We know the gold bug/Austrian case.
When the United States broke away from the gold standard in the 1970s it allowed for unchecked credit creation, beyond what could realistically be supported by economic growth.
Given this scenario, what should gold bugs make of the market’s move towards re-collateralisation in all funding areas? A move not dictated by regulators or authorities, but the markets themselves?
After all, the latest trend towards gold collateralised bank loans shows in some ways that the market is demanding the recollateralision of credit with gold.
Banks don’t need gold as much as they need cash. They use the gold to get cash. Cash is once again being backed by gold. In the interim, there is less demand for gold as a buy-and-hold asset, and more demand for its use as a funding instrument: collateral.
As the FT reported last week:
A dash for cash by European banks in a little watched corner of the gold market has accelerated this week, highlighting the continued scarcity of dollar funding even after a co-ordinated intervention in the market by the world’s largest central banks.
Gold dealers said that banks – primarily based in France and Italy – had been actively lending gold in the market in exchange for dollars in the past week.
Naturally, this recollateralisation of credit with gold has very important implications for the gold price.
While gold could previously generate an income from being loaned out — the result of gold producers’s hedging needs in an environment where gold demand was uncertain — it no longer can. Gold is now reflecting a negative lease rate, otherwise known as a repo rate. It means there is more demand for using the asset to obtain credit, than there is demand for asset, using credit. Or, for that matter, demand for hedging the asset.
The more it’s used as collateral, the more you can consider it to be on par with something like a zero-coupon Treasury bond or bill. Gold begins to determine the cost of money. What’s more, if gold begins to exchange hands as collateral more often than government bonds, it might even begin to reflect a greater velocity in its use as a monetary instrument than a government security.
If you consider that the velocity of traditional collateral such as government bonds is deteriorating, that opens the question to whether or not gold is switching places with Treasuries as the ultimate form of collateral?
In that context, the move in lease rates could be considered pretty significant. Think of them as a reflection of the cost of funding with gold. The more negative the rate, the higher the cost of funding using the collateral. And just like in the bond markets, it seems there’s been a move towards funding over short durations rather than long — meaning even gold is not enough of a guarantee to secure 12-month funds, while it used to be just a few months ago.
Here, for example, the one-month lease rate:
Here’s the three month rate:
And here, finally, is the 12-month rate (firmly in positive territory):
With more demand for gold as collateral — and with gold arguably influencing the cost of money — it’s natural that central banks should behave in gold markets like they have been used to behaving in bond markets, i.e. for executing rate policy.
When repo rates fall below the policy rate, the central bank usually intervenes by providing more collateral to alleviate collateral squeezes, lifting rates as it goes. When repo rates rise above the policy rate, the central bank can intervene by absorbing collateral from the system, making it more desirable (since there is less of it) lowering rates as it goes.
Apply that to the current market where gold ‘repo rates’ are rising, that should call for central banks to absorb gold collateral to hold rates at bay. Unless, of course, ‘repo rates’ are rising because central banks have started flooding the system with gold for use as collateral — so as to ease the funding squeezes elsewhere. While unconfirmed, it’s definitely something that’s been on the market radar this week.
The more unencumbered gold in the system, the more likely banks will use it for funding — and/or for covering shorts.
You can think of it as the ultimate QE. Or ‘printing gold’ to ease the collateral crunch.
With surplus gold being put into the system, the price of gold has no choice but to stall. Especially as those ‘squeezes’ get eliminated.
Why gold forward rate inversion is important – FT Alphaville
Cash for gold, financial market edition - FT Alphaville
Cash is king – FT Alphaville
HSBC Sues MF Global Over $850,000 of Gold – Bloomberg
SocGen and the hand of GOFO – FT Alphaville