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Executive summary:

  • Weaker yuan may mean weaker gold.
  • A Chinese financial crisis may trigger forced selling of gold.
  • A weaker yuan may complicate the implementation of the Fed's "Taper," which would be good for gold.

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I recently wrote an article detailing an investment thesis that central bank, especially the Chinese central bank or PBOC, buying of gold will likely turn out bad for gold prices. The article got the expected negative comments, but the theory I outlined was and is solid. The theory is simply that central banks don't buy gold as an investment, they buy it as part of a broader monetary policy. Central banks aren't into commodity speculation, they are into maintaining stable growth, full employment and price stability. The decision to buy or sell gold by a central bank isn't influenced by the price of gold, or at least it shouldn't be. Central banks will sell gold when they have to in order to curb inflation and slow growth, or buy gold in order to weaken its currency and stimulate economic growth. Central banks don't have a profit motive, they get to print money, so gains made on gold are irrelevant to the implementation of the chosen monetary policy.

While I thought I might be sticking my neck out a bit early when I wrote that original article, I didn't have to wait long for empirical evidence to develop that bolsters my case. Last night the yuan dropped the most since 2010.

China's yuan tumbled the most in more than three years on speculation the central bank wants an end to the currency's steady appreciation to ward off speculators before a possible widening of the trading band.

The yuan fell 0.46 percent, the most since Nov. 1, 2010, to close at 6.1266 per dollar in Shanghai, according to China Foreign Exchange Trade System prices. It slid for a sixth day and reached a six-month low of 6.1310.

Unlike the US dollar, which drives gold higher when it weakens, gold dropped overnight with the "tumbling" yuan. Had the headlines read US dollar "tumbled," gold would almost certainly have been up. The Chinese stock markets also sold off, but not by as much as I would have expected.

Feb 25 (Reuters) - Hong Kong shares reversed gains on Tuesday to end lower, tracking a sharp reversal in mainland markets, with investors still jittery over credit curbs on the property sector.

China's CSI300 share index tumbled 2.6 percent in its biggest single-day decline since July 2013, with losses accelerating after a sharp intra-day reversal for the Nasdaq-style ChiNext Composite Index of mostly high-tech start-ups listed in Shenzhen.

The Hang Seng Index ended down 0.3 percent at 22,317.2 points, bound by its 200-day moving average seen at about 22,492.7 points. The China Enterprises Index of the leading Chinese listings in Hong Kong slipped 0.6 percent.

People who think we are experiencing inflation here in the US need to pay attention to this following quote. Unlike the 1990s and early 2000s when the US was able to export its inflation to China, China has been slowly exporting inflation to the US. Since 2005 the yuan has strengthened by 35% relative to the US dollar. That means goods imported from China now cost 35% more than in 2005, all else held equal. Inflation in the US would be even lower had the yuan not appreciated, which would have further complicated things for Ben Bernanke and Janet Yellen.

The yuan has strengthened in all but three quarters since a dollar peg ended in July 2005 and its 35 percent advance against the greenback in that time is the best performance among 24 emerging-market currencies tracked by Bloomberg. Two-way capital flows will become the "new norm" for China and the exchange rate is likely to be more volatile as U.S. monetary stimulus is reined in, State Administration of Foreign Exchange said today in a report.

The PBOC is now "engineering a decline" in the yuan, and I argue that is bad for gold.

"The PBOC is engineering the yuan declines, which might mean the central bank wishes to change the perception of the one-way bet on yuan gains," said Kenix Lai, a Hong Kong-based currency analyst at Bank of East Asia Ltd. "It also looks like the PBOC is introducing two-way volatility as it prepares the renminbi for a wider trading band."

Why that is bad for gold has multiple reasons:

1) Gold is priced in US dollars on the world market. A weaker yuan means a stronger US dollar, resulting in gold costing more in yuan terms. More expensive gold in yuan terms means less "physical demand" from non-PBOC buyers in China.

2) China is largely dependent upon exporting to the US market to support its growth. Because of the huge trade deficits the US has with China, China has a huge capital surplus with the US. China owns $1.27 trillion in US government debt. That is a double edged sword. If China sells those bonds they risk increasing interest rates in the US, slowing its growth, and reducing the demand for Chinese exports. It will be very difficult for China to use US bonds to manage its monetary policy. China buying US government bonds also works against the Fed's stated policy of trying to drive inflation and interest rates higher.

China is trying to "reduce its dependency on Treasuries," Louis Kuijs, chief China economist at Royal Bank of Scotland Group Plc, told Bloomberg Television in Hong Kong today. "It's hard for them to do that, because the U.S. is still by far the most liquid market and it's actually not so easy to find room for all those billions of dollars of Chinese reserves."

3) Because of the unwanted unintended consequences of using US Government bonds to manage monetary policy, the PBOC is far more likely to use gold. If the PBOC wants to weaken the yuan, they will want to increase the ratio of uan to US dollars on the world market. To do this the PBOC would print Yuan and buy gold. Yes that will boost the demand for gold by the PBOC, but the weaker Yuan will also make gold more expensive to those who are sensitive to price changes i.e. the "physical gold" buyers. The stronger US dollar, weaker Yuan is likely to have a greater negative impact on gold than the positive impact of PBOC buying.

4) Fears of a banking or financial collapse in China are also growing. If the PBOC was forced to make good on US dollar denominated loans, the most logical approach would be to sell gold to buy US dollars. Selling US Government debt would drive rates higher, which would strengthen the US dollar, compounding the problem for China. Gold is clearly the asset to sell in a crisis, not US Government bonds.

Figures published by the Bank for International Settlements (NASDAQ:BIS) in October showed foreign currency loans booked in China, as well as cross-border borrowing by Chinese companies, had reached $880bn (£535bn) as of March 2013, from $270bn in 2009.

Analysts say this figure is now likely to exceed $1 trillion and is continuing to grow, raising the prospect of the potentially dangerous vulnerability of the Chinese financial system to a rising dollar.

"It is very hard to work out the exposures of individual banks to the Chinese financial system, but it seems to us there are some very large numbers on some of the bank's balance sheets," said the analyst.

5) During a crisis the PBOC would likely rely upon bank reserves, but those bank reserves are inyuan, and I doubt foreign banks will want yuan during a crisis - they will demand US dollars. Selling gold is a sure way to get US dollars when the yuan isn't accepted.

The question is how vulnerable would the system be at that point if that dollar funding were just to dry up overnight? How able would the authorities be to fill that gap in funding domestically?

*People focus a lot on the FX reserves, but real firepower that they have over the short-term is the deposit reserves that have been locked up. There is about $20 trillion locked up there and that is something they could draw down if they started to have significant liquidity issues.

Not all is bearish for gold, however, because an orderly engineered decline in the yuan may disrupt the Fed's "Taper" if done wrong. If the PBOC continues to diversify away from the US dollar, that may have the unwanted unintended consequence of driving US rates higher. Higher US rates not supported by lower unemployment and higher economic growth may force the Fed to slow or postpone the implementation of the "Taper." That would be good for gold, but work against the PBOC's efforts to weaken the yuan. Managing currency exchange rates, trade balances, monetary policy and economic growth is like squeezing a balloon. You try to fix one problem and it ends up creating another one somewhere else.

"The Chinese move to sell suggests central banks are becoming more wary of taking duration risk now with the Federal Reserve firmly into the tapering process," saidAaron Kohli, an interest-rate strategist in New York at BNP Paribas SA, one of 22 primary dealers that trade with the Fed. "If China continues to sell again in the next month or two, than more worries will arise as to who will buy the country's debt."

The markets are already discounting the impact of a weaker yuan, and the reaction is exactly what one would expect. A weaker yuan lowers inflation fears in the US, as imports from China fall in price. Lower priced imports from China, however, also lowers growth expectations for the US economy, as production shifts from the US back to China. What this has created is a very bad situation for Janet Yellen and the Fed. China's efforts to weaken the yuan runs counter to the Fed's plan to "Taper," and that may be why gold is no longer trading down, but is actually trading up today. An extended "Taper" will extend the slow death of gold, but it will not be able to keep gold alive forever. A slower growing US is likely to do more harm to China than a weaker yuan will benefit it, the outcome of this tug-o-war will ultimately determine the path gold will take.

Treasuries rose while the yen gained on concern weakness in China's yuan will hurt growth..

Disclaimer: This article is not an investment recommendation or solicitation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. Past performance is no guarantee of future results. For my full disclaimer and disclosure, click here.

Disclosure: I am long GLL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I own calls on GLL

Source: Reading The Tea Leaves; Yuan Down, Hang Seng Down, Gold Down Overnight