The Mystery of Gold and the Chinese Yuan (Part II)
Kitco Commentaries | Opinions, Ideas and Markets Talk
Featuring views and opinions written by market professionals, not staff journalists.
Croesus Mine double-drum air hoist, Eureka, Nevada
Throw a dash of yen & euro into the golden stir fry
August 13, 2018
My July 30 Kitco Commentary explored the curious relation of Comex gold prices and the falling Chinese yuan. Since mid-April, the yuan (CNY) or RMB, has been heading down the mineshaft - the longest fall since a shock devaluation in 2015. Gold has been in the same shaft briefly exploring lower levels just above $1,200 per ounce. The stunning correlation between the two suggests a model of gold price based on the yuan can be helpful in determining near-term bottom and tops for the lustrous metal. The July column derived such a model. The meander of the Comex December contract has remained within those model predictions to date – so far so good. Can we make the model even better? If so, are we near a bottom or is there more pain ahead?
Chinese yuan takes a pause
Figure 1 is an updated 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 pauses near the 6.85 USD/CNY level
The yuan took a pause in its dramatic ascent given last week’s price action. The RMB hovered around the 6.85 USD/CNY-level; in late July it was 6.80. However, Monday morning shows the RMB at 6.88 – we may be off to the races again.
There is a slight weakening in the short- and near-term yuan correlations with Comex gold futures. Table 1 compares rolling correlations for the two on June 26, July 27 and August 10 with three time bases for each date.
Table 1 – Rolling correlations of Chinese yuan and Comex gold
Can the unexplained variance of the former model, albeit small, be reduced further by adding in more currencies? The answer is yes. This is important because Table 1 suggests the model error increases with weakening frontend correlations.
Figure 2 shows a 3-currency model compared with actual Comex gold futures (most active contract). The added currencies are the Japenese yen (USD/JPY) and euro (EUR/USD):
Figure 2 – Gold model as a function of the yuan, yen & euro
The new 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 $5.66 per ounce (1-sigma) compared to $7.31 per ounce for the single-currency model. The dotted blue lines show upper and lower model boundaries (+/- 2-sigma). Importantly, all the gold futures data fall within these bounds.
In the July commentary, a goodness-of-fit statistical measure or “R-squared” was used to evaluate the performance of the regression model. 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.
Figure 3 is a plot of R-squared for four gold regression models based on the Chinese yuan, Japanese yen and euro separately and then all together. Each data point represents a new 3-month model computed for the indicated date.
Figure 3 – Gold model R-squared comparison for three currencies, four models
The gold model based on the yuan achieved “useful” status June 22 and continues to demonstrate steady improvement to date with an R-squared of 0.95 for the latest data. Models based on the yen and euro individually fall short of this criterion over the entire period. The new 3-currency model became useful earlier (June 15) and has steadily outperformed the other three with an R-squared of 0.97 by Friday’s close.
Looking inside the 3-currency model it is apparent that the yuan remains the primary driver of modeled gold price followed by the yen and, to a much lesser extent, the euro. Table 2 shows the gold price sensitivity given a 1% change in each of the constituent currencies.
Table 2 - Comex gold price sensitivity to a 1% change in currency levels
What does the new model tell about future gold prices?
As noted above, no Comex gold price has exceeded the 2-sigma boundaries of the 3-currency model in the past three months. If the three currencies stay near Friday’s closing levels, gold prices are bounded below by $1,204 and above by $1,227 for the near term. This is a slightly tighter range than the older gold/yuan model with an updated range of $1,201 to $1,230. Reassuringly, both models produce similar expected values ($1,215.3 for yuan only; $1,215.7 for all three). This morning’s RMB bump to just below the 6.90-level puts further pressure on the lower range.
By the sensitivities shown in Table 2, the 3-currency model offers some interesting “what ifs.” Accordingly, a 1% weakening of the yuan from Friday (roughly 6.90 USD/CNY) suggests the expected value could fall perilously close to the key $1,200-level ($1,206) assuming the other currencies remain near current levels. A further weakening of the euro has the least impact on gold price. A 1% change produces a drop to only $1,212 given the same assumptions.
More pain or near a bottom?
Kitco News’ Allen Sykora shared my most recent thoughts in his Weekly Gold Survey:
“Gold finds itself just another embattled currency as the Turkish lira and Russian ruble tumble,” he said. “It has not demonstrated its usual safe-haven appeal as financial distress spreads in emerging-market economies. However, as the U.S. dollar index scores a level not seen since June of last year, the yellow metal has shown resilience around $1,220 level for most of August with only a few brief but scary dips.”
The euro and yen are major components of the traditional U.S. Dollar Index (DXY); the Chinese yuan, Russian ruble and Turkish lira are not. There is no question that the recent ascendancy of the U.S. dollar has put pressure on dollarized commodities including gold. Table 2 suggests the primary driver lies outside major currencies.
In the July commentary, I posited the People’s Bank of China (PBOC) may be allowing their currency to fall in lock-step with gold to counterpunch U.S. imposed tariffs without triggering capital flight. China is a top global gold buyer and so are its citizens – although U.S. dollar gold prices are in decline, gold in yuan terms is relatively flat.
With some softness in the frontend correlations of Table 1, this trend may soon change. Correlations come and go in markets. Some believe the latest Commitments of Traders (COT) report points to a bullish reversal for gold even as emerging market currencies tumble.
The 3-currency model is a useful tool to determine if the yuan abdicates its lead role to say the yen – the sensitivities will change even if strong R-squared performance carries on.
If the improved model sustains as is, we may need to repair the hoist in the headline photograph to pull gold out of the currency mineshaft.
Richard P. Baker is the author and editor of The Eureka Miner’s Market Report at eurekaminer.blogspot.com. He owns shares of the SPDR Gold Trust ETF (GLD) and PowerShares DB US Dollar Bullish ETF (UUP).