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!

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.



China’s problem… easy to see

September 8, 2015

Amidst all the furore around China’s market weakness and market declines, here is China’s problem in a nutshell:

  • China lost $94 billion in Foreign Exchange Reserves in August, taking the decline to $436 billion since June 2004.
  • Foreign Exchange Reserves have fallen 11% from the June 2014 peak level.



  • Global Foreign Exchange Reserves are down 4.9% y/y – the fastest decline since 1982.

Why is this important?

Historically, foreign currency has flowed to China and the PBOC has purchased those currencies (acquiring an asset) to stop the Yuan from appreciating. They exchanged Yuan for the foreign currencies (creating a domestic currency liability). The PBOC’s balance sheet grew with foreign exchange assets and their domestic currency liability counterpart.

Left unchecked, that explosion of domestic currency liabilities into the system fuelled speculation and credit expansion – foreign exchange reserve growth reflected extremely accommodative domestic monetary policy.

Now the whole cycle has gone into reverse.

Capital is flooding out of China as the PBOC exchanges Yuan back into foreign currency for investors to flee.

The decline in foreign exchange assets, therefore, represents a substantial tightening in domestic monetary conditions as the PBOC buys Yuan (reducing the liability on its balance sheet) and hands back Dollars/Euros/Pounds etc. (reducing the assets on its balance sheet). This is why the PBOC has cut rates and cut reserve requirements for banks – they are trying desperately to fight a huge monetary policy tightening.

What more can be done?

Our view remains that meaningful Yuan devaluation over the next few years is the only real solution here for the Chinese, leading to substantial global disinflation/deflation pressure at a time of extremely low starting inflation.

Japan and Germany are particularly vulnerable given their trade overlap, some Asian banking systems (e.g. Singapore and Hong Kong) are particularly vulnerable given their extreme debt growth.