“An open, competitive, and liberalised financial market can effectively allocate scarce resources in a manner that promotes stability and prosperity far better than governmental intervention.” ― Henry Paulson
The irony of the above quote is rather obvious: Henry Paulson was a driving force behind the Troubled Asset Relief Program (TARP), which freed the United States government to purchase toxic assets and equity from financial institutions to strengthen its financial sector. That does not, however, mean the message is incorrect.
XAUCNY and the Chinese Equity Market
Earlier this year and late last year there was much debate around an implicit peg that seem to have formed between the renminbi and gold. More recently, the seven handle on the USDCNY cross has gathered much intrigue as the line in the sand for China.
We, too, have been following the price of gold in renminbi terms. Rather than signaling an impending currency devaluation, however, we think the pair can signal potential dislocations between the Chinese equity market and the economic realities on the ground.
Gold / CNY vs. CSI 300 Index (Inverted)
Source: Bloomberg
The chart above plots the price of gold in renminbi versus the Shanghai Shenzhen CSI 300 Index (inverted).
Gold strengthened between 2010 and 2012 as the equity market faltered. Then weakened well ahead of the sharp Chinese market rally of 2014/15. Notably, the bottom in gold in renminbi terms almost coincided with the peak in the Chinese equity market.
More recently, the draw down in Chinese stocks following the sharp rally at the start of the year has coincided with strengthening gold. Gold has since continued to strengthen while stocks have traded sideways, portending more bad news for equity investors.
According to a paper authored by researchers at the Japan Center of Economics Research “(1) the gold return rises significantly if stock returns fall sharply; (2) it rises as the stock market volatility increases; (3) it also rises when general financial market conditions tighten”. The quoted study focuses on the US equity market. Assuming, however, that the findings are just as applicable in China, the continued rise in gold in renminbi terms may be signalling a sharp tightening of financial conditions on the mainland.
The below chart plots the Citi Early Warning Index for China (magenta) versus the XAUCNY cross.
The above too suggests that the renminbi price of gold can act as a less volatile signal for the stresses building up in China.
Silver Updates
The below are updated versions of charts we have shared previously.
Silver has moved above its 48-month moving average. If it can continue to stay above the moving average, silver could sharply move higher.
The S&P 500 Index in silver terms in struggling around key levels. Making a silver a suitbable hedge for any US equity market weakness henceforth.
Reading Too Much into the Treasury Yield Curve
The below is a chart of the yield differential between US 10 year and 3 month Treasury securities.
Starting July, US yield curve is no longer inverted. A sharp steepening of the yield curve over following an inversion caused by a series of Federal Reserve interest rate hikes has been characteristic of the early stages of the last four US recessions. We think, however, commentators and investors may be reading too much into it. In the prior instances, a recession was signaled by a bull steepening, with the short end of the curve falling faster than the long end. This time, though, long end has been rising faster than the short end ― a bear steepening
Several factors have contributed to the reversal of the US yield curve’s inversion over the last couple of weeks. On one hand, Fed chairman Jay Powell confirmed market expectations of a near term rate cut in his testimony to Congress last week. On the other, both the New York Fed’s survey of one-year ahead consumer inflation expectations and the 10-year breakeven inflation rate signaled a pick-up in inflation expectations. As a result, the bond market has begun to price in the possible effects of firmer future inflation on future Fed policy. With the short end of the yield curve anchored by the Fed’s current dovishness and the labour market tight, any liquidity-driven improvement in the US growth outlook is likely to feed through into a further steepening of the US yield curve over the second half of this year.
The current iteration of an inversion followed by steepening resembles 1998 and not the last four recessions. In 1998, the Fed cut interest rates in response to global economic weakness following the Asian Financial Crisis and the collapse of Long Term Capital Management, resulting in a bear steepening. Between 1998 and 2000, US equities, specifically tech stocks, went parabolic.
Now is not the time to sell US equities in fear of a recession. It is the time to wait and see if we get a parabolic move higher and to gradually reduce equity exposure as markets move higher.
This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.