Good morning. Fed chair Jay Powell takes the stage today at Jackson Hole. Markets will quiver as they read too much into the little he will say.
Gold and the dollar
On Wednesday, we suggested that one of the causes of gold’s recent strength is a weakening dollar. Gold is priced in dollars, so as the dollar has fallen over the past two months on the expectation of interest rate cuts, the price of gold has gone up (this is not the only reason, of course; gold is at an all-time high in other currencies, too).
Gold and the dollar are almost always negatively correlated. Dollar pricing is just one reason. The other involves US interest rates. When rates rise relative to other countries, that draws capital into Treasuries and strengthens the dollar. And if higher nominal rates bring inflation-adjusted rates along with them, that increases the opportunity cost of holding gold and the price falls.
The pattern of negative correlation tends to break in periods of financial stress, as investors flock to gold and the dollar as safe havens. Markets ran to both gold and the dollar after the global financial crisis and the (unnamed) market repricing of late 2018, causing them both to rise in tandem.
Surprisingly, though, the two have risen together for much of gold’s big run this year. The correlation was positive in the first months of 2024, before the dollar started falling last month:
This is very unusual:
2024 has not been a time of stress. Other than a few mad days in the beginning of August, risk assets have risen, and the US economy, at least, is doing fine.
Unlike oil and the dollar, which have changed their historical relationship because of structural shifts, the simultaneous rise in the dollar and gold appears to have been due to a grab bag of unrelated factors. Gold’s historically great year was caused by simultaneous rise in demand from Chinese investors, global central banks upping their gold reserve allocations, expectations of US interest rate cuts, an amorphous mood of geopolitical uncertainty, and speculative interest from hedge funds. The dollars’ strong patch was down to US rates staying higher for longer than those in other countries.
But maybe all the factors that forced the dollar and gold into correlation are evidence of, if not a crisis exactly, then something like economic regime change. China, the world’s second-largest economy and long the engine of world growth, is slowing. Inflation, once considered a beast of the 20th century, is a live worry again. Politics in America, Europe and elsewhere are in flux. Here is Mark Farrington of Farrington Consulting, a global FX consultancy: "There is a more recent [relationship between gold and the dollar] that has developed post-GFC, post-rise of China, post-Russia/Ukraine war and the bifurcation of the global economy. At the moment, gold is switching between these various regimes, so it is difficult to trade on correlation."
Gold partisans argue the metal’s recent run proves that it is a great hedge against monetary and fiscal incontinence, and the accompanying inflation risks. But the picture is not so simple.
(Reiter and Armstrong)
Chinese sovereign bonds, banks and financial stability
In the past month or so, Chinese banks and investors have piled into bonds, in search of safe returns in a country where real estate has lost its appeal, and equities never had much. Both 10-year and 30-year bond yields hit record lows in early August. Official efforts to halt the buying pushed yields up again mid-month — but only briefly.
The other day we remarked that it was a bit odd that the Chinese Communist party is so keen to prop up the long end of China’s yield curve. The official reasoning is that it wants to avoid Silicon Valley Bank-style bank collapses. Is this a real worry?
SVB collapsed when the long-dated bonds on its balance sheet — a whopping 43 per cent of total assets — lost value after interest rates rose. It became “mark to market insolvent” and depositors ran. Chinese banks also own lots of bonds. At the end of Q1, Chinese banks owned an amazing 73 per cent of outstanding government bonds, according to Capital Economics.
But an SVB-style event is unlikely in the short term. Wei He of Gavekal Dragonomics notes a couple of reasons:
While Chinese banks hold a lot of bonds, they are only in aggregate 20 percent of bank balance sheets.
With lacklustre growth and a sluggish equity and real estate market, there is little reason for the PBoC to increase rates, or for Chinese investors to get out of the bond market.
Even if bond yields do rise and prices fall, there is really nowhere for households to put their capital right now besides banks. So a general bank run seems unlikely.
It is perfectly possible, even likely, that some individual banks have Silicon Valley-like levels of bond holdings, or worse. Bank balance sheet disclosures in China are uneven. For many banks, there is no way for outsiders to know what the asset mix is. Depositors could get wind of bond losses at a particular bank and run.
The Chinese authorities, however, know how to step in quickly when banks get in trouble, forcing stronger ones to take on the assets and liabilities of weaker ones, or creating special purpose banks to take on toxic assets. Recently, authorities closed a record 40 community banks in Liaoning province, and rolled the assets into a new regional bank. That may have been due to bond performance, bad real estate loans or something else. We just don’t know.
Low bond yields do put stress on other parts of the financial system. From Alicia Garcia-Herrero at Natixis: "Insurance companies have liabilities that are guaranteed at a certain rate, invested in sovereign bonds . . . They now have to buy at low yields to pay the same high return liabilities they have accumulated. There is a huge maturity mismatch . . . This makes insurance companies technically bankrupt."
But individual banks’ concentrated positions in bonds, if it is a systemic problem, is not the biggest one facing the Chinese financial system. Real estate loans, weak lending growth and a vague regulatory regime top the list.
If Chinese banks were to continue increasing their bond allocations, and the economy were to enjoy a rapid recovery, then there could be a problem. Perhaps the authorities were trying to send a signal to bond investors and make them aware of the risks. But the fundamental reason that yields are low is that the economic outlook is soft and Chinese households have few good investment options. Embarrassment about that reality is a better explanation for the official interventions in the bond market than worries about stability. And that same reality meant that the interventions were doomed to fail.
(Reiter and Armstrong)
This article was written by Aiden Reiter and Robert Armstrong from The Financial Times and was legally licensed through the DiveMarketplace by Industry Dive. Please direct all licensing questions to legal@industrydive.com.