Monday, August 27, 2012

China, dollars, gold, and a theory of relativity - FT Alphaville (blog)

While there was a time that the gold price represented a useful expression of investor concerns over currency debasement, that may no longer be the case. So says Simon Derrick from the Bank of New York Mellon, who argued last week that it’s probably time to re-evaluate the signals coming from the bullion market.

As he wrote last Wednesday:

We have noted on a number of occasions the importance of gold as a barometer of investor concerns over currency debasement. This, after all, was the driving force behind the uptrend in gold that defined the 1970s as well as providing the catalyst for the extraordinary rally seen since March 2001. It is therefore noticeable that since last September gold has stopped trending higher. As a result, we need to ask what this might be signalling.

Derrick notes that the change in gold’s performance coincides with Operation Twist: if QE was USD negative, then OT has proved a more neutral force.

Did Operation Twist manage to suppress some of the inflation-paranoia generated by the likes of Ron Paul, Zerohedge, Jim Rogers, Peter Schiff et al, who previously made an explicit point of calling QE “money printing” and “currency debasement”?

Who knows. Even if that’s the case, Derrick observes that something else may also be going on. For one, the stabilisation of the gold price has been accompanied by a general decline in reserve growth â€" a situation that’s been particularly observable in China:

It also seems telling that this stabilisation in the price of gold has coincided with an equally noticeable change in the pattern of reserve growth (as we highlighted on July 17th) in China. Given that a significant driver of reserve growth has been investors reacting negatively to highly accommodative monetary policy settings in the US, it seems reasonable to suggest that this tailing off in inflows could indirectly indicate the first genuine shift in sentiment towards the USD in a decade (2008 was, of course, about rather more negative forces).

It is important to note, however, that the USD is not the only currency that has finally managed to regain its composure (when measured against gold) over the past twelve months. Despite the introduction of another round of QE in the UK, it is noticeable that GBP has remained within a very tight range (possibly reflecting its status as a safe haven away from the Euro-zone) while the JPY has made a number of attempts over the past twelve months to start a strengthening trend.

There’s also the fact that on a day when QE3 hopes were tempered based on some comments by St Louis Fed president James Bullard, gold failed to budge significantly lower (as it might normally have been expected to):

The old logic â€"> [No QE] = [a case against gold] = [a dollar positive situation]… no longer seems applicable.

One interesting thought as to why this is happening comes from Julien Garran of UBS, who observed last week that out of the 12 major mining commodities, all bar gold are now in “official” bear markets â€" with prices down 20 per cent or more from recent peaks.

There’s good reason, he says, to judge this a deflationary signal â€" above all because similar patterns emerged ahead of the Great Depression of the early 1930s and other deflationary periods through history:

Most famously, commodity prices fell sharply early in 1929, well ahead of the Wall Street crash and the Great Depression of the early 1930s. Many of the brightest minds of the generation missed this signal. John Maynard Keynes, for instance, lost his personal fortune speculating at the time, and his father had to bail him out.

The difference this time, of course, is that we are no longer bound to an inflexible and rigid gold standard â€" an important point given that the proximate reason for the Great Depression was the inability of countries to expand credit in line with gold reserves, squeezing global credit growth.

Yet despite the difference, some of the very same dynamics may still be in play, he says. And that’s because the dollar standard in many ways has itself become more rigid â€" and is therefore causing some of the same problems that the inherently rigid gold standard once did.

For one, credit continues to suffer relative to reserves. A scarcity of safe dollar stores-of-value, meanwhile, is beginning to fuel exactly the same type of capital flow reversals to and from emerging markets (such as China) that gold once did during the Depression.

The dilemma now is whether these are localised or broad-based deflation signals. Either way, notes Garran, the renewed focus should be on gold:

The dilemma means that we are at a critical juncture for gold and for the industrial commodities. In a few short months we will work out whether the US economy can stand on its own two feet. The worst nightmare for structural commodity bulls is a resurgent US. But if credit conditions deteriorate and the economy fails, expect a sharp lurch down for industrial commodities, miners and for broader risk assets, followed by a major buying opportunity.

All of which fits neatly with the idea that gold holds no value on its own and that it is only gold’s relative scarcity to the overall amount of dollars in the system that ever makes it desirable. And only for as long as convertibility can be guaranteed.

The dollar relativity theory

Imagine that the number of dollar liabilities circulating through the system is actually akin to a dollar rationing system. At any particular time, there are either enough dollar rations to match the number of goods, services and assets that can be consumed with those dollars in the system exactly, or too many rations, or too few.

When there is a shortage of dollar “rations” (or dollar stores of value) , there is a relative abundance of goods, services and assets. This creates a deflationary effect. When there is an abundance of dollar “rations”, there is on the contrary a shortage of goods, services and assets, creating an inflationary impact instead. The same logic also applied to gold, when it represented the basis of the rationing system that the world used.

While the rationing system can work very effectively when there is an intelligently matched amount of rations to goods and services, it starts to fail when rations misrepresent the goods and services truly available (because someone has over-issued or under-issued rations relative to goods and services).

It’s like having butter, bread and sugar rations over-issued relative to the amount of actual butter, bread and sugar that is out there. In this scenario, the rations lose value as people realise that owning rations doesn’t necessarily guarantee access goods. Conversely, when rations are under issued relative to the amount of butter, bread and sugar â€" the rations themselves gain value and also become much more poorly distributed across society. Since it’s only by owning a ration that you can guarantee access to goods (even if the goods are abundantly available), this scenario translates to a have or have-not society.

The “standard” model

Thus, when it comes to gold and the dollar, at all times it’s the relative supply of the two that matter, and always with respect to the wider availability of goods and services.

If you suppress the growth of dollar rations at a time of general abundance, however â€" the relative advantage of holding gold begins to dwindle. More pertinently, the gold price starts to stabilise, and the two effectively begin to trade in tandem as an implicit gold standard is re-created. While expectations of more dollar rations can still destabilise the relationship in favour of gold, expectations of fewer dollar dollars in the system can have the opposite effect (leading to a preference for dollars) â€" especially if the greater practicality of holding dollars becomes a preference.

You could consider it a battle between gold and the dollar for the title of most respected and useful store of value. In this game the concept of scarcity means everything. Gold is valuable because it is scarce and indestructible. The dollar is valuable because it is scarce and practical. Most importantly the two trade in tandem until one is perceived to be more scarce than the other relative to demand. Yet, as the Great Depression showed, supply rigidity can also be the downfall of a standard-based system.

The base’s inflexibility eventually causes wealth to be squeezed into what can only be described as a poorly partitioned rationing system. It is poorly partitioned because the number of rations remains constant even as the number of goods available in the marketplace changes. So, a bit like offering 10 people in a group of 25 a coupon each to redeem one apple with, when more than 50 apples are collectively available to the group. Even if demand exists for two apples each, a lack of coupons prevents redemption and apples go to waste.

Capital flow reversal

So let’s say that the dollar standard has indeed become more rigid. Does this mean that the gold price could now be telling us something important about capital flow reversals involving holders of major dollar reserve positions?

As an example of what we mean, we’ve taken the following extract from a Ben Bernanke speech on Money, Gold and the Great Depression and amended certain players to reflect what be believe are today’s dynamics (amendments in bold):

The fact that, under the dollar standard, the value of each currency was fixed in terms of dollars implied that the rate of exchange between the two currencies within the dollar standard system was likewise fixed. As with any system of fixed exchange rates, the dollar standard was subject to speculative attack if investors doubted the ability of a country to maintain the value of its currency at the legally specified parity. In September 1931, following a period of financial upheaval in Europe that created concerns about European investments on the Continent, speculators attacked the euro, presenting euros to the ECB and demanding dollars in return. Faced with the heavy demands of speculators for dollars and a widespread loss of confidence in the euro, the ECB quickly depleted its dollar reserves. Unable to continue supporting the dollar at its official value, the ECB was forced to open swap lines with the Fed, allowing the euro to float freely, its value determined by market forces.

With the collapse of the euro, speculators turned their attention to the Chinese yuan, which (given the economic difficulties China was experiencing in the fall of 2012) looked to many to be the next currency in line for devaluation. Central banks as well as private investors converted a substantial quantity of yuan assets to dollars in September and October of 1931, reducing the China’s dollar reserves. The speculative attack on the yuan also helped to create a panic in the Chinese banking system. Fearing imminent devaluation of the yuan, many foreign and domestic depositors withdrew their funds from Chinese banks in order to convert them into dollars or other assets (like gold).


Long-established central banking practice required that the PBoC respond both to the speculative attack on the yuan and to the domestic banking panics. However, the PBoC decided to ignore the plight of the banking system and to focus only on stopping the loss of dollar reserves to protect the yuan. To stabilize the yuan, the PBoC once again raised interest rates sharply, on the view that currency speculators would be less willing to liquidate yuan assets if they could earn a higher rate of return on them. The PBoC’s strategy worked, in that the attack on the yuan subsided and the Chinese commitment to the dollar standard was successfully defended, at least for the moment. However, once again the PBoC had chosen to tighten monetary policy despite the fact that macroeconomic conditionsâ€"including an accelerating decline in output, prices, and the money supplyâ€"seemed to demand policy ease.

(To view the original see here.)

Some of the details are obviously different. The PBoC is not explicitly lifting rates.

But at the same time it is also not cutting them as radically as might be expected. Indeed it is specifically resorting to alternative easing tools â€" like reverse repos â€" because it wants to keep nominal rates as high as possible to avoid negative real returns. Thus, the overall situation is not dissimilar.

The global dollar shortage is largely exposing the PBoC to exactly the same sort of speculative attack on its reserves that the Fed experienced with respect to its gold reserves in the 1930s.

Less QE, meanwhile, only exacerbates China’s dollar shortage problem and its dependence on dollar inflows. Yet because China is doing everything it can to keep within its long-term dollar range (to avoid further outflows) some of the side-effects of these moves may now be leaking into the gold price instead.

In other words, it’s not Fed-induced “dollar debasement” the goldbugs and inflationistas should be fearing but Chinese dollar liquidations and liquidity injections.

Related links:
Propping up the gold price
â€" FT Alphaville
China central bank in gold-buying push - FT
Better the quality collateral you know? - FT Alphaville
Negative interest in cash, or goodbye banknotes - FT Alphaville
Republicans eye return to gold standard - FT

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