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China, Price of Gold Pointing to New Lehman?

One of the hallmarks of the deepest crises of the past 40 years (1973, 2008) has been a short, very sharp retrenchment in the gold price as investors liquidated investments en masse both to cover losses in other markets as well as to seek out the ultimate security of short term US government paper.

What's Next?
What's Next?

The price movements that have emerged over the past two months in gold (and silver) prices have therefore proved fascinating.

In particular, despite the implementation of further monetary policy measures in the US, a growing acknowledgement in the UK that further quantitative easing is likely from the Bank of England and even a growing body of opinion that the ECB may start to ease policy very soon, theprice of gold has plummetedin recent weeks (down over 14 percent since September).

The move in silver has been even more dramatic, dropping 28 percent since it hit its post April peak on August 23. So far, so familiar. This is, of course, not the only echo of past crises to have emerged over the past few months.

However, one that has not received quite as much attention as might have been warranted is the notable shift in the way USD/CNY has performed. In particular, it is noticeable that since the middle of August USD/CNY, far from trending lower, has found itself confined in a very well defined range.

This is almost exactly what happened back in July of 2008 when, in the face of a collapsing Chinese stock market and early signs that inflation was beginning to abate, the authorities brought the three year downtrend in USD/CNY to an abrupt halt.

Although it is certainly true that the Shanghai Composite Index continued to weaken for three months after this, the pace of losses slowed dramatically after the policy move.

This stood in marked contrast to the S&P 500 (where the lion’s share of the losses came post July) and indicated that the shift in currency policy had helped insulate the Chinese market from the worst of the 2008 global crisis.

One of the questions we asked back in 2008 was whether the reduced promise of currency appreciation would see a significant decline in hot money inflows into China and, as a result, a slowdown in the growth of the nations FX reserves.

Interestingly this is pretty well and much what happened in the months following (although other factors were clearly at work as well). It therefore seems reasonable to speculate whether a similar shift in flows has emerged over the past month or so.

If so then it seems reasonable to suppose that this may also have led to a significant decline in China’s need to diversify fresh reserves away from the USD and into currencies such as the EUR.

Unfortunately there is one other observation that needs to be made about the outcome of the crises of 1973 and 2007/2008. This is that they were followed by the two most vicious bear markets in equities in the past fifty years.

The 1973 bear market (which actually started at the end of January of that year) saw the Dow Jones Industrial Average (DJIA) collapse by 44 percent over a 22 month period with the lion's share of losses coming after the Yom Kippur war and subsequent oil embargo of October 1973.

Similarly, the first signs of the 2007/2008 bear market emerged quite early on (October 2007) but the lion’s share of losses came in the aftermath of a hugely aggressive rise in commodity prices (i.e. post May 2008). Overall the DJIA lost 54 percent between October 2007 and March 2009.

Given this it might therefore also be worth observing that the DJIA currently stands at almost exactly the same point that it did in September of 2008.

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The author is Simon Derrick, head of currency research at Bank of New York Mellon