Tag: precious metals

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Basel III and Its Impact on Bullion Pricing

There has been much commentary recently in the precious metals arena about Basel III bank regulations proposed by the Bank of International Settlements (BIS”) that are now in the process of being implemented and their potential impact on the price of gold and silver.

The Bank of International Settlements is a supranational organization based in Basel, Switzerland whose mission is to support central banks’ objective of monetary and financial stability through international cooperation.  It provides a forum for dialogue and cooperation to develop a common understanding and plans for common actions.  The BIS has proposed Basel III rules as a set of voluntary international financial standards agreed upon by BIS members in the aftermath of the 2008 financial crisis.

The Basel III regulations make a distinction between allocated and unallocated bullion accounts.  Allocated bullion accounts represent title and ownership of specific bars, with the dealer acting as custodian on the client’s behalf.  Similar to the contents of deposit boxes, allocated bullion deposits do not appear on a bank’s balance sheet.

Most bullion in London is traded and settled on an unallocated basis, where the customer does not own specific bars but has a paper claim to an amount of metal.  Thus, such contracts are often referred to as “paper gold.”  Unallocated gold obligations appear as a liability on a bank’s balance sheet.  The origin of all unallocated gold accounts is not the depositing of gold, but credit creation by banks.

Basel III regulations will classify banks’ actual physical gold holdings (allocated and held in their own vault) as safe, tier 1 assets along with cash.  Unallocated gold contracts will be classified as tier 3 assets against which greater reserves are required.  The new requirements became effective on June 28 for European banks.  US banks are required to comply effective July 1 and UK banks will begin compliance on January 1, 2022.  UK banks dominate bullion trading at the London Bullion Market Association (LBMA), so much of the impact may be delayed until later this year and early 2022.

The unallocated gold market in London is huge in comparison to the physical gold that is traded.  Approximately 600 metric tonnes of gold derivatives (unallocated gold) are traded daily between LBMA members.  This does not include trading between members and non-members or intraday turnover.

Alisdair Macleod, Head of Research at Goldmoney, and others believe that the introduction of Basel III regulations will have a significant impact on bullion trading by large banks and consequently the price of gold and silver.  Macleod writes:

The LBMA’s problem with Basel III becomes obvious. Unallocated gold liabilities cannot be used for funding the bank’s assets, and unallocated gold assets take a valuation haircut of 15% of market value as well. In the future, the former cannot be simply offset against the latter, but bullion banks in London naturally run unallocated positions on both sides of their balance sheets. Whether the bank owns vaulted allocated gold to offset some of the price risk is immaterial. If this Basel 3 proposal goes through without modification, it will effectively be the end of the LBMA’s forward settlement business, and the end of arbitrage and hedging between LBMA members and the CME’s Comex futures contracts.

Macleod argues that Comex futures for gold and silver will also be impacted.

The Swaps category on Comex (the bullion bank trading desks) is currently net short of about $24bn in the GC gold futures contract and $1.6bn in silver futures. Pressure to pare back ownership of these positions to a few genuine market makers and American bank trading desks is bound to increase, because the short positions held by European bullion banks would have to be covered…  And in London, all LBMA banking members will similarly reduce their unallocated activities because unbalanced books would be heavily penalized by the rule changes when they come in for the UK as well. That would make Comex gold and silver contracts entirely dependent on producer hedging.

Price manipulation in the gold and silver market has been frequent and obvious in the past as banks were able to create more precious metals derivatives out of nowhere.  That will be more difficult in the future as the role of derivatives declines and there is a greater reliance on physical gold and silver.

The likely result of the Basel III regulations is:

  • A reduction in open contracts at the LBMA and Comex for gold and silver bullion.
  • For those investors who want to retain price exposure to gold and silver, a shift from unallocated bullion contracts to physical bullion in a vault.
  • Higher prices for physical gold and silver bullion.

I wish all of you a Happy July 4th weekend.  If you have any questions or comments, please contact me.

Robert G. Kahl
CFA, CPA, MBA

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The Fed’s New Rationale

The Fed’s New Rationale

Federal Reserve Chairman Jerome Powell gave a speech at Jackson Hole, Wyoming to outline the Fed’s new rationale for monetary policy.  The purpose of the speech was to outline a new framework for the Fed’s monetary policy.

Chairman Powell said the review of monetary policy was motivated by “our evolving understanding of four key economic developments.”  The four economic developments that he listed are:

  1. Assessments of the potential, or longer-run, growth rate of the economy have declined. For example, since January 2012, the median estimate of potential growth from FOMC participants has fallen from 2.5 percent to 1.8 percent.
  2. The general level of interest rates has fallen both here in the United States and around the world. Estimates of the neutral federal funds rate, which is the rate consistent with the economy operating at full strength and with stable inflation, have fallen substantially, in large part reflecting a fall in the equilibrium real interest rate.
  3. The record-long expansion that ended earlier this year led to the best labor market we had seen in some time. The unemployment rate hovered near 50-year lows for roughly 2 years, well below most estimates of its sustainable level.
  4. The historically strong labor market did not trigger a significant rise in inflation. Over the years, forecasts from FOMC participants and private-sector analysts routinely showed a return to 2 percent inflation, but these forecasts were never realized on a sustainable basis.

The revised statement of longer-run goals and monetary policy was approved unanimously by the Federal Reserve Open Market Committee.  While some aspects of the Fed’s policy remain in place, Chairman Powell highlighted some changes.

  1. The Fed expressly acknowledges that interest rates at the “lower bound” of its policy range reduces their scope to support the economy in the future by cutting interest rates.
  2. Maximum employment is a broad-based and inclusive goal. They appreciate the benefits of a strong labor market, particularly for many in low- and moderate-income communities.
  3. Going forward, employment can run at or above real-time estimates of its maximum level without causing concern, unless accompanied by signs of unwanted increases in inflation or the emergence of other risks.
  4. Their actions to achieve both sides of their dual mandate (stable prices and maximum sustainable employment) will be most effective if longer-term inflation expectations remain well-anchored at 2 percent.

In a curious comment that seems designed to give the Fed more leeway, Chairman Powell said that they would not be tying themselves to a “particular mathematical formula” that defines average inflation.  Their approach “could be viewed as a flexible form of average inflation targeting.”

While the economic developments that Chairman Powell listed are accurate, some commentators believe the Fed needed a new rationale to justify the huge volume of purchases of US Treasury securities and, to a lesser extent, mortgage-backed securities.  Since September 4, 2019 (one year ago), the Fed has added $2,276 billion of US Treasury securities and $460 billion of mortgage-backed securities to their balance sheet.

The Congressional Budget Office is now projecting a federal budget deficit of $3.3 trillion for the fiscal year ending September 30, 2020.  This requires US Treasury debt issuance that far exceeds demand from the private sector, so the Fed buys much of the new debt.  The increase in the monetary base to accommodate federal deficit spending and US Treasury debt issuance is likely to lead to inflation that exceeds 2%, along with further declines in the US currency.

Note to Clients

Earlier this year, I asked clients for approval via e-mail or phone conversation to temporarily increase the maximum limit on the precious metals allocation from 15% to 30%.   I now expect the reasons for having a significant precious metals allocation to remain in place for some time.

During the next two weeks, I will be sending out revised investment guidelines to show a potential allocation range of 0 – 30% for precious metals.  In the past, I committed the maximum of 30% of portfolios to precious metals bullion.  This proved to be timely and the precious metals allocation in most accounts now exceeds the initial allocation of 30% because gold and silver have increased in price more than most securities.  I would also like some provision in the investment guidelines to acknowledge that the upper limit on the allocation may be exceeded due to better relative performance.  I am not necessarily a perma-bull on precious metals, but I believe it will continue to be an attractive asset class until the US and other governments take a rigorous stance against deficit spending and the creation of more fiat currencies.

If you have any questions, please contact me.

Sincerely,
Robert G. Kahl
CFA, CPA, MBA