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Roula Khalaf, editor-in-chief of the FT, selects her favourite stories in this weekly newsletter.

Good morning. Fed Chairman Jay Powell takes the stage today in Jackson Hole. Markets will be reeling because they are reading too much into the little he will say. We’re playing Powell Bingo: words on the board include “data dependent,” “non-housing services,” and “progress.” What else should we add? Email us: [email protected] and [email protected].

Gold and the dollar

On Wednesday, we suggested that one reason for gold’s recent strength is a weakening dollar. Gold is priced in dollars, so as the dollar has fallen over the past two months on expectations of rate cuts, the price of gold has risen (of course, this isn’t the only reason; gold is at record highs in other currencies as well).

Gold and the dollar are almost always negatively correlated. The price of the dollar is just one reason. The other has to do with U.S. interest rates. When rates rise relative to other countries, that pulls capital into Treasuries and strengthens the dollar. And when higher nominal rates bring inflation-adjusted rates, that raises the opportunity cost of holding gold and drives the price down.

The pattern of negative correlation is often broken during periods of financial stress, as investors flock to gold and the dollar as safe havens. Markets rushed to both gold and the dollar after the global financial crisis and the (unnamed) market revaluation of late 2018, causing them both to rise in tandem.

Surprisingly, though, the two have been rising together for much of gold’s big run this year. The correlation was positive in the early months of 2024, before the dollar began to fall last month:

This is very unusual:

2024 has not been a stressful period. Apart from a few crazy days in early August, risk assets have risen and the US economy is doing fine.

Unlike oil and the dollar, which have changed their historical relationship due to structural shifts, the dollar’s ​​simultaneous rise in gold appears to be the result of a grab bag of unrelated factors. Gold’s historically great year was driven by a simultaneous surge in demand from Chinese investors, global central banks increasing their gold reserve allocations, expectations of U.S. rate cuts, an amorphous mood of geopolitical uncertainty, and speculative interest from hedge funds. The dollar’s ​​strong run was driven by U.S. interest rates remaining higher than those in other countries for longer.

But perhaps all the factors that have forced the dollar and gold into correlation are evidence of, if not exactly a crisis, then something like an economic regime change. China, the world’s second-largest economy and long the engine of global growth, is slowing. Inflation, once considered a beast of the 20th century, is a live concern again. Politics in America, Europe and elsewhere are in flux. Here’s Mark Farrington of Farrington Consulting, a global FX consultancy:

There is a more recent one (gold dollar relationship) that has developed after the GFC, after the rise of China, after the Russia-Ukraine war and the split of the world economy. At the moment gold is moving between these different regimes, so it is difficult to trade on correlation.

Gold advocates argue that the metal’s recent run proves it is a great hedge against monetary and fiscal incontinence, and the associated inflationary risks. But the picture is not so simple.

(Reiter and Armstrong)

Chinese government bonds, banks and financial stability

Over the past month or so, Chinese banks and investors have been piling into bonds, seeking safe returns in a country where real estate has lost its appeal and stocks have never had much of a presence. Yields of both the 10-year and 30-year bonds hit record lows in early August. Official attempts to halt the buying pushed yields back up in mid-month — but only briefly.

We recently noted that it is a bit odd that the Chinese Communist Party is so keen to support the long end of China’s yield curve. The official reasoning is that they want to prevent Silicon Valley Bank-style banks from collapsing. Is this really a concern?

SVB collapsed as the long-term bonds on its balance sheet — a whopping 43 percent of its total assets — lost value after interest rates rose. It became “mark to market insolvent” and savers fled. Chinese banks also hold large amounts of bonds. At the end of the first quarter, Chinese banks owned a whopping 73 percent of outstanding government bonds, according to Capital Economics.

But an SVB-like event is unlikely in the short term. Wei He of Gavekal Dragonomics gives a few reasons:

• Although Chinese banks hold large amounts of bonds, these account for only 20 percent of bank balance sheets.

• Given weak growth and sluggish stock and property markets, there is little reason for the PBoC to raise rates and for Chinese investors to retreat from the bond market.

• Even if bond yields rise and prices fall, there is currently no place for households to put their capital, except in banks. A general bank run therefore seems unlikely.

It is entirely possible, even likely, that some individual banks hold bonds that are comparable to those in Silicon Valley, or worse. Disclosure of bank balance sheets in China is uneven. For many banks, there is no way for outsiders to know what the asset mix is. Depositors could get wind of bond losses at a particular bank and run.

But Chinese authorities know how to intervene quickly when banks get into trouble, either by forcing stronger banks to take over the assets and liabilities of weaker banks, or by creating special banks to take over toxic assets. Recently, authorities closed a record 40 community banks in Liaoning province and transferred their assets to a new regional bank. That could be due to bond performance, bad real estate loans, or something else. We just don’t know.

Low bond yields are putting pressure on other parts of the financial system, though. From Alicia Garcia-Herrero at Natixis:

Insurance companies have liabilities that are guaranteed at a certain rate, invested in government bonds… They now have to buy at low yields to pay the same liabilities that they have built up at a high yield. There is a huge maturity mismatch… This makes insurance companies technically bankrupt.

But the concentrated positions of individual banks in bonds, if it is a systemic problem, is not the biggest problem facing the Chinese financial system. Real estate lending, weak credit growth and a vague regulatory regime top the list.

If Chinese banks continued to increase their bond allocations and the economy recovered quickly, there could be a problem. Perhaps the authorities were trying to send a signal to bond investors and make them aware of the risks. But the fundamental reason yields are low is that the economic outlook is weak and Chinese households have few good investment options. Embarrassment about that reality is a better explanation for the official interventions in the bond market than concerns about stability. And that same reality meant that the interventions were doomed to fail.

(Reiter and Armstrong)

A good book to read

Mennonites of the Amazon region.

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