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Global Outlook

China Policy Key For Dollar And Gold

January 21, 2014, Tuesday, 18:20 GMT | 13:20 EST | 22:50 IST | 01:20 SGT
Contributed by eResearch


The current U.S. debt situation is rattling financial markets around the globe with the prospects of higher interest rates in the near future. Chinese officials in particular are concerned about their foreign reserves worth $3.5 trillion, with roughly $1.2 trillion invested in U.S. government debt. The failure of the debt ceiling debate back in October and the consequent downgrade by Standard and Poor's have heightened China's fears regarding the U.S. and its current monetary policy.
 
On January 3, 2014 the 10-Year Treasury note futures contract closed at a 3.01% yield, above the 3% level for the first trading week of the year. This is a major milestone for short-term rates. The weekly chart clearly shows a major bottom has taken place from the lows of 1.43% yield made back in July 23, of 2012. After a successful test of the 200-day moving average (MA) of 2.51% yield on October 21, 2013, the yield has risen to the highs made the last week of 2013 at the 3.04% level. With the yield trading above the 50 and 200 MA, it supports the uptrend to challenge the previous yield of 3.50 - 4.00% made in 2011. This is a major shift to higher interest rates in a relatively short period of time and could have serious repercussions for the U.S. dollar, the global economy and precious metals.
 
In my most recent interview with billionaire Eric Sprott (Chairman, CEO & Portfolio Manager of Sprott Asset Management Group), I asked if the shift in short-term rates are putting pressure on the long end of the bond market (30 year), or is it in the short-end of the yield curve? He remarked:
 
“It's not going to handle it well because literally the Fed is buying the biggest part of all those long issues and if they step away from the market then obviously the rates will go higher and we've already seen many countries, most notably China, saying we have no interest in increasing our foreign exchange reserves, i.e. buying foreign paper. As you know the Chinese essentially have stepped out of the U.S. market when they used to buy a huge percent of all bond issues. Therefore I think the Fed had to come in and buy the bonds the minute that China stepped away from the market. So if they decrease their buying it's highly likely we'll see much higher interest rates here.”
 
 
Will China move away from the U.S. dollar as the world's reserve currency?
 
With the tides in U.S. interest rates changing, China is focusing closer at the risks and consequences this could bring to the global economies. What really matters is what China does next, says Simon Derrick, BNY Mellon's Chief Currency Strategist.
 
“Whilst clearly they would hope that the United States will deal with the fiscal story in a sensible fashion, the only way they can ultimately break away from the cycle of having to lend money back to the United States is to liberalize their currency policy.”
 
China has been moving towards the liberalization of its currency policy for the past few years. Simon believes they will issue a plan in that direction by the end of this year.
 
“Or at least a dirty float for the currency, probably some point between 2015 and 2016.”
 
The net effect would be dollar bearish as the almighty dollar will probably will not get much support from other currencies when China's liberalization occurs and, consequently, create a tremendous amount of pressure on U.S. bonds with the possibility of demanding much higher rates on its sovereign debt. Sprott continued:
 
“It would be negative for the dollar but the best thing that ever happened to the dollar was the Euro, the Yen, and the Pound. The dollar is under a lot of pressure right now. Some people think that the Euro is in better shape because they have not been as active in their own bond market, for example, to what the Japanese and the U.S. have done. Obviously in the long run when you print money and have zero interest rate as a policy, then your currency will depreciate. I begin most of my presentations by essentially saying that the U.S. in insolvent, which is the easiest thing in the world to prove. So I have absolutely no interest in owning U.S. dollars unless it is absolutely necessary and I would encourage most people not to want to own any fiat currencies because of all the printing that's going on and we all know where it's going to lead. We are all just trying to string it out and we will all be able to get out before something really happens but the fact that you know something will happen is the thing that you should protect against. So I think it is all very dollar bearish.”
 
 
How would the rise in interest rate eminently affect the price of gold and silver?
 
“You know most people would suggest the high interest rates are negative for gold and silver because it is sort of the knee jerk response. One of the reasons why I love gold and silver is because in my mind there's tremendous stress on government and the banking system and a rise in rates causes paper assets to depreciate, the bonds depreciate, and it likely the stocks would depreciate.”
 
“When you realize the leverage in the banking system when you are levering 20 or 30 to 1, and so in the 30 to 1 situation, if there is a decline of 3 percent in the assets there is no capital left. That of course was the problem of the financial system back in '08 which had to be bailed out by the various central banks at the time. So it would just bring on stress in the banking system faster than it might otherwise bring on and the stress is going to happen anyway, because they are too levered and never should have got in that position in my mind as sort of an accountant looking at how levered these bank statements are. They never should have been allowed and when people finally figure out that people shouldn't have their money in a bank, which has taken people a long time to figure out, but we saw what happened in Cyprus when the depositors lost money. We see the ECB working on what they call a banking resolution which is really a new bail-in situation where the depositors would be included in the bail-in if a "too big to fail bank" failed.”
 
“You have to know that certain banks in Europe in the weaker countries the deposits must be leaving, it would be foolish to leave them there and yet the assets are all deteriorating in the sense that if I were to use what's the value of a Spanish mortgage today versus 5 years ago or what's the value of a Spanish loan to a commercial enterprise knowing what's going on in these countries that there is no economic growth, in fact there is economic decline. Plus the unemployment situation is becoming untenable and people are distressed and fomenting action on the streets. So it's not a very encouraging situation in the banking area and if people finally figure out that banks are not a place to put money think of where can they put this, yes you can put is as cash but as we described before cash is an asset that naturally depreciate. So I think ultimately it's going to be great for gold and silver, the ultimate win for gold and silver was when people lose distrust in the banking system. I think probably most people lost trust in their government and I would not be surprised if most people, when they have to read the events of what goes on in banks all the time, why would they be building trust in banks? You would think the exact opposite would be occurring and that would be very positive for gold and silver.”
 
 
Will China continue to import record levels of physical gold in 2014?
 
It seems very transparent to me that China is moving to some type of gold standard yet to be defined. But the fact is that they are developing and increasing their mining reserves and promoting private citizens to accumulate gold and silver. With the record demand expected to continue in the foreseeable future, it is very clear that we are looking at a different paradigm regarding the ownership of the precious metals from the West to the East. I asked Sprott this and he said:
 
“That's a great question. I just was off the phone with someone from the World Gold Council who is a Chinese expert and they are sticking by that their GFMS data that the World Gold Council publishes is correct. This person said he has a pretty good idea of what goes on in Chinese jewelry demand. Two years ago China imported 100 tons gold into mainland China and this year they are probably running at a 1200 ton rate, so in two years they have gone up 1100 tons.”
 
“If you, Mr. China expert, know what's going on in jewelry demand in China, then you can look at the change in demand in jewelry from 11 to 13, take it off the 1100 ton increase and you must make some conclusion of where it's going. But they don't want to do that and the obvious "where it's going" part is either substantial savers in China or the People's Bank of China and I suspect it's a combination of both. Nobody wants to say it's true until someone comes out and confirms it even though there is an unexplained difference.”
 
“We have an 1100 ton change in Chinese demand which is 29 percent of the total gold market which is a 4000 ton market and nobody seems to be willing to explain it and yet every year they come out and say demand equals supply which I don't believe the data for a second.”
 
“I think that the demand is way beyond the supply of gold and that the western banks have been involved in supplying that gold non-transparently. And as you and I and all your listeners know that zero interest rates and printing money is financially irresponsible; we all know it. I can assure you Ben Bernanke Knows it, Julia Coronado knows it, Rene Carne knows it, and Mario Draghi knows it. They know it's irresponsible; they just have to do it to try to get through to the next crisis because if they didn't print rates would be up already and we would be in Armageddon.”
 
Let us take a look at the PHYS Sprott Physical Gold Trust ETF and see what opportunities we can identify for next week of trading. The PHYS Sprott Physical Trust ETF contract closed at 10.24. The market closing below the 9-week MA (10.29) is confirmation that the trend momentum is bearish. A close above the 9-week MA would negate the weekly bearish short-term trend to neutral.
 
 
With the market closing above the VC Weekly Price Momentum Indicator of 10.11, it confirms that the price momentum is bullish. A close below it would negate the bullish signal to neutral. Cover short on corrections at the 9.95 and 9.65 levels and go long on a weekly reversal stop. If long, use the 9.65 level as a Stop Close Only and Good Till Cancelled order. Take some profits on longs as we reach the 10.41 to 10.57 levels during the week.

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