Contributed Commentaries
The Mystery of Gold and the Chinese Yuan
Kitco Commentaries | Opinions, Ideas and Markets Talk
Featuring views and opinions written by market professionals, not staff journalists.
Eureka Café and Saloon, Eureka, Nevada
As the yuan goes, so goes gold…or is it the other way around?
July 30, 2018
The Eureka Café and Saloon holds many mysteries, some say its second floor is haunted. A team from the popular television series Ghost Adventures came to Eureka, Nevada to investigate that claim last year. Once a thriving lead-silver boom town in the 1880s, Eureka is in the heart of Northern Nevada’s gold country. The Café, now closed, was once run by Chinese descendants of laborers from the early mining days. Underneath the floors of the re-opened saloon are caverns for cold storage and opium dens of yore. A few more ghosts reportedly lie beneath the old brick supporting arches of these underground vaults. A good pick for summer reruns, I won’t reveal the findings of the modern-day ghost busters but the crew is welcome back to solve a new mystery involving gold and the Chinese.
Chinese yuan on a losing streak
China’s currency, the yuan (CNY) or RMB, has been heading down the mineshaft since mid-April, the longest fall since a shock devaluation in 2015. Figure 1 is a one-year plot of USD/CNY, a rising curve denotes a weakening yuan (i.e. one U.S dollar buys more RMB).
Figure 1 – Chinese yuan reacts to trade & slowing economic data
The dramatic weakening began shortly after U.S./China tariff threats escalated in late March. The move from its strongest level on March 26 to Friday’s close at 6.8096 USD/CNY represents an 8.5% loss in value.
The People’s Bank of China’s (PBOC) has currency devaluation is their tool box to combat U.S. trade retaliation since it blunts the impact of tariffs by favoring China’s exporters. However, some of the currency weakness may also reflect weakening economic numbers coming from the Asian powerhouse. Whatever the reasons, the yuan shows no sign of slowing its descent.
A stunning correlation with Comex gold
A month ago, I noticed a very tight correlation between the yuan and Comex gold futures – both bearishly losing value since April. Table 1 compares rolling correlations for the two on June 26 and July 27 with three time bases for each date.
Table 1 – Rolling correlations of the yuan and Comex gold
The data are notable: 1) high correlation magnitude between a non-U.S. dollar currency and a precious metal (5 out of 6 > 0.9), 2) correlations persist over different time bases, and 3) highly correlative behavior remains intact for dates one month apart.
Table 1 strongly suggests modeling Comex gold as a function of the Chinese currency. I performed a 3-month linear regression on the data developing weekly models from late-April to the present. Figure 2 shows the latest model compared with actual Comex gold futures (most active contract).
Figure 2 – Gold model as a function of the yuan
The blue line model over a 3-month period (denoted by shaded boxes in Figures 1 and 2) tracks Comex gold quite closely with a statistical error of only $7.67 per ounce (1-sigma). The dotted blue lines show upper and lower model boundaries (+/- 2-sigma). Importantly, all the gold futures data falls within these bounds.
“R-squared” is a goodness-of-fit statistical measure used to evaluate the performance of linear regression. In market analysis, a model having an R-squared between 0.85 and 1.0 is typically accepted as “useful” or one that reasonably explains price movements of one security given another (note of caution: there may be better models than linear regression, R-squared does not measure the goodness of different models).
Figure 2 is a plot of R-squared for three gold regression models based on the Chinese yuan, euro and the Japanese yen. Each data point represents a new 3-month model computed for the indicated date.
Figure 2 – Gold model R-squared comparison in three currencies
The gold model based on the yuan achieved “useful” status June 22 and demonstrates steady improvement to date with an R-squared of 0.94 for the latest data. Models based on the yen and euro fall short of this criterion over the entire period.
What can the model tell about future gold prices?
As long as the present gold/yuan correlation holds, the latest model is useful for computing an expected value and range for gold prices for different currency levels as shown in Table 2.
Table 2 - Comex gold futures given USD/CNY levels
As noted above, no Comex gold price has exceeded the 2-sigma boundaries of the current model in the last three months. If the yuan remains near the 6.80 UDS/CNY-level next week, Table 2 implies gold prices will not rise above $1,235 per ounce. If, however, the yuan weakens further to 6.85 then the cap drops to $1,225. For either case, the lower bounds suggest a retest of July 19th low ($1,210.7) is not out of the question.
Chicken or egg?
The China gold/yuan conundrum is a good one - chicken or egg? Are the Chinese somehow influencing gold markets to follow their currency decline or is the daily PBOC fixing tracking the price of gold? The former seems highly unlikely; the latter, an intriguing possibility.
Gold is facing the headwinds of higher interest rates and tame inflation in the U.S. ?This and strong economic data have dramatically strengthened the U.S. dollar. In addition, speculators’ gold-futures short positions are at near all-time highs. These factors are driving short-term gold prices lower, not the Chinese. In fact, China and Russia continue to create demand by slowly adding to their gold reserves, a long-term tailwind for the yellow metal.
The PBOC remembers the capital flight and market chaos caused by the abrupt 2015 currency devaluation. The Chinese central bank may be calculating that a gold-based "soft" devaluation is the best way to minimize capital leaving the country while delivering an effective trade war counter punch. If the daily PBOC fixing is tracking gold price in U.S. dollars, holders of gold in China won't see gold wealth erosion in their native currency. For example, $1,250 gold at 6.6 USD/CNY is the same value as $1,220 gold at 6.8 USD/CNY.
The present situation favors Chinese holders of gold with a degree of wealth protection. The long play for China are higher gold prices and a stronger currency as the U.S. dollar eventually weakens. As the world's leading producer of gold, it makes some sense to entertain a de facto gold standard for their currency to disassociate from the U.S. dollar.
Correlations come and go in markets - it may take a new episode of Ghost Adventures to completely unravel the current gold/yuan mystery.
