Why You Need to Watch Yen and Gold

gold money

As far as starts to the year go, it’s never been worse. The Financial Review writes that this is the poorest start to the year for Aussie stocks on record.

And today won’t be any better. The ASX is set for more falls after another torrid session in overnight markets. European stocks finished down around 2% and in late trade in the US, stocks were down more than 2%.

Oil was down again, while copper lost more than 3%. Gold was the standout again, rising US$15 an ounce or around 1.4%. When there’s global currency turmoil, gold is a currency, not a commodity. That’s why you see the performance of gold diverge from the rest of the commodity complex right now.

Why all the carnage?

It’s the same story as yesterday, only worse. China is losing control of its currency devaluation. In the process, it has unleashed a deflationary storm.

The People’s Bank of China (PBoC) lowered the reference rate for the yuan versus the US dollar to the lowest point since last August (a move of 0.5%). And after this the Chinese market tanked immediately at the open.

Within 29 minutes, stocks plunged 7% (again) and the market wide trading halt kicked in (again). The problem for China is that it has a lot of ‘hot’ money nervously pacing around its economy. And with each decline in the exchange rate, a chunk of this hot money can’t take the strain anymore, so it flees.

Think of it as one giant margin call against China. As China tries to devalue in an orderly fashion, speculators make it hard by rushing in to take advantage of the trade. This causes an orderly devaluation to become disorderly.

Legendary investor George Soros thinks this could develop into a major crisis. From Bloomberg:

Global markets are facing a crisis and investors need to be very cautious, billionaire George Soros told an economic forum in Sri Lanka on Thursday.

China is struggling to find a new growth model and its currency devaluation is transferring problems to the rest of the world, Soros said in Colombo. A return to positive interest rates is a challenge for the developing world, he said, adding that the current environment has similarities to 2008.

‘“China has a major adjustment problem,” Soros said. “I would say it amounts to a crisis. When I look at the financial markets there is a serious challenge which reminds me of the crisis we had in 2008.”

One major difference between now and 2008 is that it doesn’t involve the global property market. Not yet anyway. Given bank balance sheets are mostly capitalised with property, or land, it suggests a banking crisis is not likely.

But given the complexity of the situation, who can be sure?

Let me attempt to explain what I think is happening in China and why you need to be cautious…

For years, ‘hot’, or speculative money flowed into China. It came via cheap US dollar loans (or using commodities as collateral) and amounted to leveraged bets on a slowly appreciating yuan versus the US dollar. No one knows how much hot money flowed in, but it represented a decent amount of China’s at one point US$4 trillion foreign exchange pile.

Now that pile is shrinking as the money escapes, and flows back to where it came from. This is an important point. Firstly, it represents a tightening of credit in China. That’s not good for an economy struggling for growth right now.

And when I say money ‘flows back to where it came from’, I mean flows back to the bank or institution that made the loan. When you repay a loan, the money effectively disappears.

In the same way that new loans create demand in an economy, the repayment of outstanding loans extinguishes demand. As far as I can work out, this is what’s causing big falls across stock and commodity markets.

That is, as leveraged bets on the yuan unwind (meaning debts are repaid) demand for ‘risk assets’ (stocks, commodities, high yield debt) falls, and so the price for these assets falls too.

As evidence of the hot money escaping China, yesterday the PBoC reported a larger than expected drop in foreign exchange reserves of US$108 billion during December. Keep in mind the carnage didn’t kick off until the New Year so you can bet that this outflow will pick up pace in January.

The question is how long will this go on for? Certainly, markets can’t sustain the pace of the past few days for much longer. Calm will be restored. But no one will be certain whether the selling is over for good.

More importantly, investors are quickly losing confidence that authorities have the situation under control. The post-2008 market recovery was in large part built on confidence in global policymakers. It was especially built on confidence in China’s policymakers. That is now waning.

This is partly the reason why you’re seeing gold come back into play as a safe haven currency. Have a look at the chart below. It shows the Japanese yen versus the Aussie dollar (red line) and gold priced in Aussie dollars (black line).

Source: StockCharts

[click to open in new window]

As you can see, there is a tight correlation between the two. The spike in early 2016 tells you that getting your cash out of Aussie dollars and in to yen and gold is a good way to diversify the risk emanating out of China.

It will be interesting to see whether these trends persist. Sure, you’ll see a pullback soon enough. But if the yen and gold breach the highs of 2015 (made just after the prior yuan devaluation) then it’s a sign of increasing global risk aversion.

Along with many other indicators, gold and yen (priced in Aussie dollars) will be important markets to watch in the months ahead.

Greg Canavan,

For The Daily Reckoning

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Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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