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Technician at heart. Fundamentalist in spirit.
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  • The Premium to Risk Free Gold

    China's central bank Governor Zhou Xiaochuan recently spoke of the need to diversify China's massive $3 trillion in reserves. Given the size of the reserves, the question becomes how China will manage its FOREX reserves in the face of rising inflation while maximizing return.

    Central banks all over the world can prevent currency from rising by intervening in the foreign exchange market. The process involves sterilization in which the government sells bonds to contract the domestic money supply in order to buy foreign assets. The problem is the interest on the domestic bond is usually higher than the interest earned on the foreign asset lowering the rate of return.

    In the classic model, the assumption is that treasuries provide a risk free rate of return. Quantitative Easing changes the paradigm by adding an essential component – the risked rate of return measured by the change in gold prices. Because the market tends to be efficient, this change is expected and the price of gold is “fair.”

    But does that price really reflect the economic circumstances?

    When the Fed started printing money to lower rates, China had to buy more dollars in order to keep its currency peg. This amount is reflected in the risked rate of return as measured in the change in Gold prices due to quantities easing. To a certain extent, China’s inflation can be contained by monetary tightening. In the long term, China will have to develop the Yuan denominated bond market. In the short term, I believe that the price of Gold is undervalued by $450-900/oz (the increase in the price of gold since 2008). Commodity prices will keep increasing until the Fed raises rates or China shifts some of its inflationary pressures to gold.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
    Apr 29 1:06 AM | Link | Comment!
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