China absorbs huge gold volumes, but does it matter for prices?

The latest set of demand and supply trends released from GFMS and the World Gold Council largely focus on the continued of flows into China.  There, however, is still disagreement about where the gold is going, with there a large apparent increase in use of gold as collateral for financing.

The flow of gold from west to east looks like it is slowing, largely because ETF investors have stopped selling down so aggressively.  But while there has been a remarkable shift in demand patterns for physical metals, its not clear that it has mattered so much for the gold price, which still looks to be a function of the same factors driving real interest rates and FX markets.

Chinese demand rose 260 tonnes in 2013 according the WGC (lower than the GFMS data) to overtake India as the worlds largest consumer. While this is a big increase, it is quite a bit below apparent supply (mine supply + net imports from HK).  Many have speculated this has ended up in central bank vaults, but the more likely explanation is that there has been an increase in the use of gold for financing in the midst of tight credit markets.

The financing dynamic is not so supportive of bulls looking for Chinese demand looking to propel prices higher. But the reality is that these trends would have had limited influence over prices over the last year or so.

To be sure, gold prices have mostly moved in a consistent fashion against movements in the US dollar and real interest rates post the height of financial market turmoil in 2008.  This is shown in the chart on left, with the model for prices explained in more detail in this post.

This model doesn't forecast gold prices.  But it does tell you what is important.  While its not perfect, if around 80-90% of movements in gold prices are due to whatever is driving real interest rates and the the dollar (contrary to the belief of some), then its better to focus on those factors much more so than Chinese demand flows.

Perhaps the shifting consumption dynamics, along with increasing depth in SHFE & SGE gold markets, while change the dynamics of gold pricing away from the current paradigm.  But from an investment perspective, I think its better to wait to see evidence of that occurring rather than assuming that it will.

In the short run, we have seen some notable deviations in gold from movements in other variables. Even in the last few months, we have seen gold rally fairly strongly as real interest rates traded sideways.

But that seemed to be more about trading on geopolitical tensions, with appetite for these trades perhaps waning with the news flow.  Right now bonds and gold are largely on par.

Net speculative long positions have come off recent highs, but are still at a relatively high level. The risk seems to be an increase in shorts given net longs are about where they have been since mid-2013.

ETF investors have also started to sell more aggressively in the last month or so after a stabilisation through March.  This is in stark contrast to PGMs, where new products have started to gain more traction, particularly in palladium.

So at present, it seems investors are positioning themselves an improving economic outlook which should see yields rise.

This is not bullish, but it may not be as destructive to gold prices as some are forecasting.  In particular, it appears that investors want to sell the shorter end of the yield curve rather than the longer end.  Longer term yields seem more important to the gold thesis and while they may rise, it may not be as aggressive as some are thinking.