Can Gold Break Its Connection To The Yen?

| About: SPDR Gold (GLD)
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In the past 5 years, at no time would a gold portfolio have fallen below a yen portfolio, though these two portfolios move in tandem.

The correlation between gold and yen must logically break.

Consider GDX or GLD as your investment vehicles to hedge Japanese exposure.

The SPDR Gold Trust ET (NYSEARCA:GLD) correlates to the price of gold as the fund holds only physical gold. I often use this ETF as a proxy to run one-to-one analyses on stocks and other ETFs. In this article, I will expose an interesting pattern in GLD and what that might mean for gold investors.

But first, I should respond to readers of my last article on GLD. The main question I received was whether GLD is superior to the Market Vectors Gold Miners ETF (NYSEARCA:GDX). As I point out here, GLD and GDX both have their pros and cons, with GDX being the more volatile of the two and thus better for swing traders than investors.

GDX and GLD move in tandem. Almost everyone knows this, as GDX is reliant on the price of gold. So the following applies to both ETFs.

Governments, hedge funds, investors, and traders all have their hands in gold for different reasons. Some believe that gold is a strong fallback for if/when fiat currencies fail. Others believe gold is a good hedge for a market crash/correction.

Regardless of your viewpoint, you must recognize that gold has strong correlations with certain traded instruments, from its positive correlation with silver to its negative correlation with the stock market. These correlations change over time. But most remarkably is gold's newfound correlation with yen, as tracked by the Japanese Yen Trust ETF (NYSEARCA:FXY):

This correlation goes back roughly five years; prior to that it does not hold. My correlation analysis from Jan 1st, 2011 shows a 50% correlation, meaning that 50% of the movements in gold can be explained by movements in the yen.

Understanding the Correlation

This correlation makes sense but comes late. The yen and gold have been traditional fallbacks for a weakening dollar. Yet, clearly gold has outperformed the yen. Comparing a pure gold portfolio to a pure yen portfolio, assuming both were bought five years ago, at no time would the gold portfolio have fallen below the yen portfolio, though these two portfolios move in tandem.

Gold investors are likely asking, "What's the point of understanding this correlation?" This is a useless question at the moment, just as "What's the point of understanding the risk of CDOs?" was a useless question in 2007. In other words, when this correlation eventually breaks down, we will be looking at a drastically different market. As shown above, the yen already underperforms gold, and when the correlation breaks, I believe gold will come out on top.

Essentially, the breaking of this correlation will imply a stronger USD/JPY in addition to a weaker USD/XAU. That is, the value of both the yen and the dollar will weaken, with gold coming out on top (or at least remaining stable, making it appear as if it were rising in value). This is all part of the new currency wars, in which the major economies attempt to devalue their currencies to increase exports and employment.

Why would they do this? Global growth and trade have been falling, giving export advantages to countries with lower valued currencies. The Bank of Japan, for instance, has consciously engaged in this currency war by opting for quantitative easing and negative interest rates.

When Japan engages in such currency wars, the yen is less likely to be a safe haven currency; the gold-yen correlation breaks. Thus, watching the gold-yen correlation fluctuations can tell us when both the dollar and yen are beginning to lose their power. This is important because you could not see this from the USD/JPY rate alone.

When the Correlation Breaks

American investors underestimate the importance of Japan in the world's economy. As I've said in virtually every article I've published on the macro economy, Japan is the trend-setter for all economies. A crack in the gold-yen correlation could equate to Japan losing its status as the top exporter of capital (e.g., an upward move in gold in light of a falling yen implies weaker trading partners).

But why now? What fundamental difference would cause this five-year correlation break? The answer lies in negative interest rates (NIRP).

Like the Fed, the Bank of Japan (BOJ) has a 2% inflation target. To achieve this target, the BOJ cuts rates, which have now gone into negative territory. Negative rates make sense for both parties, even if they don't make sense from a third party perspective: The BOJ forces cash hoarders to find better investments, while cash hoarders exchange the risk of negative interest for that of the theft or loss of physical money.

But here is where the correlation logically breaks. Consider the following:

  1. Store physical yen or store physical gold
  2. Hold yen in a bank or gold in a fund
  3. Hold yen in a fund or gold in a fund

The first and third situations point to gold being a better investment because the future of gold is less certain than the yen's decline, which is at the hands of the BOJ's interventions. In the second situation, holding gold in a fund is superior because you have a 0% yield as opposed to a negative yield. That is, in any case, gold becomes the superior option, a fact that leads to a break in the gold-yen correlation.

For Japanese citizens, given the choice of yen or gold, the only economically logical choice is to hold gold. Thus, the gold-yen correlation must break. As Japanese bonds are giving negative yields, gold does not follow.

The gold-yen correlation is about to break, and the survivor of a weak economy will be the same as that in the past: gold, which has emerged unscathed from currency disasters since the beginning of written history.

Practical Advice

  1. Understand that the yen and gold prices are about to become uncoupled.
  2. If you're holding physical, bank yen, or yen-based bonds, switch to gold as your default.
  3. Consider GDX or GLD as your investment vehicles to hedge Japanese exposure.

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Disclosure: I am/we are long GLD.

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.