Will A Liquidity Squeeze In Gold Cause Prices To Go Up?

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Gold investors took a hit recently as the yellow metal slumped 6% on growing bets that the Federal Reserve would start raising interest rates earlier than expected. The dollar index and real yields both climbed as the Fed turned hawkish, which weighed on the gold price.

Gold nuggets on top of American paper money representing gold stocks

Source: Shutterstock

One analyst expects a deeper correction in the yellow metal, while another predicts a price above $2,000 an ounce by the end of the year.

Demand for Gold Returns

In an email, Edward Moya of OANDA said demand for gold has been coming back slowly as investors become more confident that the Fed is still probably years away from changing anything despite its talk about ending stimulus.

“Gold has recovered around 30% of the plunge that stemmed from FOMC hawkish tilt and could continue to do so on the break of the $1,800 level,” Moya said. “Gold’s best friend has been a weaker dollar that stemmed from an ultra-accommodative Fed.”

He also said gold would have two friends for the time being, which are the accommodative Fed for the next 18 months or so and a new wave of inflation hedges stemming from many of the tightening cycles from central banks in emerging markets like the Czech Republic and Hungary.

Watching the Economic Data

Victor Argonov, senior analyst at fintech EXANTE, noted that calm returned to the gold market at the beginning of this week after what he describes as a “mini taper tantrum” last week. He added that futures initially slid further at the open after European investors started their day, but they bought the dip in futures.

Argonov said the dollar index reached its highest level in two months as gold and copper slumped last week due to the Fed’s surprise hawkishness. Going forward, investors will watch the incoming economic data and speeches by central bank officials to figure out if the reflation trade is over or if last week was just a hiccup.

“Some investors fear that with inflation rising rapidly around the world, the vast programs of asset purchases might have to be tapered sooner than expected by major central banks such as the Federal Reserve and European Central Bank,” Argonov said in an email. “Further hawkish commentary from the Fed or signs of above-forecast inflation may mean the dollar’s rise is not just a short-squeeze recovery. If that’s the case, then we could see buck-denominated commodities come under further pressure.”

He warned that the dollar could strengthen again soon despite Monday’s weakness, while the metal could enter a deeper correction despite rising inflation. However, not everyone expects gold to enter another deep correction. Inflation is usually good for metals, but not if it means that the Fed will start raising interest rates.

Basel III

According to another expert, one other factor to consider for the metal is Basel III. Goldex CEO Sylvia Carrasco told Kitco that Basel III could trigger a liquidity squeeze in gold, pushing prices as high as $2,100 an ounce by the end of the year.

The Basel III agreement goes into effect on June 28 for European banks and Jan. 1, 2022 for British banks. The Basel Committee on Banking Supervision reached the agreement after the Global Financial Crisis of 2007 to 2009. Many of the measures in the agreement have to do with banks having enough capital, stress testing, and liquidity in the market.

One of the biggest changes in Basel III is the reclassification of gold from a Tier 3 asset, which is the riskiest asset class, to a Tier 1 asset, which includes currencies and cash. Carrasco believes the change might make it more expensive to sell and buy unallocated gold.

Allocated Versus Unallocated Gold

The agreement requires that banks hold an 85% Required Stable Funding against the clearing and financing of precious metals transactions. Before Basel III, banks weren’t required to hold any stable funding against such transactions. Carrasco explained that Basel III requires dealers or banks to “collateralize 85% of the value of their unallocated gold with a Tier 1 asset, which is cash.”

Kitco gave an example of a bank with $1 billion in gold positions, including $300 million in allocated gold and $700 million in unallocated gold. Before Basel III goes into effect, the bank isn’t required to hold any collateral for that $700 million in unallocated gold. However, after Basel III, unallocated gold is considered as risky as stocks.

Allocated gold is physical metal that has been minted and is being held in a vault and owned by a customer. On the other hand, unallocated gold is similar to credit because it doesn’t have to be in a vault, and it’s like the customer is trading against a bullion dealer’s balance sheets. The bullion dealer isn’t required to have the gold when it’s unallocated. Additionally, unallocated gold can be sold 20 times to 20 people, while allocated gold can only be sold one time.

Liquidity Squeeze?

Carrasco expects the changes in the Basel III agreement to cause a liquidity squeeze in the metal, driving the precious metal to $2,100 an ounce by the end of the year. She looks for the biggest impact of Basel III to hit toward the end of the year right before the agreement goes into effect in the U.K. Carrasco said the largest amount of unallocated gold is traded in London.

Starting on June 28, only one-third of European banks will have to follow the new agreement. The rest won’t have to follow the rules until January 1, 2022. Carrasco explained that allocated gold is finite, while unallocated gold is infinite.

“If people turn to allocated gold, liquidity will be squeezed, and prices should go up,” she told Kitco. “There are X amount of bars around until more is produced. Bullion banks hedge themselves with COMEX futures. They have tremendous short positions in COMEX, and they are getting rid of them. If from the end of June they need to start selling their short positions, that automatically creates an increase in the price of gold.”

On the date of publication, Michelle Jones did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.

Michelle Jones is editor-in-chief for ValueWalk.com and has been with the site since 2012. Previously, she was a television news producer for eight years. She produced the morning news programs for the NBC affiliates in Evansville, Indiana and Huntsville, Alabama and spent a short time at the CBS affiliate in Huntsville. She has experience as a writer and public relations expert for a wide variety of businesses. Email her at Mjones@valuewalk.com. 

Michelle Jones is editor-in-chief for ValueWalk.com and has been with the site since 2012. Previously, she was a television news producer for eight years. She produced the morning news programs for the NBC affiliates in Evansville, Indiana and Huntsville, Alabama and spent a short time at the CBS affiliate in Huntsville. She has experience as a writer and public relations expert for a wide variety of businesses. Email her at Mjones@valuewalk.com.


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