In this excellent article, Jeffrey P. Snider, Chief Investment Strategist at Alhambra Investment Partners, demonstrates that movements in the gold price coincide perfectly with periods of acute stress in the banking system, specifically shortages of collateral.
The reason for this is that, “gold holds a property in banking that makes it especially valuable – it is universal. It crosses national boundaries easily. In the modern financial world of short-term liabilities and wholesale money, this universality can come in handy. A US$ mortgage bond can obtain bank wholesale repo funding only in US$’s, but gold can obtain “repo” funding in any currency trading.
That means in times of extreme stress, gold acts like a universal liquidity stopgap – when all else fails, repo gold. The operational reality of a gold repo is a gold lease, charged at the forward rate (GOFO). In terms of market mechanics, a dramatic increase in gold leasing is seen as a massive increase in supply on the paper markets.
For various reasons in the past five years, collateral chains and the available collateral pool has dwindled dramatically. That has left banks to scramble for operational bypasses, but it also has led to periods of very acute stress.
When we match the price of gold against these stressed periods, they coincide perfectly. In other words, whenever collateralized lending has become problematic banks appeal to the universal collateral. Unfortunately, that looks like gold selling to the uninitiated.”
Mr Snider shows a series of charts that show these periods of extreme stress in the banking system (the failure of Bear Stearns, the bankruptcy of Lehman Brothers, the US debt downgrade, etc.), and how these problems with counterparties and collateral marry up with steep declines in the price of gold.
He notes that in each case, “the gold selloff has previewed a larger decline in systemic liquidity that eventually catches other asset classes”. Crucially, “this does not change the appeal of gold on the demand side – in these stressed periods there are defined trends of safety buying”.
Each time banks are faced with “a debilitating funding environment” the price of gold falls, only to rebound as funding problems ease.
“In every case where a dramatic selloff in gold has been seen across currencies, the hard collapse has been coincidental to collateral issues in the global system.
These volatile movements in gold prices do not conform to traditional ideas about what makes gold prices move. Conventional wisdom posits, all too simplistically, that gold prices correlate exclusively with inflation expectations and real interest rates. What has been proven otherwise, without ambiguity, is that this is at best an incomplete explanation. Given the manner in which the banking system dominates asset markets and currency markets, the often more extreme motivations from financial firms should be given a more prominent place, particularly since these very factors match prices in exact chronology. This is entirely a product of global liquidity and the true interbank currency pool (collateral availability).”
Mr Snider concludes that, “While central banks and politicians have proclaimed the Great Crisis as a relic of the past, there is an element to all this ‘liquidity’ coming from central banks that acts in a counterproductive fashion”. Quantitative easing actually disrupts available collateral, and the more QE that is undertaken, the less liquid the financial system becomes, “because QE essentially removes usable collateral from the aggregate collateral pool”.
“It is very possible, in my opinion likely, that QE is again wreaking havoc on collateral systems across the globe. If that is the case, then the collapse in gold prices both indicates this illiquid stance and portends something worse developing down the road.
Recent history has been very clear about the role of gold and interbank financing. There is no reason to think this time is different”.
Read the full article here.