On China's Golden Plans

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Includes: DGP, DGZ, DIA, DZZ, GDX, GDXJ, GLD, IAU, JJM, JJN, PTD, PTM, SLV, SPY, UBG, UBM, UDN, USV, UUP
by: Przemyslaw Radomski, CFA

When politicians talk it is always a good idea to try and read between the lines.

This Tuesday China's chief foreign exchange regulator, Yi Gang, told reporters that China is not interested in increasing its gold reserves.

Really?

Mr. Yi’s speech was accompanied by a downswing in the gold price - they moved lower by mere $3 within an hour of his speech but since then the market seems to have absorbed the news and moved on. On Wednesday speculation grew that accelerating inflation will force China to raise interest rates.

Investors and newsletter writers (we among them) have long speculated that China has a pressing need to start buying gold to reduce its giant hoard of U.S. dollars. We conjectured that China might buy the 191.3 tons that the IMF wants to sell. After all, what could be more logical than to buy the gold off-market?

But Mr. Yi, who is the director of the fortuitously named SAFE, (China’s State Administration of Foreign Exchange) had a few things to say that seem to put a damper on the planned Chinese gold party.

Gold is not a bad asset, but currently a few factors limit our ability to increase foreign exchange investment in gold,” he told reporters.

He noted that gold tends to be volatile and that gold’s returns are not steady enough to allow SAFE to increase investment in the yellow metal. Buying gold would cause the price to shoot up.

China realizes that it would be difficult to buy all the gold it wants without sending the price through the roof. That would be like an elephant shopping in a china shop. Let’s keep in mind that in April 2009 the price of gold received a boost from China’s first acknowledgment that since 2003 it had increased its reserves by 454 metric tons to 1,054 to become the world’s fifth largest holder of gold. China accumulated the gold quietly without the whole world noticing and without elaborating on where it had sourced the additional bullion. It was believed that the gold came from domestic sources and may have included refined scrap metal.

Based on data from the World Gold Council, China is the world’s largest gold producer and the second-largest consumer of gold, after India. Chinese annual gold output is approximately 300 metric tons, while the nation consumes roughly 400 metric tons per year, according to Mr. Yi, who also serves as vice governor of the People's Bank of China. China’s gold holdings represent only a small portion of its total foreign-exchange reserves. According to figures of Chinese holdings at the end of 2009, gold comprised approximately 1.6% of China’s foreign-exchange reserves at the current market price of gold.

So, if you take Mr. Yi at his words, it would seem that China doesn’t have plans to buy gold on the open market. That may well be the case, but we find it hard to believe that China is giving up its quest to increase its gold holdings. It would seem a more prudent course of action to publicly say that you don’t want to buy gold, but to buy relatively small amounts on dips when no one is paying attention.

There are other possibilities and here is where we need to read between the lines and see what other Chinese officials have been saying about gold. An official from the China Gold Association told The China Daily that rather than buy gold from the IMF, China would buy gold directly by buying gold mines "abroad" thus giving China a constant and permanent supply without moving the markets.

China is in an awkward position. It can’t buy gold on the open market without sending prices through the roof; neither can it unload U.S. Treasuries without sending those prices through the floor. So what can China do?

By saying that it is not interested in gold China hopes to keep the prices down, and by creating the illusion of confidence in U.S. Treasuries, it can prop up a market "too big to fail" long enough to exit slowly over time. Speaking of the U.S. Economy, this week we would like to comment on the precious metal with multiple industrial uses - silver. Let's begin with the very-long-term chart (charts courtesy of stockcharts.com.)

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Beginning with the very-long-term chart - silver is still showing long-term strength (along with positive fundamentals) with higher prices projected out to 2011. This estimation is founded in a large part on the long-term cyclical turning points present on the silver market that we've originally featured in the November 13th 2009 Premium Update (Subscribers only). Please note how precise that particular signal was in timing the end of the rally.

Consequently, the end of the 2011 is also likely to mark a significant turning point in the price of silver.

However, the shorter-term price situation is not as bullish.

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The above chart suggests that silver will be a bit anemic over the shorter-term. Although it was not clearly visible in the past weeks, looking at the charts with the RSI and stochastic readings in mind, silver’s historical cyclical tendencies point to a downturn. This decline could be easily triggered by a downturn on the general stock market.

There's one more thing that we'd like to emphasize as far as silver is concerned. Please note that the white metal has been recently rather reluctant to move lower along with other parts of the PM sector. This might be seen as a short-term bullish sign at the first sight, but we believe that this interpretation might be misleading. First of the two reasons is silver's high correlation with the main stock indices, which have been rising lately (but are not likely to move much higher) and the second one is that this is exactly the way one should expect silver to behave during the topping process.

Please take a look at the mid-August 2009 top, mid-October 2009 top, late-November 2009 top, and the early-January 2010 top. They have all begun with a small consolidation, during which silver didn't move much lower, which gave hope to all silver bulls. Still, a sharp slide followed erasing profits of those who refused to close their long positions in the white metal. Again, this might be the case also today.

Summing up, speculative bullish positions right now should be done with extreme caution, and only if you are able to monitor the market for almost the whole session. We realize that it doesn't sound encouraging especially for active Traders, but opening a speculative position at this point doesn't seem justified from the risk/reward point of view.

Disclosure: No positions