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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. 

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