "printing money" with abandon. The global monetary base exploded during this period, so naturally gold rose, so the theory goes, because the world was being flooded with fiat currency. Gold was the only port in an eventual inflationary storm.

Yet Chinese and U.S. inflation rates are still relatively low. There has been over a decade of impressive expansion of bank reserves and yuan, but inflation has so far failed to show up. As I explained here, the truth is that the Fed has NOT been "printing money" as is widely believed—the Fed has simply been accommodating a huge increase in the demand for safe securities. The BoC hasn't been "printing money" either, because it has simply been purchasing the net inflow of dollars to China and converting those dollars to yuan so they can accommodate the impressive growth of the Chinese economy.

Don Luskin, a good friend, got me started down the path to an explanation for how China's forex reserves are connected to the rise in the price of gold. He argues that the outstanding stock of gold is relatively fixed—growing only about 3% per year—but that the demand for gold has jumped by orders of magnitude since China, India, and other emerging markets have enjoyed explosive growth and prosperity gains. In other words, the number of potential buyers of gold has risen much faster than the supply of gold, so naturally gold's price has increased. This is not a story about massive money printing and hyper-inflationary consequences, it is a story about a one-time surge in the demand for the limited supply of gold.


That surge in Chinese demand for gold stopped almost two years ago as China's capital inflows have settled down to more manageable levels, and it has exposed the price of gold for what it was all along—a bubble that was inflating and would sooner or later deflate. Gold now is coming back down to more reasonable levels, both relative to other commodities and relative to its long-term average inflation-adjusted price, as seen in the chart above.

I don't see anything wrong here. This is not a reason to panic, unless you are long a lot of gold. And as Larry Kudlow reminds us, the last time we saw a large and sustained decline in the price of gold—in the early 1980s—it was setting the stage for a multi-year economic and equity boom. 

11 comments:

Gloeschi said...

Larry Kudlow! Mr. Goldilocks! Hilarious to see some people STILL taking investment advice from the Pollyannas at the Consumer and Business News Channel.

Bob said...

I'm curious who Gloeschi is?

Do you never have anything to say that isn't a derision to what Scott offers?

What should it be? What should we do? What is the correct path?

As far as I can tell Gloeshchi offers nothing constructive in the dialogue.

Unknown said...

Last night I noticed about 10-15 minutes before the rash of disappointing Chinese data came out was when gold, silver and oil suddenly started crashing. I suspect there are entities in China who get advance word of those things and acted accordingly. Since the only discernible catalyst for such a massive crash was that Chinese data, I suspect the thesis about China being the main driver of the price of gold over the past 10 years is probably the correct one.

Benjamin said...

Gold fevers and enfeebles the mind, turning the stalwart into blubbering imbeciles.

Great blogging---still not sure about gold.

They are buying gold in India to avoid taxes---and India's middle and upper classes are expanding.

The globe's commodities have had a great run---but high prices bring supply and cut demand.

In Thailand, I was set to plant cassava that is converted into ethanol for the China market. Problem is, S. Korean money has gone into Vietnam and Cambodia. and planted vast hectares with cassava. Prices are soft. That, in a nutshell, is the commodities market. Commodities usually get cheaper over time, not more expensive.

Gold stands alone, it value set by some incalculable metric imagined by the buyer of the day. Gold's value is also set by jewelry and gift buyers in China. And China is getting richer too.

Ultimately, the price of gold is unimportant, and signifies nothing. All gold is fool's gold, as my grandfather taught me.

What counts is real economic output.

Brian H said...

I agree with Bob regarding Gloeschi. His comments are consistently over the line in terms of being rude and pointless.

Matteo Civera said...

Do you think that there will be a sort of standstill due to the recent news about chinese economy?

CDLIC said...

Scott,

What do you think of supply-sider Paul Craig Roberts(President Reagan appointee as Assistant Secretary of the Treasury for Economic Policy from 1975 to 1978) take regarding the drop in gold?

Titled: Assault on Gold

April 13, 2013

I was the first to point out that the Federal Reserve was rigging all markets, not merely bond prices and interest rates, and that the Fed is rigging the bullion market in order to protect the US dollar’s exchange value, which is threatened by the Fed’s quantitative easing. With the Fed adding to the supply of dollars faster than the demand for dollars is increasing, the price or exchange value of the dollar is set up to fall.

A fall in the dollar’s exchange rate would push up import prices and, thereby, domestic inflation, and the Fed would lose control over interest rates. The bond market would collapse and with it the values of debt-related derivatives on the “banks too big too fail” balance sheets. The financial system would be in turmoil, and panic would reign.

Rapidly rising bullion prices were an indication of loss of confidence in the dollar and were signaling a drop in the dollar’s exchange rate. The Fed used naked shorts in the paper gold market to offset the price effect of a rising demand for bullion possession. Short sales that drive down the price trigger stop-loss orders that automatically lead to individual sales of bullion holdings once their loss limits are reached.

According to Andrew Maguire, on Friday, April 12, the Fed’s agents hit the market with 500 tons of naked shorts. Normally, a short is when an investor thinks the price of a stock or commodity is going to fall. He wants to sell the item in advance of the fall, pocket the money, and then buy the item back after it falls in price, thus making money on the short sale. If he doesn’t have the item, he borrows it from someone who does, putting up cash collateral equal to the current market price. Then he sells the item, waits for it to fall in price, buys it back at the lower price and returns it to the owner who returns his collateral. If enough shorts are sold, the result can be to drive down the market price.

A naked short is when the short seller does not have or borrow the item that he shorts, but sells shorts regardless. In the paper gold market, the participants are betting on gold prices and are content with the monetary payment. Therefore, generally, as participants are not interested in taking delivery of the gold, naked shorts do not need to be covered with the physical metal.

In other words, with naked shorts, no physical metal is actually sold.

People ask me how I know that the Fed is rigging the bullion price and seem surprised that anyone would think the Fed and its bullion bank agents would do such a thing, despite the public knowledge that the Fed is rigging the bond market and the banks with the Fed’s knowledge rigged the Libor rate. The answer is that the circumstantial evidence is powerful.

Consider the 500 tons of paper gold sold on Friday. Begin with the question, how many ounces is 500 tons? There are 2,000 pounds to one ton. 500 tons equal 1,000,000 pounds. There are 16 ounces to one pound, which comes to 16 million ounces of short sales on Friday.

Who has 16 million ounces of gold? At the beginning gold price that day of about $1,550, that comes to $24,800,000,000. Who has that kind of money?

What happens when 500 tons of gold sales are dumped on the market at one time or on one day? Correct, it drives the price down. Investors who want to get out of large positions would spread sales out over time so as not to lower their sales proceeds. The sale took gold down by about $73 per ounce. That means the seller or sellers lost up to $73 dollars 16 million times, or $1,168,000,000.

Who can afford to lose that kind of money? Only a central bank that can print it.

[article continued below]

CDLIC said...

[continued from above]
I believe that the authorities would like to drive the gold price down further and will, if they can, hit the gold market twice more next week and put gold at $1,400 per ounce or lower. The successive declines could perhaps spook individual holders of physical gold and result in actual net sales of physical gold as people reduced their holdings of the metal.

However, bullion dealer Bill Haynes told kingworldnews.com that last Friday bullion purchasers among the public outpaced sellers by 50 to 1, and that the premiums over the spot price on gold and silver coins are the highest in decades. I myself checked with Gainesville Coins and was told that far more buyers than sellers had responded to the price drop.

Unless the authorities have the actual metal with which to back up the short selling, they could be met with demands for deliveries. Unable to cover the shorts with real metal, the scheme would be exposed.

Do the authorities have the metal with which to cover shorts? I do not know. However, knowledgeable dealers are suspicious. Some think that US physical stocks of gold were used up in sales in efforts to disrupt the rise in the gold price from $272 in December 2000 to $1,900 in 2011. They point to Germany’s recent request that the US return the German gold stored in the US, and to the US government’s reply that it would return the gold piecemeal over seven years. If the US has the gold, why not return it to Germany?

The clear implication is that the US cannot deliver the gold.

Andrew Maguire also reports that foreign central banks, especially China, are loading up on physical gold at the low prices made possible by the short selling. If central banks are using their dollar holdings to purchase bullion at bargain prices, the likely results will be pressure on the dollar’s exchange value and a declining market supply of physical bullion. In other words, by trying to protect the dollar from its quantitative easing policy, the Fed might be hastening the dollar’s demise.

Possibly the Fed fears a dollar crisis or derivative blowup is nearing and is trying to reset the gold/dollar price prior to the outbreak of trouble. If ill winds are forecast, the Fed might feel it is better positioned to deal with crisis if the price of bullion is lower and confidence in bullion as a refuge has been shaken.

In addition to short selling that is clearly intended to drive down the gold price, orchestration is also indicated by the advance announcements this month first from brokerage houses and then from Goldman Sachs that hedge funds and institutional investors would be selling their gold positions. The purpose of these announcements was to encourage individual investors to get out of gold before the big boys did. Does anyone believe that hedge funds and Wall Street would announce their sales in advance so the small fry can get out of gold at a higher price than they do?

If these advanced announcements are not orchestration, what are they?

I see the orchestrated effort to suppress the price of gold and silver as a sign that the authorities are frightened that trouble is brewing that they cannot control unless there is strong confidence in the dollar. Otherwise, what is the point of the heavy short selling and orchestrated announcements of gold sales in advance of the sales?

Scott Grannis said...

Re: Paul Craig Roberts. I used to have great respect for him many years ago, but that is no longer the case. I have seen too many disjointed commentaries from him over the past decade, and this one is a good example. He used to be all about serious economics, now he is all about conspiracy theories.

wesley mouch said...

Scott
Given that manipulation of LIBOR is acknowledged to have happened is it such a stretch to imagine that the gold market may be manipulated? There is a lot of circumstantial evidence that the govt MAY be manipulating the gold price. See gata.com for more info.

Bloggi said...

@CDLIC
As it looks now you were right. Check out Shanghai Gold Exchange (SGE) in Aug. 2013. China is buying physical gold like crazy.

More than 2000 t of physical gold will be delivered in 2013.
Source: http://koosjansen.blogspot.de/2013/09/week-37-shanghai-gold-exchange-physical.html

The Chinese took that physical gold from those gold ETFs.

From where will they get that physical gold when those sources are depleted?