A Cold Wind from the East

From the August 17, 2015 HRA Journal: Issue 237

Well, that wasn’t fun.  Gold plunged through $1140 and toyed with $1080 for three weeks before making a small comeback.  You can make a case the drop and the reaction to it being the “capitulation event” we’ve been waiting for but I’m not totally sold on that.   I still want to see that first Fed rate hike next month which  I think is more likely to mark a bottom though the longer gold holds above $1100 the stronger the case for the last plunge being “it”.

China provided the black swan with its Yuan depreciation.  How far that goes remains to be seen.  Beijing is managing the Shanghai market “well” so maybe it has the same luck with the currency. 

For our purposes the important thing is whether the Yuan cut and rate cuts I expect to follow it actually help turn China around. If they do the picture for all metals will improve. The bad news is that will take time and the market for most commodities could still get worse before they get better even if the PBOC pulls the proverbial rabbit out of the hat here. Looks like there are several potential endgames that should resolve themselves in September/ October.  It won’t be boring at least!


Bearish gold traders finally got their wish, with bullion collapsing below $1140 after repeated tests since late 2014.  The one that finally succeeded was a doozy.  A $2.7 billion trade right before Tokyo opened on a Sunday afternoon.  Absolutely the best timing if the intent was to maximize price damage which it clearly was.

As I noted in an SD that went out the night of that attack I don’t see any conspiracy here, just a very large player that was probably short already doubling down to ensure their existing positions would be even more profitable.  With so much gold negative and commodity negative news crossing the wires and the USD strengthening it was a smart trade.  Not nice mind you, but smart.

The question now is where we go from here.   My gut sense is still that the bottom for the commodity complex in general happens near the date of the first Fed rate increase.  I’m still assuming that will be September.  Recent events in the currency markets may have changed things for gold itself.  It may be bottoming now though I think we can’t discount another leg down until we see how gold trades through a Fed rate increase. Bond traders still aren’t positioning for a rate increase in September but everyone else is. 

I’m basing the assumption about a rate increase marking the bottom on sentiment more than anything else. I find it hard to get as worked up as everyone else seems to be about a 25 basis point rate increase from a base of zero.  At a practical level it’s close to meaningless.  Combined with other recent events however it may lead to a change in sentiment for equities.

Bond traders may not be sold on a September rate increase but they have plenty of other things troubling them. The yield curve has been flattening as traders move into longer dated US bonds.  That implies concern by fixed income traders.  They are willing to hold longer maturities for less rate premium which is considered a risk on trade. Everyone has been buying Treasuries and the 10 year yield is back down close to 2% again.

Elsewhere in the bond market, spreads between Treasuries and corporate debt have been rising rapidly in the past few weeks.  Like the shrinking term premium this is a sign of growing stresses in the bond market and a negative view of the economy by bond traders.  

The guys in the (virtual) bond pits are not always right but their track record on macro issues is at least as good as equity traders. It’s definitely better than the algorithmic trading programs and hedge funds that seem to be dominating daily trading volume on New York lately.  I’m no perma-bear but the level of caution being exhibited in the fixed income market gives me pause.   We all know New York is overdue for a correction and September is a popular month for them.

 On the big market equity side of things my largest concern is the worsening market breadth.  This obviously hasn’t had much impact on the major indices which are near all-time highs but it will if it continues.  A number of the sectors that where pushing higher have faltered during this earnings season.  The only market sectors really holding up the S&P right now are Consumer Discretionary and Healthcare.   It’s worked so far but it’s a dangerous set up. 

The two charts above show the trace of Gold and the US Dollar during the past year.  After repeated attempts to push gold through $1080 the bears have backed off for now.   The yellow metal is enjoying a bounce and its coming from an expected source for an unexpected reason.  That brings us to the most important recent news out there; China’s decision to devalue.  It’s equally interesting to note that the US Dollar Index seems to be losing some momentum.  A higher USD is getting blamed for many things including falling commodity prices. The chart on the previous page does not indicate enough strength to account for recent losses in commodity prices.

As most of you know, I was skeptical about China devaluing while it was still trying to get the Yuan included in the IMFs Special Drawing Rights currency basket.  While SDRs don’t have a lot of private commercial use inclusion in SDRs is a vote of confidence that would elevate the Yun to official reserve currency status.

A couple of weeks ago the IMF decided not to add the Yuan at this time, saying it may reconsider in a year or so.  Its main reason is the Yuan is still not a fully convertible free floating currency.  That’s true, but it’s also ironic and I’m thinking Beijing isn’t appreciating the irony much.  The Yuan is indeed not fully convertible but that is being worked on. 

There are financial modernizations needed that will make the Yuan a practical trade currency for broad use inside and outside China. That is coming along but it’s not quite there yet.

Where the irony must come in for China is that the Yuan has been one of the most stable—and strongest—currencies in the world through the last decade. Take a look at the 10 year USD per Yuan chart below.  If China is manipulating its currency for trade advantage it’s doing a spectacularly bad job.

Beijing keeps the Yuan on a floating peg to the USD.  It was keeping the Yuan stable to make a point that it was taking the high road and staying out of the currency wars.

China has been the grown up in the room for quite a while.  The Yuan rose 35% against the USD during the last decade.  When other central banks, especially the US Fed, were using depreciation as a monetary tool during the Great Recession the Yuan was solid as a rock.  When the ECB pushed to depreciate the Euro, Japan sold the Yen and BRIC currencies joined the party the PBOC kept the Yuan stable against the US making Chinese exports much more expensive everywhere else.  It held on while other developed countries gave up their pegs (seen a Swiss Franc chart lately?) even while its own economy was faltering. No longer.

China lowered its “reference rate” two days in a row and indicated it would give traders a freer hand in pricing the Yuan.  The markets are freaking out a bit.  Asian and commodity producer currencies and commodities themselves are getting pasted.  Black swans have been spotted near Wall St.

The endless US election process has started.  US politicians seem to be particularly clueless when it comes to China’s competitiveness and its handling of the Yuan so I thought we should all keep the history lesson above in mind.  Yes, China just let its currency fall but it was the last man standing.  It’s simply doing what the IMF wants by giving the market more say in the currency’s value.  Americans assume the Yuan would rise strongly in an open market but I’m not so sure.  If Shanghai really crashed and China lowers interest rates (which I think it wants to do and what I believe is the real end game for Beijing) the Yuan could fall further.  It looks like the PBOC propped the currency up several times as traders sold.

The US started this mess with it’s original QE program.  While Washington was paying off banker debts and Europe was hiding under the blanket China rolled out a trillion dollar plus spending program on real stuff to keep the world economy from imploding in 2009.  Keep that firmly in mind when US presidential candidates start bleating about Chinese “currency manipulation”.  Which they will.

China has been slowing rapidly and the drop in exports in the last monthly report was a shocker to everyone. Letting the currency depreciate a bit gives Beijing some breathing room.  It doesn’t sound like China really wants a big depreciation but it does want to cut interest rates. 

It’s unknown how much foreign money is sloshing around in Chinese markets but its not a small amount.  Cutting interest rates (they are several percent higher than other G8 countries) could lead to large scale capital outflows. China has massive foreign reserves but doesn’t want to waste them on currency defense. the Yuan could fall further.  What are the outcomes here and how to they impact the resource space? Here are a few:

1) Fears about Chinese growth have been reinforced. Traders got nervous after the Shanghai market started falling and economic readings worsened.  Weak PMI readings and a big fall in exports last month was the last straw.  Fears about China are the main reason commodities have been taking it on the chin.  The yuan devaluation made that worse though it’s worth noting most commodities didn’t follow the Yuan lower on day two.  Unless traders see a reason to believe China ISN’T slowing more rapidly expect pressure on any company or currency considered dependent on China. That is why not only miners got hurt.  Providers of luxury goods and German sedans beloved by China’s nouveau riche got hit just as hard.

2) ASEAN Competitor Countries lives just got harder.   I don’t see a reversal of the recent offshoring trend in Asia. The cheapest low skilled manufacturing jobs are moving to Vietnam, Cambodia, and other low wage neighbors. China is trying to kick start growth and raise living standards. They don’t want those lowest wage jobs back and Chinese workers wouldn’t take them. Even so a larger devaluation will make it harder for low margin Asian manufacturers and may slow the movement of the next level of skilled jobs out of China.  Competitive devaluation, at least in Asia, is a real possibility.

3) China is effectively Exporting Deflation.  Probably true if the Yuan drops enough but I can’t see how any G8 country complains with a straight face.  That is exactly what Japan, the EU and even the US have been doing for years now.  It IS a problem however.  It’s one reason why Yields have dropped in the US.  Fears of a real slowdown in China also has bond traders trimming bets on a September rate hike.  If you accept that Chinese competition has a direct impact on US wages this adds another difficulty for the Fed.  If both inflation and wages gains ease again it’s tough to argue for a rate hike. I agree with Fed governors who want to normalize rates but it just became a more dangerous choice.

Metal prices have been falling for a month as traders weighed the risk of a steeper slowdown in China.  The devaluation just accelerated the trend.   The assumption is that metals priced in USD will become more expensive for Chinese importers who will cut orders.  At the same time, cheaper currencies in producer countries allow miners there to shave margins and sell more cheaply.  A vicious circle is born.

Maybe that is how it all ends but it seems like oversimplification to me.  A lot of commodities are traded as baskets that match ETFs.  Hedge funds and others don’t discriminate much or take individual circumstances into account.  That is why things like copper and grains have traded together when there is no real reason they should.  That is a short term effect that should lessen.

Some of the hardest hit metals and raw materials are ones where China is a large producer itself.  Steel and aluminum come to mind.  For those markets a much cheaper Yuan will hurt.  They are oversupplied and Chinese producers will shave their margins and undercut others.  Iron ore and coal are both in heavy oversupply. Gauging the effects of the devaluation based on commodities like that is pointless.

If the Yuan falls 10-20% it’s going to make metals more expensive in local Chinese prices.  Newsflash—that would simply bring most of them back to prices levels that were the norm for the past few years.  If the Chinese economy really craters metal demand will too but it won’t fall significantly because prices go up ten percent in Yuan terms.  A lot of the current reaction is day traders and hedge funds flipping.  Whatever happens with the Yuan will take time to fully impact.

China isn’t letting the Yuan fall to annoy US politicians.  That’s just a happy side effect.  This is happening so Beijing can try to reflate an economy that has been a source of stability for the past fifteen years.  We should be cheering them on.

Yes, China may see higher exports but I expect phase two of this operation will include interest rate cuts that are justified, not a QE exercise.  A freely floating currency makes it easier to deal with capital outflows that would follow lower rates.  The fact is, most objective observers with no political axe to grind view the Yuan as 10-20% overvalued. Don’t be shocked if it drops.

I don’t expect metal prices to keep tracking the Yuan lower if looser monetary policy helps reflate the Chinese economy.

And what of gold?  Take a look at the charts on page two. The financial press has been uniformly wrong about the direction of both gold and the US Dollar since the Yuan started falling. 

It’s dawning on traders that this episode may worsen deflationary pressures a strong dollar and weak energy prices already threaten.  As we know, the strong dollar is bad for exports and equally bad for repatriated profits of US multinationals. Another risk factor has been added to the equation.  These added risks have some discounting the odds of a September rate cut.  That’s part of the reason the USD hasn’t had a stronger rally.

More risk across several markets and a stable USD helped gold bounce off its lows.   Keep mind how many Chinese consumers own gold.  In Yuan terms gold has done very well in the past few days.  It’s’ “doing its job” as a hedge.  It’s also one of the only assets uncorrelated to equities.

If the new risks injected into the world financial system by a falling Yuan bring on a correction that will help gold too.  I’m still betting on another bottom near the September Fed meeting that could be lower than the recent $1080 floor. Beijing may have brought the bottom forward but let’s see how this plays out.

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