“the Chinese have more retaliatory options available to them than just tariffs, and it seems they are already using them…” Here’s the details…
Unless you have been under a rock for the past few months, you know there is an escalating trade war going on between the U.S. and China. The U.S. is imposing tariffs on Chinese products, and China is responding in kind. But the Chinese have more retaliatory options available to them than just tariffs, and it seems they are already using them.
Since its low at 6.2470 on March 27, the USD/CNY exchange rate has risen 6% to 6.6150. Put a different way, that’s a 6% “devaluation” of the yuan.
This serves multiple functions. It negates the effect of U.S. tariffs by reducing the price of Chinese products in dollar terms and maintains or increases Chinese exports to the U.S. But it could have a much more significant impact on the U.S. stock market in the short-term.
The last time the Chinese devalued the yuan by 3% in August 2015, the S&P 500 fell 11% from 2103 to 1867. Now they have already devalued their yuan by 6% in just 3 months, and there may be more to come. But the S&P 500 has not felt its effect. Yet.
Another effect of this yuan devaluation is that on Gold priced in dollar terms. The Gold/USD exchange rate is calculated by dividing the Gold/CNY exchange rate by USD/CNY. For example:
Gold at $1255 = 8280 / 6.5976
Assuming a stable Gold/CNY exchange rate, a higher USD/CNY reduces the price of Gold in dollar terms.
Noticeably, since that devaluation in August 2015, Gold has steadily narrowed its price range relative to the yuan with lower and lower highs and a floor at ~8200, almost as if China is increasingly pegging the yuan to Gold between 8200 to 8300 yuan.
This would have been negative for Gold priced in dollars, but USD/CNY fell by an even greater amount until its low on March 27. It is no coincidence that Gold subsequently peaked at 1369 on April 11.
Should the USD/CNY continue to rise as Gold/CNY remains between 8200-8300, then Gold will continue to fall. China would be okay with this in the short-term, because it would mean that they can sell dollars and buy Gold at cheaper and cheaper prices, especially if they believe the dollar’s days as global reserve currency are coming to an end. China and Russia have been leading the de-dollarization process globally. Chinese officials have been very vocal about their goal to end the dollar as the global reserve currency and replace it with a supranational currency, such as the SDR. China has also been producing and buying Gold, and Gold mining operations and refineries, for well over a decade now and do not export an ounce. Backing their currency on a de facto basis with Gold increases its acceptance as payment in global trade deals, especially for oil, and makes China a more attractive destination for foreign capital investments, further internationalizing the yuan and diminishing the role of the dollar in the process.
But will the U.S. tolerate an ever-weakening yuan? Unlikely. Tariffs were supposed to increase the prices of Chinese exports to the U.S. in dollar terms. Devaluation undermines that goal completely. In response, this could force the U.S. to label China a currency manipulator. Then there are several further options on the table for China.
In further retaliation against the U.S., China could unilaterally revalue Gold in yuan terms. Gold in dollar terms would theoretically not be affected, because the USD/CNY exchange rate would revalue itself higher by a similar amount, theoretically. But if the Chinese chose this option, they would be putting Gold back front and center in the global monetary system and diminish the dollar’s role as global reserve currency, likely putting significant upward pressure on Gold priced in dollars.
China “officially” has 1,843 metric tons of Gold as of June 2018, according to the World Gold Council, placing them 5 th behind Russia (at 1,910), the IMF, the US and the EU, in that order. However, China has been producing over 400 tons of Gold for over a decade without exporting an ounce. Conservatively, that would put China’s holdings at 4,000 tons in the past ten years alone. This does not include Gold they are actively purchasing on the world stage, either, or Gold from mining operations they have purchased in other countries, such as Africa and possibly South America too.
Recent reports also show that Gold exports from the U.S. directly to Hong Kong (China’s conduit) and China, plus those indirectly via London and Switzerland, are rising. This constitutes more than all of U.S.’ gold mining production during the same period. So all of the U.S.’ Gold is going elsewhere—and primarily Eastward.
Suffice to say that China’s true holdings of Gold are far, far higher than the official number. What if they announced that real number? I don’t expect them to. The Chinese like to play their cards close to their chest and do things in an orderly fashion over time… but they could. This would instantly revalue Gold around the world, in my opinion, and cause a slide in the dollar in particular.
Perhaps the most likely option for the Chinese is to begin selling their massive pile of U.S. Treasuries, which a recent report from SGH Macro Advisors suggested is on the table in a Bloomberg Report this week:
As the largest foreign holder of U.S. treasuries—and with the second biggest holder, Japan, already selling—should China begin actively selling, the act itself would put some pressure on the dollar. But the symbolism would have an even greater effect, in my opinion. The principal beneficiary would be Gold.
Alternatively, U.S. and China trade tensions could deescalate and USD/CNY simply falls back down again.
In the short-term, rising USD/CNY is clearly a negative for Gold, but there are multiple scenarios for this to reverse soon.
Longer term, the prospects for Gold remain extremely bullish. Multiple countries continue to buy Gold in anticipation of higher Gold prices, especially China and Russia. But it is the repatriation of Gold by many countries recently that is really significant. Why do they no longer feel comfortable leaving their Gold in a vault at the New York Fed? Germany wanted their Gold back 3 years earlier than planned. Why the rush? I believe it is because they are concerned about major economic and fiscal issues ahead for the U.S. and a slide in the value of the dollar. Based on Germany’s rush to get their Gold back, and many countries following suit recently, those issues could transpire sooner rather than later.
It was also noticeable and certainly no coincidence that JP Morgan took delivery of 3 million ounces of “physical” Silver the week of June 11 when Silver was slammed down, taking their Silver mountain to a new all-time high of over 143mln ounces. It appears that they, too, are preparing for higher precious metal prices.
Simply put, long-term: “Follow the Smart Money.”