How big will the gold crash be?

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From Macquarie:

 Gold might be on course for its second-worst quarterly performance since 1982, but it remains well above last year’s price low, despite a stronger dollar, high bond yields and ominous signs physical demand is hamstrung. So we ask – why is it so high?

 That real yields are still lower, combined with a higher level of overall investment (perhaps focusing on non-US factors) seems the most plausible explanation. Real yields retreated on Friday, but investors continue to sell, and if that is the explanation then there is a risk of further losses in the very near term, even if the external environment is unchanged.

 Gold might be on course for its second-worst quarterly performance since 1982, but it remains well above last year’s price lows, despite a stronger dollar, high yields and ominous signs physical demand is hamstrung. So we ask – why is it so high?

 Gold on Wednesday/Thursday plunged in the wake of a hawkish Fed policy meeting, with the US central bank not only raising interest rates but signalling a faster pace of rate hikes in 2017. If it stays around this level its quarterly performance will be roughly a 15% loss – the second poorest (after 2Q13) quarterly performance since 1982.

 But things could be worse. After all its London settlement price yesterday of $1,127/oz is still $78/oz, or 7%, higher than the low of $1,049/oz seen almost exactly a year ago on 17 December1 , when gold also fell in anticipation of a Fed hiking cycle.

 One thing that could explain this would be a weaker US dollar. If that was the case then gold might be lower in key currencies of consumers, helping demand, or producers, curbing supply. But by and large the US dollar is stronger against other world currencies. It is stronger against the commonly followed DXY basket, by 4%, and while that is perhaps a misleading comparison given the sickly British pound is a large part of that index, it is up 2% against the Indian rupee, 4% against the euro and 7% against the Chinese yuan. This means in key consuming currencies the gold price is even higher relative to last year’s low (Fig 2) – in CNY it is 15% higher.

 There are some currencies that have strengthened against the dollar over this period, and as such the gold price has done worse – quite often key producer currencies, although only in South African rand (ZAR) is the gold price actually lower YoY. This might be keeping supply constrained and, hence, the gold price firmer, but it seems unlikely given the time lags involved and the limited impact production volumes have on the gold price to start with. The Japanese yen (JPY) gold price stands out for its stability, testament to the fact the yen and gold tend to move closely together.

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If it is not the dollar that is keeping gold up, another possibility is low yields, the other financial market metric that is closely correlated to the gold price. As Fig 3 shows, the 10yr US Treasury yield has, however, soared far higher than it was last year (it is in fact the highest it has been since mid-2014). Our calculated global 10yr yield, which weights the issuance of 10yr bonds by the four large European economies, the United States, Japan and China, is less rampant, unsurprisingly, given both the Bank of Japan and ECB remain strong buyers of bonds, but is still as high as it was this time last year (Fig 4).

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 The yields which have not yet reached last year’s level, however, are the real yields as measured by Treasury Inflation Protected Securities (TIPs). These have increased significantly in recent weeks and even days – closing 15 December at 0.70%, up from 0% at the end of 3Q, marking their third-biggest quarterly increase since 2000. But they remain below the peak seen this time last year of 0.84%.

 Another way of measuring real yields is to deflate the 10yr nominal yield by the CPI. This gives mixed messages. Using the headline CPI (blue in Fig 6) real yields remain far below last year’s levels because inflation has risen on higher oil prices; using the core CPI, which excludes such volatile readings, it is back to last year’s levels (though not as high as in mid-2015, suggesting this measure does not correlate to the gold price that well).  In short, though, still-lower real yields, perhaps driven by higher inflation, could help explain at least partially why gold is higher YoY.

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 Turning to gold market specifics, if we look at physically backed ETF demand we see that the selloff this 4Q has been much more severe than last 4Q, with 175t having been liquidated so far compared with just 60t last year. But then again we know the price decline has been much more severe this year; it is the level that is higher. And the level of gold ETF holdings (Fig 8) remains far higher than that seen in 2015.

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 It is hard to know whether this is bearish or bullish. A much larger stock of gold ETF investment implies much more potential for outflows, and as of Thursday there has been no sign these are slowing (indeed given the lag in reporting it is likely outflows in the next few days will be higher post the Fed meeting). But it could also mean investors remain more committed to the market, perhaps reflecting a fear of future inflation or heightened geopolitical risks.

 What is definitely bearish is the current capacity of the physical end markets to absorb new mine supply/investor selling, with the two giants of India and China both not operating at full steam, although for different reasons.

 The biggest concern is India. Their gold imports have been low all year, and though they showed signs of recovery in October, the recent demonetization has changed things. Initially it led to a large spike in imports, as people swapped soon-to-be-scrapped banknotes for gold, but this soon subsided, partly because of government intervention, and attention has now turned to the potential for much lower imports in the next few months on a shortage of cash, especially affecting unofficial imports, combined with plentiful supply already in the country. That Indian import desire is low, rather than it being frustrated, is shown by the Indian gold price being in line with the international price (Fig 9).

 In China gold imports have been reasonable during 2016, indeed perhaps too reasonable given press reports suggest in November/December the Chinese government has reduced available import licences. The reasons for this can only be debated, with the focus on attempts to reduce capital outflows (but we note that there have been issues with import quotas at year-end before). Importantly, in contrast to India desired demand does not seem weaker, as the premium of the Chinese price over the international price this week hit its highest in three years at more than $40/oz (Fig 9), despite the significant stocks that have been built up within the country in recent years.

 Regardless of the reasons, the short-term impact of either is hardly positive. Fig 10 shows that typically when ETF outflows (shown as positive in the chart) have been high, Chinese/Indian imports have risen. This is not surprising – the gold has to go somewhere, and therefore the gold price falls to encourage buyers. In late-2016 imports were particularly high, cushioning the impact of ETF outflows, but while this year they had begun to rise, especially in November (we are still waiting for Chinese import data), December’s were likely to have been much lower. At a time when ETF outflows are high it is unsurprising therefore that the price has fallen.

 That said, it adds to the puzzle that the gold price is still higher than last year. Indeed, of the main metrics we use to ‘value’ the gold price, only lower real yields really justifies it, and then only to an extent. A larger stock of ETF investment (and indeed futures positioning) than last year surely plays a role and can be justified if investors are focusing on things other than US yields and the dollar, eg, higher global risk or future inflation prospects. But it also means gold remains vulnerable, as the year draws to a close, of further losses, even if the external environment does not change for the worse.

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My own take is much more simple. Gold is still high because fiat current skepticism is still high. And it will likely remains so with the euro in danger of disintegration over the next few years.

Having said that, the most important valuation driver for gold by some distance is the USD. Given I see a bull market to $1.10 on the DXY and possibly a blow off top even higher as the business cycle ends, I can see gold going much lower yet, unless the euro really does start to fall apart.

Thus gold today should be positioned in your portfolio as an insurance policy against a long tail forex meltdown. If you’re in it to profit a shorter term gain then sell the next rally.

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About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.