Two Weekend Developments

There have been two developments over the weekend that may impact trading when the markets reopen on April 15 in Asia. Technically, they both took place on Friday, but after many markets were closed.  

We begin with the largest drop in gold prices in two months. The expansion of central bank balance sheets was supposed to lead to the debasement of paper money and the appreciation of gold.  The BOJ announcement on April 4 and the doubling of the pace of its accumulation of long-term assets was hoped to mark the end of the gold's multi-month downtrend.  

Late longs were in weak hands.   The collapse of the decentralized internet money, bitcoins, which has captured the imaginations of many, most likely was coincidental with the sell-off in gold prices.  Others  may be better placed to assess the impact of a bearish gold report by a major US investment house.  

We suspect that events, real and anticipated, in Europe provided the last drop of tea that overflowed the cup.  Faced with rising costs,  the Cypriot government, the same one that initially proposed to tax insured depositors, had signaled it is prepared to sell the bulk of its gold holdings (10 of 14 tonnes) to raise cash (~400 mln euros).  

The fact gold is technically owned by the central bank and it apparently was not consulted, was not lost on the observers.  The central bank objected to the incursions on its independence and another central banker tendered his resignation, bringing, the departures to three and leaving the central bank with only two members on its governing council.  

Even though the Cypriot gold sales would be the largest official sales since France's 17.4 tonnes in H1 09, the concern was larger than Cyprus.  The way many spun the story was that the EU or ECB was insisting on Cyprus to sell its gold.  Subsequent reports suggest this was not the case.  Gold sales were identified by the Cypriot government as one of the ways it could raise funds. 

ECB President Draghi's insisted that the proceeds of the gold sales be used to cover the exposure of the Emergency Lending Assistance (ELA) program.  Recall ELA assistance is granted by the national central bank on the basis of collateral that insufficient for borrowing from the ECB.  It is done with the ECB's approval but, and this is key, at the risk of the national central bank.  That risk is backed by the central bank's assets, which includes gold.  

Draghi's stand denies the Cypriot government the ability to raid the national central bank.  This should help bolster the nominal independence of the Cypriot central bank.  The tension brought to the surface by the gold sales was not between Cyprus and the ECB or EU, but between Cyprus' government and central bank.  To be clear then, Draghi did not order the gold sales, but did insist that the proceeds belonged to the central bank not the government.  

Nevertheless, as with treatment of Cypriot depositors, will its gold sales be a template going forward?  This issue also weighed on market psychology.  Portugal, where the courts recently disallowed some of the government's austerity measures, is seen a potential candidate.  It has about 382.5 tonnes of monetary gold, which is worth about 15.3 bln euros.   

Spain holds 281 tonnes of gold, with a street value of around 11 bln euros.   Italy, has the fourth largest national holding of gold at  2,451 tonnes of gold.  It is worth a little less than 100 bln euros, which is about 5% of its public sector debt.    Rather than simply liquidate their gold, countries may be attracted to the benefit of using the gold to back new borrowings. It allows not only retention of its god, but also leverages it.  

The other important development was the US Treasury's semi-annual report on the foreign exchange market.  Despite the bluster, neither Republican nor Democrat president has cited China as a currency market manipulator in 18 years.  The Obama Administration continued to refrain from doing so, though acknowledging that the yuan remains significantly undervalued. 

It is difficult to make this case, and tellingly the IMF has toned down its assessment about how much the yuan is under-valued.  The US Treasury noted that between June 2010 and February 2013, the yuan as appreciated by 16.2%.   

As we have noted previously, Chinese wages continue to rise and this is impacted competitiveness. One factoid that captures this is that Chinese unit labor costs appear now to be above Mexico's.  Chinese businesses have three strategies to cope with the shifting competitiveness:  move production deeper into the interior of China to take advantage of cheaper labor, move production off-shore for some labor intensive production, such as textiles and footwear, and deploy labor-saving technology.  

While the US-Chinese tensions in the foreign exchange market is usually the focus of these reports, this time the US Treasury's stance toward Japan was also of much interest.  The yen, which was trading firmly all day last Friday, rose quickly in thin trading late in the NY afternoon following the Treasury's report.  

We think the thin market exaggerated the market's initial misunderstanding of the Treasury's assessment of Japan.  The US Treasury previously objected to comments from some Japanese officials offering exchange rate targets.  Japanese officials have tempered their comments and moved into compliance with the G7 and G20 statements.  

The IMF has endorsed the thrust of the BOJ's efforts, and the Abe government more broadly.  The US Treasury report also recognized that Japan is directing its efforts to domestic objectives and has refrained from objectionable comments.    It is in that context that the statement about continuing to press Japan to adhere to its G7/G20 commitments should be understood.  

There are G20 and IMF meetings at the end of the week. We do not believe the US Treasury report was a criticism of Japanese policy.  Nor do we expected the G20 and/or the IMF to voice serious objections to efforts to reflate the world's third largest economy.