Short gold on failed breakout and potential for Chinese yuan appreciation

I sold the August gold contract with a stop near today's peak.   There are a few reasons driving the trade

1) I don't think the movements in gold are widely understood.  I mentioned (on Twitter) Fred Wilson's article on why he thought gold was a poor investment.  Fred was looking at gold as an asset and points out that unlike many other assets its only source of return is price appreciation.  I think this misses the point that gold is more like a currency.  Jim Hamilton reaches a similar conclusion, offering that gold's movements might best be explained by government bond purchasers worrying about the value of the money they are repaid in.

2) The typical reserve currencies - the U.S. dollar, the Japanese yen, and the Euro - all have varying degrees of the same problem.  Their debt levels to GDP are historically high giving them incentive to devalue their currencies.  Typically investors would hedge this risk in other currencies that pay interest rather than gold but there is a worry of policy contagion and likely a need to diversify across many currency options (of which gold is one) to find liquidity with the biggest currencies looking dubious.

Now we are getting to why I would short gold, since the statements above are bullish.

3)  China is a large country with a vibrant economy and excess reserves. It is in some ways the opposite of the traditional reserve currencies with no risk of devaluation to meet debt obligations.  Devaluation risks in China stem from its desire to maintain a weak currency to promote exports.  That policy is probably growing less viable.  They addressed this problem in 2005-2008 by allowing the yuan to appreciate.  That policy of an appreciating yuan is likely to resume now.  The yuan pays interest so to the extent investor can utilise it for hedging purposes it is a better alternative than gold.  This should remove some of the hedging demand in gold.  The yuan revalue may go slowly and may not even go at all but as long as investor access grows, Chinese coupon receipts will win out over gold storage payments.  I expect more news on the Yuan over the next few weeks with the most likely thing being some movement in the daily mid-point. (Update: This has now happened while my this post sat in the editor.)

4) The technical picture and sentiment might make for a swift drop.  Gold's recent new highs, signs of increasing retail ownership, and the obviousness of the money-printing-fiscal-debacle discussed above likely have some leaning the wrong way and speculating on price appreciation rather than just hedging.  I expect the hedge flows are bigger and will dominate the price direction while speculators add to volatility and chase momentum both ways.  The COMEX futures are just above their 20 day exponential moving average as I type and a lower low will occur at 1216.  Either of these levels breaking might be enough to cause the momentum to swing bearish in a hurry.

So to summarise, I see the bullish case for gold but the pressure to use gold as a currency hedge should fall on this Yuan move.  Any further price drop might lead to a sharper and longer term fall as weak hands are shaken out and momentum traders change direction.