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China's gold buying spree could reset fundamental price assumptions
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(Kitco News) -
Sky-high demand for gold from both China’s central bank and its citizenry might not be a short-term trend, but may actually be resetting the fundamental price assumptions of the precious metal, according to a number of analysts and market participants.
China’s central bank continues buying
The People’s Bank of China (PBoC) has been buying gold at a torrid pace. According to updated foreign reserve data, China’s central bank bought 29 tonnes of gold in August, lifting year-to-date purchases to 155 tonnes. Last month's data was also the central bank's biggest purchase since December.
Gold is seen as an obvious way to support the value of the national currency, which has been under considerable pressure since COVID-19, and which continues to suffer from the impacts of onshoring and lower global demand for Chinese exports.
Gold is also viewed as the presumed cornerstone asset for the much-ballyhooed BRICS currency, a potential commodity-backed rival to the U.S. dollar, which has been gaining traction as the bloc welcomes major commodity producers into the fold, and which could move from theory to reality at next year’s summit in Russia.
Even if the BRICS currency turns out to be a longer-term project, or is shelved altogether, the more modest goal of bloc members settling international trade in their own national currencies would still require far higher levels of confidence in the value of those currencies than currently exists. Gold’s long history as a stable store of value makes it an ideal foundation for countries’ trust in one another’s fiat.
Chinese consumers get in on the action
But it’s not just the Chinese state that’s shown a voracious appetite for the yellow metal. Recent months have seen China’s domestic gold prices spike well above international spot prices as the country’s wealthy and middle class have clamored to secure the value of their own savings.
The population’s appetite for gold was so great that the PBoC intervened in the market by banning banks from importing gold, which pushed the spread between the spot price of gold in Shanghai and in London to a record $121 per ounce in mid-September.
In an interview with Kitco News, John Reade, chief market strategist at the World Gold Council, said that a perfect storm is brewing in China's gold market. Reade noted that premiums on the SGE vs. Comex futures hit 6.4% on Sept. 14, the highest level he has seen since he started monitoring the gold market.
“It's not the first time we've seen the premium blow up. But it is the first time we've seen the premium blow this high,” he said. “So it probably does show you that there's something different going on.”
Reade said China’s domestic premiums will have an impact on the broader market.
“China is the biggest gold consumer on the planet,” he said. “It's the biggest gold importer; it's the biggest gold refinery; it's the biggest jewelry market, and one of the biggest investment markets. It has the potential to grow.”
“What happens in China doesn't stay in China,” Reade said.
The government began relaxing restrictions on Sept. 15, and domestic prices pulled back from their highs. But the premium has started to climb again. Yesterday morning, Shanghai was charging 5.31% higher for an ounce of gold than the global spot price. By the afternoon’s close, the premium had risen to 5.48%.
With the Chinese real estate market in freefall, youth unemployment skyrocketing, and a deepening trade war with the United States only exacerbating the ongoing global economic slowdown, it’s reasonable to assume that Chinese investors will continue to make the same long-term bet on gold that their own central bank appears to be making.
Paradigm shift for precious metals
When the central bank of the world’s second-largest economy (which also happens to be the biggest BRICS member by far) and the citizens of the world’s second-most populous nation are both on board with gold for the medium to long term, investors may need to update the basic price assumptions that underpin the precious metals market.
A recent Bloomberg article by Eddie Spence and Yvonne Yue Li analyzes the historical relationship between the price of gold and the price of money and shows evidence that this foundational correlation may already have broken down.
In other words, Shanghai might not be the only gold market with an outsized premium.
“Gold is the quintessential ‘anti-dollar’ — a place to turn for those who distrust fiat currency — so it seemed natural that prices would rise in a world of low real interest rates and cheap dollars,” they write. “Or when rates went up, gold, which pays no yield, naturally became less attractive, sending prices tumbling.”
They say this appears to no longer be the case. “As inflation-adjusted rates soared this year to the highest since the financial crisis, bullion has barely blinked,” they write. “Real yields — measured by the 10-year Treasury inflation-protected securities, or TIPS, — jumped again on Thursday to the highest since 2009, while spot gold nudged down a mere 0.5% the same day. The last time real rates were this high, gold was about half the price.”
Spence and Li write that this could represent “a paradigm shift for the precious metal” where the most basic and longstanding calculations of gold’s market value may no longer be applicable and begs the question of whether “a new base” driven by Chinese demand has already been established.
“Our models told us it’s $200 too expensive,” Berenberg portfolio manager Marco Hochst told the reporters, while acknowledging that his own fund continues to hold 7% of its AUM in gold. “In our view the future looks much more attractive for gold.”
This position was reinforced by Chantelle Schieven of Capitalight Research in a recent interview with Kitco News. "Given how strong the U.S. dollar has been and how high bond yields are, gold prices should be $100 to $200 lower,” Schieven said. “The fact that prices are not lower shows just how much demand there is in the marketplace.”
Stuart Allsop of Icon Economics also noted the strong reverse correlation that gold prices have with real bond yields, and said that given where yields are currently, the precious metal should be much cheaper.
“The last time the iShares TIPS Bond ETF (TIP), which tracks the performance of inflation-linked bonds, was at current levels, gold traded at around $1,000/oz,” he wrote. “Even when we add in the impact of inflation over time, gold should still be trading around $1,500/oz based on the performance of TIP.”
While there are different ways of assessing the “fair value” of gold, Spence and Li write that “at their essence, most reflect the basic principles of where bullion is trading compared with real US bond yields and the dollar. Normally money managers would sell the haven metal as the dollar strengthens and the interest paid by other safe assets like bonds and cash rises.”
But fund managers haven’t sold off their gold positions en masse, because they seem to recognize a fundamental shift in the demand dynamics, which has created “the large ‘premium’ to where the models say it should be trading.”
“I get no yield on gold, but I can get yield on cash,” Anthony Saglimbene, chief market strategist at Ameriprise Financial Inc. told the reporters. “In that respect, I’m surprised at how resilient gold has been.”
Gold’s higher floor means new ceiling
Other analysts insist that gold prices are still very much being driven by the traditional relationship to bond yields, but that price has been reset at a higher level, which means the metal also has higher upside potential once yields pull back, the dollar declines, the U.S. economy slows significantly, or some combination of these.
“There has been a level break higher in the nominal gold price,” Macquarie’s Marcus Garvey told Bloomberg. “Once you get the financial flows as a tailwind, I think it makes a decent push higher.”
In a recent interview with Kitco News, Carley Garner, co-founder of the brokerage firm DeCarley Trading, said that gold is positioned to hit new all-time highs when the U.S. dollar's momentum starts to fade.
Garner said she expects the U.S. dollar index to hold resistance below 105 points. Ultimately, she sees the U.S. dollar eventually retesting support at 99 points.
"If we break below that support level, we are probably going back towards the mid-nineties and if that's the case, that's a game changer for gold," she said. "Suddenly, we are not looking at $2,000 gold but new all-time highs."
A breakdown in the U.S. dollar could eventually push gold prices to $2,600 an ounce, she said.
Garner said that one of the reasons why she sees so much potential in gold is because of how resilient it has been in the last few months. While bond yields in the U.S. remain above 4%, gold has held critical support around its 20-day moving average.
A peak in long-term yields would remove another headwind for gold, she said.
"We are basically sitting on the biggest net short in bonds on record and at some point, that is going to unwind itself," Garner said. "This trade will be unwound and that is going to push interest rates lower. When positioning is this extreme, it's just a matter of time."
And Lisa Shalett, Chief Investment Officer at Morgan Stanley Wealth Management, believes that gold’s resilience in the face of the runup in real interest rates means the yellow metal is presenting investors with a buying opportunity.
“Like equities, which have continued to shrug off the negative implications of rising real rates, gold, which moves inversely to real rates and in turn to the U.S. dollar DXY, has remained extremely resilient,” Shalett wrote in a recent note to clients. “Regarding the intermediate outlook, we are buyers of gold on weakness or declines in rates.”
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