The Next Phase For Gold

Precious metals prices are currently fixed on strikes at mines in S Africa. Potential unrest is pushing PM prices higher. In the current weakening global trade environment, is it possible that an increase in worker unrest upsets the supply of metals at exactly when banks are shifting toward gold? Major disruption to platinum is expected from the current strike and the possibility exists for spillovers into other mines in the region. This comes after significant strife in South American mines and production facilities in the past eighteen months. The supply side of the metals equation is far from certain.

On the demand side, however, is exactly where attention should be focused. The new Basel Rules are positioning gold to enter the all-important ZERO RISK WEIGHTING category (targeted for adoption in 2015). Upon adoption, the new proposed rules would “elevate” gold in the regulatory hierarchy to the same status as cash and OECD sovereign debt in terms of capital ratios and regulatory leverage. Even the FDIC and OCC here in the United States have opened the requisite comment periods to adopt this proposal for US bank treatment.

It is mixed into the structure of much larger and broader rules changes (there are a lot of them, and they are extremely complex) so there is no sure thing here (there will likely be a lot in the new proposed rules that banks will push back on). What is extremely important is that the next phase in the re-evolution of gold’s role in banking is nearly upon us. The previous bank trend of treating gold as a banking pariah has notably changed. The second phase in gold’s re-evaluation has been seen as central banks have resumed buying gold in the past few years after being large net sellers since the late 1980’s (or the early 1980’s in the case of the Federal Reserve). As of this week, all the major futures exchanges just added gold as acceptable collateral for derivatives and repos (both the biggies, the CME Group and LCH, will accept gold as financial collateral starting Tuesday). These are not small changes to the financial system’s treatment of PM’s, it’s another major inflection.

The primary problem of gold as an asset, from the banking perspective, is that it has no intrinsic cash flows. It just sits there. So gold swaps and leasing were invented to “monetize” gold stocks so that bullion and central banks could at the same time maintain legal title (leasing is another form of hypothecation, except claims on gold are treated in the accounting rules as exactly the same as owning physical metal inside your vault which is no longer there). But from a market point of view, a gold lease is added supply to the seller side, especially in futures. That means banks and central banks, for most of the last twenty plus years, have been moving physical out of their vaults in exchange for holding encumbrances (paper claims). That is why the futures markets for PM’s are as large and liquid today.

If banks can now, under these proposed rules, keep the physical in their vaults and monetize it as collateral in derivative arrangements (IR swaps mostly), then they have a new outlet to obtain positive cash flows from gold without rendering additional physical selling – an almost exact reversal of the leasing/swap dynamic. This is also extremely useful if gold is accepted at the zero risk weighting, meaning that it would provide not only direct monetization for gold holders, it would do so with added regulatory and capital leverage (which is all that banks are after for any asset they own). Less selling pressure has been positive for price thirteen years , but it might also lead to banks reclaiming physical stocks from the market place if demand is high as a preferred collateral (which would be the case as uncertainty rises, particularly with regard to currency risk since gold is a good hedge against shifting currency prospects).

Since last year gold has been trading in tandem with bonds for the most part. I think it is a mistake to simply look at gold solely in terms of an inflation hedge or its relation to negative real interest rates, or even deflation. There is a missing financial element that has been working against the price for a long time. For those that aren’t familiar, the Washington Agreement was signed in September 1999. It was a collective agreement among central banks to limit the amount of central bank selling of gold bullion through leases and swaps, and hardly anyone knows anything about it. Not coincidentally, the bottom in the global gold market had been seen in the weeks leading up to the accord (it took another two years for gold to break out higher, but the price never reached that low again). It was the beginning of the gold bull, the first phase of gold’s reclamation project within the financial economy. It was an important shift in how central banks were viewing their own gold holdings and cannot be overstated. Now that the same process is reaching into the bank level, the re-orientation of gold back into banking is the next phase in this multi-decade secular financial trend. There are other factors to consider, of course, but prices should adjust accordingly.

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