Yesterday, the Shanghai Composite Index tumbled 6.4 percent. What does it imply for the gold market?

Bears Strike Back

The Shanghai Composite Index plunged 6.4 percent (187.47 points) on Thursday, hitting a three-week low. The decline practically erased a 10 percent rebound in the index from the January low and extended its fall this year to 22.5 percent. It’s the world’s worst performing stock index, not counting Greece. Why did the equity prices fall? There are a few explanations.

First, short-term liquidity tightened. The Shanghai Interbank Offered Rates (Shibor), rates at which commercial banks lend to each other, increased as the People’s Bank of China withdrew 455.5 billion yuan of short-term loans from the market last week. It was the highest weekly net withdrawal level in three years. And a total of 960 billion yuan of reverse repurchase agreements are due to mature this week. In consequence, the overnight Shibor jumped to 2.004 percent, the highest since late January.

Second, investors could take profits after a 10-percent rebound. They have been hammered by months of volatile trading, so they could be prompted to exit. The timing may be no accident, since investors could be afraid of some negative news from the G-20 meeting (which takes place… in Shangai) or March National People’s Congress when new plans may be presented. There were also some concerns about restraining housing-price gains in some cities. Moreover, the PBOC fixed the yuan at lower levels to the U.S. dollar in the last three sessions, which could recall the steep devaluation of August. Importantly, the sell-off was intensified after regulators banned Zhongrong Life Insurance Co. from adding to its equity investments because it became insolvent.

Worries about China Remain

Generally, it seems that investors were just waiting for a catalyst to sell. There is little confidence in the market, so an increase in money-market rates led to a sell-off. Investors are simply afraid of further declines. The government and central bank may try to intervene to calm the markets, but they are not likely to reverse the trend. On the contrary, they seem to exacerbate the problem. The share selling limitations prevent the market from reaching an equilibrium and raise uncertainty about future prices. Moreover, the prospect of the devaluation of yuan is still hanging over global markets like the Sword of Damocles, increasing the uncertainty and destabilizing the markets. The Chinese authorities are in a trap. To ease worries and downward pressures on the exchange rate, they should undertake a significant one-time devaluation. However, such a move could be now interpreted as a signal that the Chinese slowdown is far more severe than everybody thought, which could lead to capital flight from China, exacerbating the yuan’s devaluation.

Actually, the Chinese slowdown is more severe than it is commonly assumed and it has not bottomed out yet. Private gauges of manufacturing activity showed that it shrunk for the eleventh straight month in January, while Chinese banks face a significant problem of non-performing loans.

Conclusions

The take-home message is that the Shanghai Composite Index fell again, indicating that bears returned to the Chinese stock market. The renewed worries about China should be supportive for the price of gold. However, the most important factor for gold investors is the question whether the Chinese weakness will entail negative spillover effects in Western markets. Yesterday, the U.S. and European markets shrugged off China’s market turmoil. However, gold continued to rise. It may mean two things. Either there is still a lot of uncertainty in the markets, despite calm reactions in the U.S. and European stock markets after a fresh plunge in China, or the current demand for gold reflects something more than just fear.

Disclaimer: Please note that the aim of the above analysis is to discuss the likely long-term impact of the featured phenomenon on the price of gold and this analysis does not indicate (nor does it aim to do so) whether gold is likely to move higher or lower in the short- or medium term. In order to determine the latter, many additional factors need to be considered (i.e. sentiment, chart patterns, cycles, indicators, ratios, self-similar patterns and more) and we are taking them into account (and discussing the short- and medium-term outlook) in our trading alerts.

Thank you.

Arkadiusz Sieron
Sunshine Profits‘ Gold News Monitor and Market Overview Editor

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