Trade Talks Fail, More Tariffs on Deck, Higher USD/CNY, Lower Gold Prices - David Brady, CFA (24/08/2018)

August 24, 2018

While I see the risk of a lower low in Gold to come, I am looking forward to a possible stock market crash in the U.S. soon and a subsequent Fed reversal of policy to cause a peak in the dollar and a historic bottom in Gold, other precious metals, and commodities in general.

Gold’s peg to the yuan remains intact. USD/CNY is the principal driver of Gold prices and has been since USD/CNY bottomed and Gold peaked on April 11, five months ago. China has been devaluing the yuan to offset U.S. tariffs. The U.S. plans to implement 25% tariffs on 40% or $200bln of Chinese exports to the U.S. on Sept 5, coupled with the risk that the U.S. threatens to add 25% tariffs on the remaining $300bln also. If this were to occur, I would expect USD/CNY to rise further, possibly greater than 7, causing Gold to fall to lower lows.

News of trade talks between the U.S. and China this week predictably led to a drop in USD/CNY as China tried to appease the U.S. prior to the talks.

Gold finally caught a bounce as a result.

However, as each graph above shows, both had partially reversed their recent moves prior to completion of the talks due to declining expectations of a positive outcome. Negative comments from both sides ahead of time regarding prospects for the meeting, coupled with the fact that lower level officials from the U.S. and China were taking part, tempered hopes for any kind of resolution.

The trade talks ended yesterday and were an abject failure, at least from a U.S. perspective—something I predicted in my previous article ( https://www.sprottmoney.com/Blog/a-new-or-false-dawn-for-gold-.html):

Now the risk is that 25% tariffs are implemented on Sept 5, the USD/CNY rises as expected and Gold falls to lower lows.

I would welcome such an outcome because it would enable purchase of physical Gold at bargain prices, given what I expect to come in the next few months. There is a perfect storm brewing for stocks, and a significant increase in the USD/CNY would only compound those headwinds contributing to a crash in the U.S. stock market of ~30%, in my opinion.

Given the importance of stocks to Federal Tax Receipts, I expect the Fed to revert to “stimulus on steroids”. The latest FOMC minutes on Wednesday confirm this expectation. The Fed opened the minutes talking about a return to ZIRP, QE, and other alternative policy tools in response to the next crisis. It also cited the trade war as the principal risk to the economy and markets. Should such a crash occur and the Fed does reverse policy, I expect the dollar to peak and fall. USD/CNY would likely peak and fall too. At this point, Gold would begin a truly meteoric rally.

Why do I say meteoric? We just have to look at the traditional indicators, such as technicals, sentiment, and positioning, for the fuel for such a rally.

POSITIONING

Money Managers (“Funds”)—the so-called “dumb money”, because they tend to be wrong at extremes—had the biggest net short position ever since records began in 2006. At 83k contracts, that is more than three times greater than the previous record set in December 2015, when Gold bottomed and began its historic rally from 1045 to 1377 in just over six months.

This provides a massive amount of fuel for the rally in Gold once it starts, and these Funds have to cover their record level of shorts.

At the same time, the Commercials—the so-called “smart money”, because they tend to be right at extremes—had their lowest net short position since December 2015. When you strip out the Producers component, the Banks are actually long, ready and waiting for the coming rally. Of course, Funds could become even more short and Banks even more long, but this is extremely bullish for Gold once the bottom is reached and for the size of the rally to follow.

SENTIMENT

Gold made a quadruple bottom at a spot DSI of 6 last week, which most would consider extremely bullish. But we were at a low of 10 back on May 15 ^th, and we’ve been in and out of single digits since, yet Gold continued to fall in price.

Furthermore, Gold may choose to repeat what it did in Nov-Dec 2015, when it rose from a positively divergent higher low in the spot DSI but at a lower low in price (shown by purple line below). This supports my view for a higher low in the spot DSI but at a lower low in the price of Gold to coincide with an end to the trade war or a reversal in Fed policy.

The 21-day moving average is a lagging indicator relative to the spot DSI, but it is less volatile and therefore a better indicator of the trend in sentiment. It fell to a low of 10.9 last Thursday, its lowest level since December 2016, when it reached 9.7. Gold rose straight up from there in 2016, and it could do so again in the weeks and months ahead.

Alternatively, it could also repeat what happened between August 2015 and January 2016 (shown by orange line above). The 21-DMA bottomed at 12 in August 2015, rose, then fell back to a positively divergent 14 in early January 2016. Like the spot DSI, this marries well with my expectation for a lower low in Gold before it takes off on a Fed policy reversal.

Massive fuel here, too, for the rally to come, sentiment is clearly uber-bearish.

TECHNICALS

Suffice to say that Gold has suffered some major technical damage. The trend is clear: A series of lower high and lower lows. Other than being horrendously oversold until the current bounce, there is little chart-wise to be bullish about, in my opinion.

Gold has fallen over $200 from its peak in April, with barely a bounce along the way. All thanks to the trade war and USD/CNY, in my opinion. Gold hasn’t been able to reach its 23.6% retracement of the entire decline from 1369 to 1168 at 1216. There are multiple Fibonacci resistances between 1211-1223.

Focusing on the weekly chart for whatever bright spots there are, the slope of the decline and its size is almost as bad as that following Trump’s election in November 2016, which is counter-intuitively bullish.

The RSI is extremely oversold at 24. The MACD Histogram does appear to have bottomed and is slowly turning up. The MACD Line is over-extended and close to December 2016 lows. Gold is setting up well for a positively divergent lower low, if it chooses to do so. There is little in the way of support between here and the 2016 low of 1124, save for the 1168 low last week.

CONCLUSION

Given the expected failure of the trade talks between the U.S. and China, it is likely that additional 25% tariffs are implemented by the U.S. on Sept 5. If this occurs, I see USD/CNY going higher and Gold going lower in the short term. But Gold is just building up fuel from a technical, sentiment and positioning perspective to soar higher once the USD/CNY peaks.

On that note, many are rightfully upset about the decline in Gold and the contribution of China to that decline via the weakening of the yuan. In my opinion, China controlling the Gold price is the best thing that could ever have happened to Gold in the long-term. Unlike the Bullion Banks on the COMEX, China has a vested interest in a higher Gold price long-term—once they are done buying it on the cheap in dollar terms, that is. They want an end to the dollar as the global reserve currency. What do you think will happen to Gold in dollar terms when that occurs? This is the reason that China has been loading up on Gold for years. Russia too. To hedge against a crash in the dollar.

Follow the smart money long-term.