Just in case...

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There once was was an English castaway, stuck on a desert island in the Pacific. When by accident a ship discovered the unfortunate man after 20 years, they found him running around naked, only wearing a bowler hat. When asked why he was running around naked, the answer was : "Why not, hardly any one comes around here". So why the bowler hat then ? "That's just in case some one should drop by".

In a world of financial uncertainty, an ace up the sleeve always comes in handy. To illustrate the growing uncertainty and the current difficulty of asset allocation in portfolios, this is what Marc Faber - another famous Dr Doom - had to say about it last week : "For the time being, I buy gold. I don't know what else to buy". And Marc Faber is not the only one "in the dark". Besides growing interest of small retail players (through ETFs, physical coins..), it seems that the big players such as central banks world-wide have become increasingly active on the gold market, for the first time in nearly two decades becoming net-buyers. A cynic might conclude that this is the ultimate contrarian indicator and that it is high time to sell (at previous occasions, when central banks were heavily involved in the gold market through selling, it was the start of a bull market). Well, this time it might be different, certainly in view of some other big shifts going on and the potential which is still there.

First of all, China has changed the rules of the game after it gave in this weekend to major pressure coming out of the US. The pressure was put out of two angles. Angle no 1 involves the well known argument of accusing China to keep its exchange rate artificially low and hereby causing a huge US trade deficit. Looking at the numbers however, it seems to be a an exclusive US problem because the Chinese trade balance with the G-20 ex US shows a small deficit. Nevertheless, by announcing a certain willingness to let the Yuan appreciate, China has created some deflection from the G-20 summit in Toronto next weekend. Deflection to the extent that we should not expect major exchange rate moves in the Yuan/USD rate. The second angle of US pressure comes from the decreasing interest of China in US debt. China holds some 900 bio USD in US Treasuries which is about 30% of its total forex reserves. It had been steadily decreasing its position until the Obama administration came along two months ago. And China was not the only net seller over the past 6 months, also Russia substantially decreased its holdings in US Treasuries. The following graph gives the monthly evolution in bio USD of holdings in US Treasuries since November 2009 :

Active gold buyers over the last year were India (bought 200 tons from IMF, raising its total to 615 tons) and Russia which has systematically, month after month, been adding gold to its central bank reserves. Russia has also increased its mining efforts last year by increasing production (new mines) by almost 20%. For China the same applies and one can expect that a lot of this new production will directly end up in the vaults of Bejing and Moscow. And these are not the only central banks adding gold as a form of diversification. This week it has been reported that Saudi Arabia has more than doubled its reserves, from the previously announced 143 tonnes to the current 323 tonnes.

Now if we look at the composition of the reserves of the most powerful central banks in the world, the picture becomes as follows :

Some argue that decreasing yields on bonds and higher gold prices can go hand in hand : if it seems deflation is not the outcome , than gold will be the hedge for the "long" bond position. So central banks buy up government debt and gold to be risk (inflation) neutral ? Could be, but then some big players still have a long way to go. Look at China and Russia for example : Their gold position, though fairly big, is far from sufficient to hedge against a US or global inflation surprise. And not surprisingly, BRIC countries are the ones to monitor closely : China holds 30% of its reserve exposure in UST, Russia 20%. India seems quite all right (8,7% UST) but Brazil is on the other extreme : 73% of its reserves (164 bio USD) is invested in UST bills/bonds while its gold reserve amounts a meager 1,12 bio USD or 0,5% of its total; So with the exception of India, BRIC central banks have still some way to go, call it diversification, call it inflation hedge or hedge against $ weakness under the motto "just in case".

The fact that BRIC and OPEC (Saudi Arabia) have been at the centre of this small story is no surprise either. These countries are steadily changing the power relationships in global economics and/or have a lot to win or to loose. If the USD for example looses some of its unique international reserve status, hoarding gold might basically be an excellent instrument in anticipation. On the the status of reserve currency, it is not only the USD coming under fire but also the Euro. Last week, several statements of central bank officials pointed in that direction. Bot Christian Noyer (ECB) and Alexei Ulyukaiev (Russian CB) stated that Australian and Canadian $ become increasingly attractive for central bank diversification purposes. UBS, the world's no2 forex trader, recently issued a report in which it predicts that the IMF will add the Canadian and Australian $ to a basket of currencies it uses in transactions. Liquidity of these markets for the time being prohibits these currencies and debt assets to become a biggger part of CB portfolios.

As for China and the latest developments on the Yuan, the US cannot have it both ways by imposing currency pressure ("please accept a weaker $") and debt pressure ("please continue to buy our debt in $"). The natural outcome of this game might be that yields on US Treasury bonds should go higher because of the risk premium (monetization, weak currency outlook) and the fact that China will have less reserves at its disposition to buy US debt. This is just a consequence of demand (down) and supply (up), requiring lower prices and hence higher yields.

To finally put it in a broader context, the present "gold bug" might just be a reflection of what happens when "real" economics is overtaken by "illusionary" economics, the latter translated in over-stimulus through debt creation and money printing. So at some stage, the stresses of debt-money overwhelm the system. In a transitory stage, the only solution for debt-based money systems is the printing of more money to counteract deflation fears. And then inevitably money metals such as gold and silver come to the rise, merely reflecting the loss of value of paper and electronic fiat money. So is the current fiat system ruined and is a form of metal standard re-emerging ? May be it is still too soon to make this call but in the mean time, it doesn't hurt either to wear a bowler hat, just in case.