Gold and the USD

As we have shown in previous blogs, the relationship between the US Dollar and Gold is complex and not quite as simple as it is often described.

The complexity of the relationship can be seen in the following chart, which shows the monthly % change in the Gold price against the monthly % change in the USD effective exchange rate index ranked by decile from 1980–2014. The 1st decile is the 10% of observations where the USD had the largest monthly decline (and vice versa): so, in the decile of largest monthly USD declines the Gold price rose, on average, 3% and in the decile of the largest monthly USD increases the Gold price fell, on average, 1.9%.


The graph shows, on average, that dollar weakness tends to correspond with gold strength but dollar strength doesn’t really hit gold prices until it becomes serious (i.e. out in the 10th percentile). There is no clear symmetry in the relationship between the USD and Gold prices.

With a number of identifiable, and negative, tail risks, including:

  • BREXIT fallout;
  • Extreme US equity overvaluation;
  • Chinese Yuan devaluation risk;
  • Saudi Riyal devaluation risk;
  • US recession and Global deflation risk;
  • Persistent Yen strength and the increasing frailty of the Japanese banking system and;
  • the perilous state of Italian Banks;

we can see many reasons for US Dollar strength.

Whilst modest monthly USD appreciation has little or no impact on Gold, we can see an environment where that “normal” decline in Gold at extremes of USD strength fails to materializes, where Gold and the USD both rally on rising risk aversion.

A stronger USD and rising Gold price will, no doubt, puzzle many investors used to the “normality” shown in the next chart, which shows the frequency with which the Gold price fell within each USD decile: so, for example, in the 10% of months where the USD had its biggest increases the Gold price fell 72.5% of the time and, on average, by 1.9%.


With large USD declines, the Gold price only fell 22.5% of the time.

The breaking of this relationship will, in our view, signal the loss of confidence in the ability of Central Banks to ride to the rescue of an overleveraged, deflationary biased and horribly unbalanced global economy with a crude assertion that all that ails the economy and markets is a lack of liquidity.

Alongside Gold versus USD, we also need to watch the relationship between European Bank stocks and US Treasury yields. Falling European bank stock prices mean just one thing: lower US Treasury yields.


So, look out for a rising Gold price, a stronger USD, falling European bank stocks and declining US Treasury yields simultaneously. It’s one very large canary!

A turn in the credit cycle

This is interesting and worth keeping an eye on: US C&I (Commercial and Industrial) loan delinquencies have started to turn up, signalling the turn in the credit cycle. A rise in delinquencies implies a tightening in bank loan terms with about a one-year lag. We would expect lending to be weakening from here on out …


It also has implications for Equities, of course:

VIX volatility (the volatility index for the implied volatility on the S&P500 equity index, and a generally accepted barometer of market sentiment / risk appetite) tends to follow a similar cycle: volatility tends to increase with a modest lag from delinquencies (hardly surprising that equities dislike tightening credit conditions).


Unsurprisingly, the equity index itself moves with volatility in a lag from credit conditions:


These are just interesting credit developments worth watching, in our opinion.

This fits together with the pressure on European banks, and impending credit contraction, that we have previously highlighted.

And with conditions outside China tightening – Singapore and Hong Kong are prime examples of the credit crunch enveloping S East Asia – it leaves China’s 25% y/y credit growth looking quite anomalous, apart from being entirely unsustainable.


Abe’s warning

Japanese Prime Minister Shinzo Abe warned his counterparts at the G7 meeting in Japan that the world may be facing another “Lehman’s moment” (alluding to severe stresses in the financial system, indicated in his view by the weakness of commodity prices).

Once again, when we thought it would not be possible, Japanese policymakers surprise us with the paucity of their true understanding. It’s not Commodity Prices that worry us – they are simply the manifestation of an underlying process of rebalancing that the Japanese have correctly identified. It’s the perilous state of the Japanese banks and the ongoing damage being inflicted by Japanese monetary policy that is, to us, of most concern.

Mr Abe said, “We agreed on the perception that we are facing serious risks, that the world economy is facing serious risks”.

In that regard, he’s right, but the most worrying point is that Japanese Banks pose a substantial and worsening threat to Global Financial Stability. Here’s the picture:

Firstly, Yen 80 trillion of annual QE by the Bank of Japan (fully 15% of GDP each year) has left the Bank of Japan (BoJ) owning 27% of the outstanding STOCK of Japanese Government Bonds. They were purchased from banks that held them with a nice running “carry” (the difference between the cash rate they paid on their deposits liabilities used to fund them and the yield on the bonds themselves) that has now disappeared. Japanese banks, as a direct consequence of the Bank of Japan, now have approaching 20% of their entire ASSETS in cash and deposits:

Needless to say, those assets earn nothing.

Image 1

Secondly, Japanese licensed banks have 9.6% of their assets in Central Government Bonds – the yield on those bonds is now below the deposit rate paid to new deposits. That’s not good for earnings, when you pay a higher rate out than you get on your investment.

Image 2

Thirdly, the general loan rate for new loans is fast converging on the deposit rate paid to new deposits, and the margin on loans to the real economy is evaporating:

IMage 3

Fourthly, banks are being “squeezed” from one side by the BoJ and “squeezed” on the other side by depositors: the level of cash in circulation in Japan relative to GDP is marching ever higher.

It stands at 18% versus 7% in 1990 and has trended higher continuously in the last 25 years:

Image 4

So, to recap:

  • Japanese banks hold extraordinary levels of non-earning cash on their balance sheets (in fact, the interest rate on the Yen 280 trillion of excess reserves held in the current account at the Bank of Japan is negative)
  • Government bonds yield less than the rate paid to depositors
  • New loan rates are barely above the rate paid to new depositors
  • The economy is becoming increasingly “cash based” – cash / GDP is way beyond international comparison
  • Non-Performing Loans, NPLs, as in China, are being concealed and understated

We’d say the likelihood of a “Lehman’s moment”, as Mr Abe notes, can’t be ignored… But we’d go further and urge Mr Abe to pay closer attention to the destruction of the Japanese Banks being propagated by the Bank of Japan’s QE policy. Any further QE, or a move to increasing negative official rates, just exacerbates the problem. Hopefully Mr Abe showed some charts like these and didn’t overplay the decline in commodity prices.

The Bank of Japan’s monetary policy is sowing the seeds for a systemic Japanese banking crisis – the TSE banks index is down 39% y/y for a reason.

Déjà vu

Last August, and again earlier this year, Chinese devaluation and the threat of a more serious decline in the Yuan (combined with USD strength) sowed the seeds of brief periods of significant drawdown in Global equity markets: the Global Index fell 12% in the month after last August’s trivial devaluation, and almost 14% in the weeks leading up to mid-February, when Yuan devaluation fears again re-surfaced.

Despite net outflows continuing apace through the first quarter – almost matching the entire outflow in the first 11 months of last year – and heavy Central Bank intervention, together with some tightening of controls at the margin, the Yuan actually strengthened in a move (vindictive, some speculators might say!) designed to head off speculative pressures and provide reassurance that all is well in the East. Another $1trillion in loans helped, but that’s neither here nor there in China these days. Move along, nothing to see here…

But we know differently. We know that you simply cannot grow credit $2.5 trillion annually with no corresponding nominal income growth; we know you cannot add capacity where there is already too much capacity; and that you cannot grow bank balance sheets at a rate annually equivalent to 40% of nominal GDP. Not if you want to keep your exchange rate fixed, you can’t.

And that’s where recent developments are interesting, the Chinese officially target the Yuan against the CFETs index – against a basket of 13 currencies (about one quarter USD weighted) and the Yuan has depreciated 1.3% since the end of March (5.9% year to date). From the mid-January low, the Yuan appreciated 2.1% against the USD through the end of March but has depreciated 1.2% versus the USD subsequently. They’ve unwound half the appreciation of the prior weeks.

Quietly, and under the radar, the Chinese have been letting the Yuan slide against the CFETs basket and, probably more importantly for the market, against USD.

Graph 1

This USD strength is seen in the broad USD appreciation in recent weeks: the next chart shows the percentage of currencies in the US effective exchange rate basket that the US has appreciated against in the last 20 days: the USD has appreciated against 80% of the currencies in its own basket.

Graph 2

We are seeing broad USD strength, broad Yuan weakness and, significantly, the Chinese quietly letting the Yuan slide against the USD.

This feels like déjà vu from our standpoint.

The global economy is already at low altitude, the median annual growth rate in our broad national sample is just 1.9% with over half growing less than 2% annually, and appears to be losing speed, again over half have growth slowing. Another round of Yuan/USD weakness into that mix is likely to precipitate just the same reaction as we saw last summer and earlier this year. Perhaps it’s time to seek out that tin hat again…

US Corporate Profits

Corporate profit data made for some really grim reading after the Easter break.

  • Post Tax non-Financial Corporate Sector Profits Down 19% y/y


Why? Employee compensation share in output rising very rapidly now and crushing margins.



  • So, margins and profit growth going exactly as the historical data set would imply:

3-year outlook


5-year outlook


  • Unit profit data confirm the story.


All this from nose-bleed valuation – based upon valuation measures with a strong and consistent historical relationship with forward returns… and with the “China Crisis” still looming.




Bear markets… less bearish

Looking back at the S&P 500 bear markets over the last fifty years or so, an interesting observation springs out of the data:

We looked at the % of up days versus the % of down days in each bull and bear market: the chart shows the difference (% up less % down days).


  1. Each cycle has seen a greater bias towards up days and away from down days (that applies for bull and bear markets).
  2. Bull markets have become increasingly bullish and bear markets decreasingly bearish. So much that, in fact, in the 2007/9 bear market (the biggest since the 1930s) there were “just” 49% down days (versus 47% up days) – a brutal bear market and the market fell less than half the time.
  3. Bear markets with, on balance, fewer down days increase the anxiety and pain of not being in the market, particularly so if the market is flat/up more than it is down.



Just a useful reminder that bear markets increasingly come in “batch form” i.e. with sudden, large declines interspersed with modest gains/stability rather than in a continuous and even process of declines outnumbering gains…. bear markets seem to be progressively less bearish.



Japan responds

As we have noted in our written material several times since the Chinese authorities buckled last August under the weight of enormous domestic capital outflows, when China accounts for approximately 20% of your exports and 25% of your imports you have to respond… and respond the Bank of Japan did. Initially by suggesting the imposition of capital controls in China and now with firm action by a shift to negative interest rates.

The Bank of Japan has set itself the target of 2% inflation – despite QE amounting to 15% of GDP annually that has left them holding 26% of the stock of outstanding Japanese government debt (up from just 7% in early 2013). Japanese core inflation (Inflation excluding food and tax effects) still stands at a meagre 0.1%.

What’s going wrong?

Well, quite simply, that QE doesn’t work in Japan in the way you might argue it works elsewhere.

Here’s the picture:

Firstly, injections of monetary liquidity – through asset purchases – are offset entirely by a decline in the velocity of circulation of money – in short, more money does less, leaving you where you started.


Secondly, the liquidity injected simply ends up in the “current account” at the Bank of Japan – that is to say, banks hold the cash in the form of mountainous reserves at the central bank.

The level of current account deposits at the Bank of Japan stands at a mind-boggling Yen 253 trillion (up 42% y/y) – that is approximately half of GDP.


The Japanese system is incomparably awash with liquidity and one strong product of that has been a sharply weaker yen (the effect on equity prices and subsequent wealth effect on consumption – the transmission channel for QE in the USA – is negligible when Japanese households have just 10% of their assets in equities versus 53% in cash). The channel through which Japanese QE works – and Japanese QE is on a scale that dwarves that in any other country besides China (where state-approved bank balance sheet expansion effectively replicates QE) – is through an explicit policy to drive the yen down and thereby import some inflation whilst giving Japanese exporters a bit of a boost.

However, along come the Chinese in the middle of the largest credit bubble in history and throw a “spanner in the works” with a weaker yuan.

The yen has appreciated approximately 12% against the yuan since last August. That hurts. It hurts a lot and is a substantial headwind for Japanese QE.

The only thing to do, according to the Bank of Japan right now, is make interest rates negative and force that Yen 253 trillion of liquidity out into the economy via bank lending.

Why? Because the appreciation of the yen is pushing inflation the wrong way, if left unchallenged Japan will slip back into core deflation very quickly.

Core inflation responds with about a ten month lag to the exchange rate.


Moreover, the exchange rate impacts the output gap (gap between actual and potential output) and that also drives inflation.

An appreciating exchange rate turns the output gap negative and that pushes down on inflation.


So, easy to see why the Bank of Japan responded. They said it was to encourage banks to lend those reserves, but we know better.

It’s just the first little warning shot in an open currency fight with the Chinese.

With the yuan under severe pressure as a consequence of persistent and ongoing domestic capital flight, and a devaluation of 20%+ extremely likely, it’s just the start. The Bank of Japan will, in due course, be stepping up its bond purchases and pushing rates further into negative territory in a determined – and ultimately successful – effort to drive the yen down sharply.

More fuel to the global deflationary fire.



Severe Stress

We have written at length, and in great detail, over the last nine months about the stresses in the Chinese banking system and the threat to both Chinese and global stability.

As if more proof were needed the following chart, showing the volume of interbank lending in China, illustrates the extent of the pressure on a banking system that is enormously over-extended in an economy that is overleveraged and with extreme overvaluation in equities, real estate, and increasingly, government bonds (10 year government bonds currently yielding less than one percentage point more than US 10 year government bonds).

Yes, in November 2015 (latest data) Chinese interbank lending hit Yuan 8769 billion (or Yuan 8.8 trillion, about $1.4 trillion)


In year on year terms the level of lending has exploded.


Now, interbank lending has typically been a way for Chinese banks to get around PBOC (People’s Bank of China) restrictions on balance sheet growth and leverage (loans can be made via other banks and are off balance sheet and circumvent loan/deposit ratio limits and capital requirements). The PBOC has tried on several occasions to address this loophole in the structure of regulations to little or no effect.

The enormous increase in interbank lending can only mean the following: the banking system is creaking under the strain of capital flight and tightening domestic liquidity conditions and that bad loans must be piling up at an alarming rate.

How should banks respond to this sort of scenario? Well, look at US banks after the subprime crisis. US banks reduced their credit market debt outstanding by approximately $3 trillion between the end of 2008 and the end of 2015. They reduced debt to add approximately $1 trillion in equity. Eminently sensible – swap debt for equity and deleverage.

What have Chinese banks actually done? Well, step forward anyone who wants Chinese bank equity… I don’t see a crowd. So, the Chinese response has been to increase bank leverage (when they are talking about deleveraging the system). Extremely worrying.

Consider that the balance sheet of Chinese depository corporations (“banks”) is $31 trillion, or three times Chinese GDP, and has quadrupled since the global credit crisis began in 2008. There you begin to see just how important Chinese banks are – they have a balance sheet equivalent to 30% of global GDP. Moreover, they are very inefficient lenders. In the last four quarters alone they expanded their balance sheets by $4.3 trillion when Chinese GDP grew just $0.5 trillion… which means just one thing, lots and lots of bad/non-performing loans in the pipeline.

And, for all those who think the Chinese can use their $3.3 trillion in foreign reserves to bail out the banks, perhaps the following information might be helpful. Assuming just 20% of Chinese bank assets are non-performing at peak (and that number is very, very modest by historical Chinese standards) and with a 50% recovery rate, you write off $3 trillion for the banks (0.2 * $31 trillion = $6.2 trillion and 0.5 * $6.2 trillion = $3.1 trillion). A relatively benign credit event cleans out PBOC reserves (assuming there is no further flight). If you think those FX reserves give the PBOC ample firepower to hold up their banking system then you are possibly guilty of wishful thinking and blind optimism.

Keeping to the USD peg, keeping real rates high enough to stem the capital outflow, deleveraging the financial system and keeping the economy motoring? These are impossibly incompatible objectives. Only one way out (as we highlighted many months back) – a significant decline in the Yuan (20% plus) that exports all of China’s problems to Japan and the West in a deflationary tsunami.



Emerging markets… it ain’t growth

The common mantra we hear quite frequently is that investors need to be invested in emerging markets because that’s where the growth is (“emerging middle class”, “growing population”, “emerging consumer”, “sclerotic hopeless developed countries”, “technology take-up” etc.). Sounds pretty reasonable on the surface, so let’s take a look at the responsiveness of absolute and relative emerging market equity returns to absolute and relative GDP growth. If growth matters it should be pretty self-evident in the data.

The first chart shows emerging market local currency equity index returns plotted against nominal GDP growth.

There appears to be no relationship here at all – the R-squared coefficient is zero (for the statistically-minded that means that none of the variance in EME (emerging market equity) returns is explained by emerging market GDP growth. And, yes, there can be alpha with no correlation).


Ah, but perhaps there is a lag, so let’s look at EME returns with a one-year lag to GDP growth.


Again, nothing.

Thomas Huxley’s wonderful quote comes to mind “The great tragedy of Science – the slaying of a beautiful hypothesis by an ugly fact”.

Looks like the variability of EME returns are not well explained by GDP growth at all.

What if we look at the relative performance of EME vs world equities against the relative GDP growth of developing and advanced countries?

Nothing changes. We can say pretty confidently that faster growth in the developing world versus the developed world are of no consequence for relative equity returns.


What if we get more granular and look at individual markets? The following chart looks at the growth versus returns relationship for Brazil over the last fifteen years (constrained by data limitations).

Once again, the story is familiar, it ain’t growth variability driving the Brazilian equity market.


Mix real and nominal variables (not for the purist, admittedly, but let’s do it) or impose lags and the picture doesn’t change at all.

So, the next time “emerging market equity” and “growth” appear together think hard about that relationship (or lack of, in reality).

The case for EME is far more subtle than superior growth = superior returns.

  • The dilution from equity issuance to finance the growth must be considered.
  • The source, scale and cost of capital to and from developing countries must be considered.
  • Valuation and risk premia must be considered.
  • The distribution of the returns to growth between owners of capital and agents for capital (wages, empire building, dividends) must be considered – shareholders are not the only potential beneficiaries from aggregate earnings growth.

Today, the structural unwinding of $6 trillion or more of net capital inflow into the emerging markets in the last cycles is the dominant theme, in our view, and only when that has played out fully would we be confident in investing in emerging markets (by which time valuation and momentum will, hopefully, both be enticing).



A little goes a long way

On the face of it, a 25 basis point (bp) increase in the US federal funds rate (the interest rate at which banks trade their excess reserves) looks pretty benign and inconsequential. Janet Yellen appeared to play down the consequences, but any student of economics knows that a little bit of tightening can go a long way under extreme circumstances.

Unfortunately, these are extreme circumstances and, in combination with liquidity developments outside the US, the US Fed just tightened global liquidity conditions very aggressively.

The first chart shows the relationship between the monetary base (under the control of the Fed: notes and coins + required bank reserves + excess bank reserves) and the short term interest rate.

On the vertical axis is the interest rate and on the horizontal axis something economists call the “liquidity preference”, which is simply the amount of monetary base per unit of GDP (or, in other words, how much “money” supports each dollar of gross domestic product).

  • At very low levels of interest rates the opportunity cost of holding money becomes trivial/near zero and so more money is willingly held.
  • At very high levels of interest rates the opportunity cost of holding money is very punitive so less money is willingly held.

Money moves faster around the economy (works harder) when interest rates are high and more slowly around the economy (works less hard) when interest rates are low.


Where are we now?

Well, unfortunately for the Fed, we are out at the far right of the chart with rates near 0 and liquidity preference at a record 22/23 cents per dollar of GDP.

So what?

Well, as we noted, money works harder when interest rates go up so for the Fed to actually tighten monetary policy they need to remove liquidity (“monetary base”) from the system. Otherwise, paradoxically, by raising rates they will have eased monetary policy (made money work harder).

How much liquidity do they need to remove?

Well, let’s look at the chart. A 25 bp short rate implies liquidity preference (money/GDP) about 30% below the current level, around 16 cents from 22/23 cents per dollar.

Given that excess bank reserves held at the Fed are $2.58 trillion, or 65% of the total monetary base, it would imply that the Fed needs to remove around $800 billion in liquidity from the system.

Note: the relationship between interest rates and liquidity (the size of the Fed’s balance sheet) is non-linear. In short, each successive 25 bp of tightening requires less liquidity removal; the liquidity removal is highly front-loaded (this was noted by former Fed Board member Professor Charles Plosser as far back as 2011). So, the first 25 bp is the hardest, requiring the better part of $1 trillion of liquidity removal. The next 25 bp are a further $200 billion (approximately) and so on.


Indeed, that’s a lot of liquidity taken out of the system. That must have an impact on market liquidity, asset prices and the US dollar.

However, it gets worse. Look at the drawdown in global foreign exchange reserves (essentially, capital leaving the emerging markets).


Emerging markets are losing liquidity at an almost unprecedented rate just at the point where the US Fed is likely to be taking the best part of $1 trillion out of the system – global liquidity conditions are tightening severely.

As always, we will observe and respond as/when/if the Fed follows the path.