If the chart below is correct, then gold could have much further to fall. The USD/JPY-implied target would be 1,000 USD per ounce. Is this kind of analysis reliable?
USD/JPY used to be a risk-off asset, driven by risk aversion as much as XAU/USD (gold/USD). Yet, USD/JPY now reacts to fundamentals (Kuroda's monetary policy). Among the few macro drivers of the pair, the real interest rates spread between T-notes and JGB is probably more telling. As can be seen below, the current level is consistent with Kuroda's 2% inflation target.
The recent upward move in USD/JPY was not driven by the numerical target but by the fear of strong financial outflows triggered by the new BOJ's buying program. The real question is: to what extent will the eviction of private buyers from JGBs purchases translate into net external outflows: amount and direction (euro sovereign, US stocks…)?
Considering that, on average, gross issues amount to JPY 10trn a month and redemptions JPY 7.5trn, Bank of Japan purchases will cover net issues in the JGB market (i.e. gross issues less redemptions) and then buy a further JPY 50trn of existing bonds. The crowding-out effect means that up to JPY 50bn could end up being invested in debt instruments outside Japan.
The breakdown between domestic and foreign assets is still unclear, but the impact on the JPY should clearly be negative. In any case, comparing Fed and BOJ balance sheets based on their respective purchase programs shows that the FX is clearly ahead of the curve (chart below).
Above all, as the XAU/JPY also fell, there is no substitution of a Fed QE fear for a BOJ QE fear that would translate into a stronger XAU/JPY.
Gold's prices are now disconnected from the external value of the dollar (see correlation break below) and real interest rates. Combined with ugly technicals, this lack of fundamental support may explain why gold continues to fall.
We should not rule out a possible mean reversion in the gold vs. USD relationship, as it happened in the past (2009, 2010, 2011). A glimpse on the long run chart suggests that in the 1990s, the correlation, albeit negative, was weak and close to insignificant. This could be a new normal.
Interestingly enough, the USD does not seem to be the driver of both pairs' moves (USD/JPY and XAU/USD). The USD/JPY increase is, above all, a reflection of the weakness of the Yen, as a byproduct of the BOJ policy. Gold does not seem to suffer from its fundamentals, but from an accumulation of irrelevant scapegoats. At this point nobody seems to know how to calculate or assess gold's face value.
So, how should we deal with our first question? Can we really trust this chart?
This analysis suggests that both pairs may not be as related as my chart implies. This is good news for gold bugs since, if the BOJ reflation works, the USD/JPY could (at least temporarily) breach the 100 threshold, pushing gold prices down even further.
In the very short run though, there might be another way of using it: if gold is deemed to have corrected enough, then it might suggest that USD/JPY has some room for a short run correction as well.