Odd Intermarket Correlations

As noted in our previous missive, we are beginning to feel a bit like the patron saint of lost causes when talking about gold. It feels very counter-intuitive that gold should decline when ever more central banks are embarking on massively inflationary policies. For instance, gold crashed in April four days after Mr. Kuroda announced that massive debasement of the Japanese currency was about to begin. Yesterday, the Australian and South Korean central banks cut their interest rates to extremely low levels – the latter clearly in reaction to the BoJ's new policy. The rate cut in South Korea was the 511th cut in administered interest rates in the world since 2008.


Apparently the market is focused on two major aspects of the Japanese debasement policy: for one thing, it leads to a stronger US dollar – and a stronger dollar is traditionally negative for gold. For another, it has removed much of the anxiety that beset the bond markets of essentially insolvent sovereigns in the euro area. Everybody just assumes that Japan's institutions will now ditch their domestic investments and rush into Italian and Spanish bonds – even though they have not done so just yet. In their eagerness to front-run clumsy and slow Japanese pension funds, investors are now bidding these bonds up willy-nilly. There is therefore – on the surface at least – far less sovereign debt risk than there used to be.

All of this is regarded as negative for gold, hence gold's decline has resumed. However, we believe this interpretation to be extremely short-sighted. In reality, the lack of market pressure increases sovereign risk instead of decreasing it, as the willingness to enact reform has been weakened across the board. As French finance minister Moscovici triumphantly declared last week: “Austerity is dead”. Bond market investors should beware.



Italy,10 yr
Italy's 10 year government bond yield – yields in the euro area's periphery have plunged in expectation of Japanese buying. This is slightly bizarre reasoning, but there it is – click to enlarge.



Gold and Gold Stocks

Here is how the gold market has so far reacted to further decline in the yen and the concomitant surge in the dollar index:



Gold, short term

Gold plunges as the yen retreats further, in the process violating short term support- click to enlarge.



On a daily chart, we can see that a very short term support level has been violated in the process:



Gold, daily
Gold, daily – a short term support level in the 1445 area has been broken- click to enlarge.



However, the question is whether this decline actually makes any sense. We would submit that it does not. It would also appear that gold stocks have become somewhat more resilient to declines in the price of gold, a potentially important signal in our opinion:



HUI and Gold
The HUI is only reluctantly following gold lower over the past two days- click to enlarge.



It should also be pointed out that in the very short term, gold is inter alia moved by the actions of the holders of gold-linked structured notes, a derivative product that has recently produced large losses for its holders. The details on this can be found in this article at Bloomberg.


“Investors in structured notes tied to gold exacerbated the biggest slump in prices since 1980 as they sold the precious metal to contain losses on the securities, according to BNP Paribas SA.


Private banks that bought so-called reverse convertibles risked losing money when the gold price breached predetermined price levels, said Guillaume Picot, the global head of commodity investor sales and structuring at BNP Paribas in Paris.

“It’s hard to determine what was the biggest cause for gold’s decline, but structured products played a part in exacerbating the downward spiral,” said Picot.”


While it is hard to tell to what extent these positions still influence the recent volatility, it should be clear that any moves tied to these derivatives have nothing to do with gold market fundamentals as such – in other words, these securities produce additional 'noise' in the gold market.

As a good friend of ours has pointed out, if one looks at a very long term chart of gold and gold stocks, the current situation could one day well prove in hindsight to have represented an excellent buying opportunity. Certainly the current valuation of gold stocks tells us that one has a very decent 'margin of error' now in holding them.



Gold and gold stocks, long term. Gold has hit a strong support trendline in its recent decline – meanwhile, gold stock valuations are now extremely low. As noted previously, one has to go back to 1942 to find a similar ratio of gold stocks to gold- click to enlarge.



While this is neither here nor there, we also wanted to show the massive surge in Chinese gold imports via Hong Kong. Note that the most recent increase in imports depicted on this chart occurred before the recent decline in the gold price. By all accounts, buying has increased even further after the decline.

The amounts involved are not really all that significant for the gold market, but what this shows is that gold demand in Asia remains very strong. This surge in physical buying may well provide a floor for the gold price.

However, the most important determinant of the gold price remains of course the reservation demand of current gold holders, which can only be inferred from the price action itself and the state of the fundamental drivers of the gold market.



China Gold Imports
Gold imports into China through Hong Kong (chart via CLSA). A massive surge occurred already prior to the recent rout in gold. Since then, buying has reportedly increased even more- click to enlarge.



Currency Moves Influencing Gold Sentiment

We also wanted to briefly show the surge in the dollar index and the concomitant decline in the euro, which has now joined the yen's move lower.



The dollar index soars as both the yen and the euro plummet- click to enlarge.



The euro has come under pressure as well in the short term- click to enlarge.




The recent move lower in gold may have more to do with market structure related influences than anything else. To the extent that it is based on deliberations on the decrease in sovereign debt risk, it is actually not justified in our opinion, as those risks have not really gone away.

Lastly, virtually all the major central banks are now inflating all-out. Thus the most important bullish long term driver of the gold market remains perfectly intact. Of course there is no telling how big the current correction may yet become. However, sentiment in the gold market is so bleak that the downside potential from here on out seems limited.


Charts by: BarCharts, BigCharts, Stockcharts, CLSA 




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6 Responses to “Gold and the Yen”

  • csinvesting:

    Dear Dr. Tenebrarum:
    I don’t quite understand this logic:
    Apparently the market is focused on two major aspects of the Japanese debasement policy: for one thing, it leads to a stronger US dollar – and a stronger dollar is traditionally negative for gold. For another, it has removed much of the anxiety that beset the bond markets of essentially insolvent sovereigns in the euro area.
    Say Y =  1 oz of Gold on May 15 2012 and the supply of gold is constant over a year
    Say X = $1650 per oz of gold in US on May 12 but the supply of dollars doubles in one year to 2x
    While the  basket of non-US currencies exchanges into one dollar at Z on May 12 2012, but icreases in one year by 4z
    So the dollar’s exchange rate has doubled vs non-US currencies while the gold//US dollar ratio has halved in one year.
    The dollar depreciating LESS than foreign currencies–how does that effect the dollar/gold ratio?   Are you talking perception or reality. 
    Forest Gump doesn’t get it.

    • SavvyGuy:

      In market pricing, everything is relative. Furthermore, gold is and has been one of the most fungible commodities worldwide over millennia. Per your example, with foreign currencies expanding their money supply 4x while the US$ was being expanded only 2x, this causes gold to become twice as expensive for foreign buyers in foreign countries as compared to US pricing in US$.
      This way, even though the supply of US$ has doubled in your example, the US$ price of gold will fall because foreign buyers are being priced out of buying gold in their local currencies at a faster rate (4x/2x=2x) than in the US.

  • JasonEmery:

    “However, the question is whether this decline actually makes any sense”
    It doesn’t make sense to me.  What makes even less sense is why the intraday range of the gold price is so large.  Yesterday’s (friday’s) $40 range was a whopper, but the intraday moves have been exaggerated, during and since the crash.  What is particularly odd is the size of the candlesticks over the last 12 trading sessions.  Gold has gone sideways and yet the oversized intra day moves persist.  Why is so much intra day space needed to keep the the price in one place.  (hint: that’s a rhetorical question, lol)

    • SavvyGuy:

      IMHO, the gold market has sensed that the long-term decline in interest rates since the early 1980’s is getting close to bottoming out and reversing to the upside. Big gold holders are looking to get out before gold prices fall any further. On the other side, buyers sense that the Fed may actively allow inflation to take hold before raising short-term rates. This is probably why we’re seeing unusual volatility.

      • worldend666:

        A rise in interest rates doesn’t necessarily signal strength in the economy this time round. It will severely hamper the US government’s ability to pay down their debt. This is the moment the gold bugs have been waiting 15+ years for. A rise in interest rates in a high debt environment would be a gold buy signal for me.

        • JasonEmery:

          worldend666 SavvyGuy
          “A rise in interest rates doesn’t necessarily signal strength in the economy this time round.”  Correct.  Actually, interest rates appear to be range bound near a 30-year low, not rising.  But even if this latest bounce results in a few higher highs and higher lows, it doesn’t appear that wage pressures are driving it.

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