Yuan Too Free? And Can the Fed Afford It?

Back in the swing of things here, and the first week bodes exciting for the year.

That’s assuming it’s just like last year. And in many ways, it already is.

But if the current trading action continues, the next three or four weeks will make and break investors’ fortunes.

Let me be brief with a quick rundown on the important items that are mimicking developments in early 2016.

Rate Hikes are a Gold’s Best Friend?

What?

No!

Yes!! Apparently.

In December 2015, the Federal Reserve hiked its benchmark rate of interest for the first time in many years.

In December 2016, the Federal Reserve hiked its benchmark rate of interest for the first time since December 2015 … which was the first time in many years.

The price of gold bottomed one day after the Fed hike in 2015.

The price of gold bottomed one day after the Fed hike in 2016.

Gold went on to rally as much as 29% in the first half of 2016.

How far will gold go in the first half of 2017?

For that answer — or clues to the answer, rather — we have to understand what changed the game for gold despite the rate hike that should have been bearish.

Will the first half of 2017 look like the first half of 2016 for gold?

What Changed the Game for Gold

First, the rate hike was very much priced in. And so were subsequent rate hikes.

Four hikes were supposed to happen in 2016. Only one happened … and not until December.

Three hikes are supposed to happen in 2017. And last week’s Fed minutes release suggested even more rate hikes if economic data warrants.

Yet gold is up 4.75% in the 13 days through Thursday, Jan. 5, with the thrust of that move coming from another déjà vu moment …

Enter the PBoC. Please!

Yuan Too Free?

For many years, the subject of Chinese currency manipulation has served as all kinds of political fodder. It even played a small role in the populist-friendly campaign of President-elect Donald Trump.

But in financial markets, the issue has been somewhat less-significant.

Except for a couple key moments.

The Chinese yuan has been steadily losing value as capital outflows create a negative feedback loop of selling and depreciation.

Despite calls of currency manipulation to drive the yuan lower, Chinese officials have been instead trying to prop up the value of the yuan to stem capital outflows.

At the start of 2016, the People’s Bank of China stepped in by jacking up the offshore yuan deposit rate to nearly 70%.

If you look at that chart, the story for 2017 (note the blue dot in the upper-right corner) is the same as for 2016 …

They are trying to stop money from leaving China. The offshore deposit rate hit 80% last week!

Suffice it to say, there is an "onshore" exchange rate and an "offshore" exchange rate. The difference between the two can exacerbate speculative capital flows for those looking to borrow onshore yuan to fund investments denominated in offshore yuan, more or less.

Jacking up the deposit rate on offshore yuan discourages speculation.

What does this have to do with gold?

Well, not much to the naked eye. But the value of the yuan has to be measured against something.

And if global officials find a need to work together to keep the yuan from losing more value, then that "something" it’s measured against needs to lose value.

Can the Fed?

The main measure of the Chinese yuan, as it concerns global liquidity flows, is the U.S. dollar.

The euro and Japanese yen are two other important measures by which the yuan can be valued.

It was the U.S. dollar that lost value at the start of 2016.

It seems the U.S. dollar is reacting the same way this year. And if the U.S. dollar loses value, it tends to be supportive of gold prices.

At the same time, if coordinated currency intervention is needed, then maybe the situation is perceived as dire for the Chinese economy … and serious enough to spark global contagion concerns.

Chinese capital outflows are such a significant threat that data-keepers are trying to hide the real rate of outflows. From Goldman Sachs:

So here China sits, scurrying to reassure Chinese investors that rising rates in the U.S. … and economic headwinds at home … are not reason to be looking for investments abroad.

But they are burning through FX reserves as they "sit."

This, over time, reduces their flexibility in managing their exchange-rate regime.

And judging by the trajectory of debt in China’s economy, they probably don’t want to give up their exchange-rate management flexibility … despite the jawboning to liberalize their currency.

They simply cannot yet afford the yuan to be too free.

The big question, for us, is: Can the Fed?

Can the Fed afford to let the world perceive China’s currency struggles as a problem too big for Chinese officials to manage themselves?

In 2016, investors’ kneejerk answer was "No, the Fed cannot afford to not manage investor perceptions."

As a result, markets crumbled for a couple weeks. And the next Fed rate hike was postponed for an entire year.

In 2017, will investors react differently?

Do right,
JR

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“JR” specializes in trading commodities, currencies and options. He has spent nearly 10 years analyzing financial markets and writing about global economics. JR honed his trading techniques and global-macro worldview alongside his father, Jack Crooks, at Black Swan Capital. JR also …