No Bottom in Gold until Trade War Ends
No Bottom in Gold until Trade War Ends by David Brady – Sprott Money
I keep getting the same arguments trying to undermine the existence of a Chinese peg for Gold in yuan terms, despite having clearly provided the rationale for why the Chinese would enforce such a peg and the simple math for why it is now almost exclusively driving Gold price.
At the end of the day, as we say in Ireland, “the proof is in the pudding”. This means that if Gold continues to track movements in XAU/CNY, and USD/CNY in particular, then you have your answer. It’s self-evident, simple math.
Instead, I am going to focus on where USD/CNY is likely headed and, therefore, where Gold is headed.
USD/CNY’s rise began when President Trump first floated the idea of tariffs on Chinese exports to the U.S. It is no coincidence that the closing low in USD/CNY at 6.2680 on Apr 11 th coincided with the peak in Gold at 1369 the same day. It is also no surprise to me that USD/CNY has risen close to 10% since then, or put a different way, the yuan has been devalued by ~10%, the same amount as U.S. tariffs on Chinese goods until very recently. You see, China imports a lot fewer U.S. goods than it exports to the U.S., hence the massive U.S. trade deficit with China. So it cannot respond in kind with tariffs on U.S. goods and therefore must resort to other methods, such as devaluation of the yuan. And if there were any lingering doubt that China was using a weaker yuan to offset U.S. tariffs, this was dispelled in a Global Times article on Tuesday:
Therefore, in order to determine where USD/CNY and Gold are headed, we need to consider the next possible steps in this escalating trade war—and when and how it might end.
The latest salvo from the U.S. was the Aug 1st announcement by U.S. Trade Representative Robert Lighthizer, following direction from Trump to consider increasing the proposed level of tariffs on $200bln of Chinese goods from 10% to 25%. These would go into effect on Sept 5 or later, following an observation or comment period. Put simply, this was to give time for the Chinese to respond or, better yet, agree to U.S. demands.
China did respond almost immediately, but not in the way the U.S. wanted. China vowed it would retaliate with its own countermeasures. Foreign Ministry spokesman Geng Shuang stated in Beijing:
- “China’s position on the China-U.S. trade issue is firm and clear. Pressure and blackmail from the U.S. side will never work on China.”
- “Dialogue should be established on the basis of mutual respect and equality, and on the basis of rules and trust.”
- “Unilateral intimidation and pressure will not achieve the desired effect.”
USD/CNY continued to rise from 6.82 to a high of 6.90 by Aug 3 rd, its highest level since May, 2017. Meanwhile, Gold fell from $1233 to $1212 at the same time. More importantly, this response illustrated a key point in this trade war: China is clearly not going to back down but will continue to respond in kind to escalation from the U.S., which means that this will not be resolved quickly but will be a protracted war.
This view is supported by numerous comments to this effect in Chinese media since. Below are just a select few:
- “The U.S. is trying to conclude the trade disputes swiftly, but China is prepared for a protracted war.” Aug 5
- “Kudlow should warn the Trump administration not to underestimate China’s determination to fight to the end.” Aug 5
- “We don’t fear sacrificing short-term interests… China has time to fight to the end.” Aug 5
- “If the U.S. insists on fighting a trade war, China will fight back.” Aug 4
- “China will eventually defeat the trade blackmail of the U.S. and it is impossible to force China into surrender to the U.S. coercion.” Aug 6
- “China didn’t choose a trade war but was forced to accept it. China will not surrender to the U.S., nor could it ignore the trade war. The only way is to face it and win it.” Aug 6
Speaks for itself, doesn’t it. The core of the issue for the Chinese is not so much the U.S. demands but the manner in which they are being delivered. China is all about saving face, and they believe the U.S. is using “bullying tactics” to force them to agree to U.S. demands. “China’s leaders do not wish to appear as buckling under U.S. pressure.” China has repeatedly stated that they are willing to sit down and negotiate the trade issues between the two countries, but it must be on an “equal footing”. This doesn’t marry well with Trump’s negotiating tactics nor those of John Bolton in particular.
Why is all of this relevant? Because it means the U.S. and China are in a stalemate. Neither is willing to back down. I prefer to put it this way: The U.S. and China are playing a game of chicken, and both are waiting to see who breaks first. As the U.S. increases tariffs and their scope, China just responds in kind. One of the tools the Chinese are clearly using is a weaker yuan, a higher USD/CNY, which is what has been driving Gold lower since April. Given that a resolution appears to be nowhere in sight, this trade war is likely to continue a lot longer than many expect, which doesn’t bode well for the yuan or Gold.
So how does this all end and when? The U.S. is clearly betting on the fact that rising tariffs will bring the Chinese economy to its knees, and therefore China will ultimately capitulate to U.S. demands. By contrast, China is betting on two potential outcomes:
- U.S. tariffs hit U.S. businesses and consumers, such as farmers and the fishing industry recently, dramatically slowing the U.S. economy and becoming politically unpopular in the U.S. ahead of Midterm elections in November, thereby softening the U.S. stance. Much like proposed tariffs on car imports from the EU were widely unpopular and forced a negotiation between the U.S. and EU on the issue.
- A crash in U.S. financial markets, most notably the stock market, which unlike in China is key to U.S. Federal Tax Receipts and, therefore, U.S. Government finances. A yuan devaluation of 3% in August 2015 caused a sharp reversal in stocks. That was when the S&P was 30% lower than it is today, and the yuan has already been devalued ~10% to date. Such a crash would likely force the Fed to reverse policy towards ‘QE’ and lower interest rates, causing the dollar to drop. USD/CNY would also drop, negating the need for tariffs by making all Chinese exports to the U.S. more expensive in dollar terms and U.S. exports to China cheaper in yuan terms, reducing the trade deficit between the two countries.
As I said earlier, 25% tariffs on 40% or $200bln of Chinese exports are due to go into effect on Sept 5 or thereafter. Given the rhetoric on both sides since then, I wouldn’t be surprised to see Trump threaten what he said a month ago and propose a 25% tariff on ALL Chinese exports to the U.S., ~$500bln. If China were to remain consistent and respond in kind, one would expect a dramatic response to such a move that could tank U.S. and world markets.
This would also come at a time when the Fed and global central banks are tightening global liquidity, the lifeblood of stock markets, which is expected to be negative in Q4. The punchbowl is being removed. Furthermore, the Fed’s balance sheet reduction program will hit $50bln per month in October, at a time when treasury issuance is already increasing $100bln per month and foreign demand is waning. Sounds like a perfect storm for a stock market crash, in my opinion.
Should such a crash occur in September or October, given the importance of the stock market to U.S. finances, I would expect the Fed to reverse policy to stimulus on steroids and the dollar to fall. USD/CNY also. This would be the peak in USD/CNY and the bottom in Gold for the foreseeable future, perhaps ever.
In the short-term, there is an observation period before the 25% tariffs are implemented. China could try to appease the U.S. by allowing the USD/CNY to fall temporarily, which would cause Gold to bounce. If they do, it is unlikely to work, and USD/CNY will go higher again, perhaps beyond 7, and Gold will fall to lower lows before the endgame is reached.
In summary, Ivan Martchev put it best in his “original” Marketwatch article: https://www.marketwatch.com/story/trump-is-foolish-to-think-china-will-back-down-from-a-trade-war-2018-08-02