Where have all the flowers gone, long time passing
Where have all the flowers gone, long time ago
Where have all the flowers gone?
Young girls have picked them everyone.
Oh, when will they ever learn?
Oh, when will they ever learn?
Peter, Paul and Mary
Impact of the volume of gold repo transactions
Gold bulls often point to the correlation between the percentage change in the price of gold and the percentage change in the money supply (World Monetary Base). The correlation since 1977 has been 80%.
Based on those figures, if the gold price had risen by as much as the World Monetary Base since 1977, it would actually be around $US3328 per ounce right now, instead of about $US1300. I am not predicting for a minute that the gold price is going to $3,328 per ounce. But what I am keen to explore in this article is another dynamic at play which may explain why there has been a lot of yellow-metal selling recently, sending the price plunging.
The potential implications for investors are profound. This dynamic could help explain why quantitative easing (QE) by central banks is not yet boosting economic growth very successfully and why QE may actually be the root cause of gold’s recent plunge.
The sell-off in gold may be due to a certain type of financing activity in the banking system which utilises gold as collateral to obtain and then deploy capital in the normal course of business operations. This transaction is known as a gold repo, or repurchase agreement.
Quite simply, a repo is like a 100% collateralised loan. The party that seeks the loan may have some form of collateral on its balance sheet – typically, Treasury bonds, gold, or some other type of security. This party sells that collateral to the loan provider and receives cash to the current value of the security. They then use that cash to conduct business (lending activity, investment, etc.) However, at the time they sell they also agree to buy the collateral back at a slightly higher price at a fixed point in the future. The difference between the sale price and the repurchase price is akin to an interest rate on the cash that they have received.
They agree to buy back the whole amount of the collateral at that time. The buyback price is not determined by market movements in the price of the particular type of collateral during the repo term. So if the market price of the collateral (e.g. Treasury bonds or gold) moves during the repo term, the collateral provider bears that risk.
At the start of the repo term, the title to the collateral passes to the party providing the cash. The collateral is, effectively, sold. From the market’s point of view, if gold is being used as repo collateral, and gold repo activity is high at a particular point in time, the gold price will fall under the influence of that selling pressure.
So why would gold holders want to lend out their gold in preference to other forms of collateral? One reason may be that they have a shortage of relatively liquid alternatives. If you don’t have enough US Treasury securities on your balance sheet to repo in order to get cash to fund your operations, you may have little choice but to resort to entering into gold repurchase agreements.
An increase in the need for gold to be used as collateral in repo transactions has, in part, been driven by tighter regulation of the banking system since the GFC, which restricts what banks can use as collateral in these agreements in order to bring greater stability to the system.
In a recent press article the Head of The Bank of England’s Sterling Markets division Andrew Hauser spoke about the collateral drought:
“Hauser noted the demand for high-quality liquid collateral is “set to rise sharply” as a result of changes in market practice, regulation and central banking.
He cited the Financial Stability Board’s (FSB) estimation that liquidity regulation and OTC margin requirements could create the demand for an additional $4 trillion worth of collateral – “at least” a third of the collateral in circulation today.”
“…He accepted that meeting the increased demand will involve mobilising the high-quality asset stock that is held by long-term investors and “locked away” in payments systems.”
That is one reason for increased gold sales. However, another school of thought says it is quantitative easing itself that is a major cause of the collateral drought. In other words, QE may be doing more harm than good! Treasury securities, often used in repo transactions, have become increasingly hard to find because the US Federal Reserve is holding $US1.5 trillion of these securities on its books as part of the QE process. A receiver of collateral often also enters into another repo agreement using the same collateral (known as rehypothecation), which creates a multiplier effect of 2.5 times. It therefore turns out the repo market is actually short around $US5 trillion worth of bonds needed for collateral purposes!
This, the argument goes, is why market participants are being forced to repo (sell) their gold.
Historically, gold repo activity has increased when liquidity has been very tight in collateral markets. This occurred during the Bear Stearns crisis, the failure of government mortgage outfit Fannie Mae, and during the European sovereign debt crisis. It was also evident during gold’s most recent plunge.
The repo market is the life-blood of global markets and economies. Its circulatory activity helps drive the “velocity of money”. Deny the repo markets collateral and you will choke that blood supply from the economy. These sharp falls in gold are a sign that the repo market is desperately short of collateral and that QE, which should be helping to boost liquidity so banks can lend to the real economy and boost growth, is not working as it should.
Investors in gold need to be aware of the presence and possible increase in the volume of gold repo transactions – a corollary of the quantitative easing programs – and their ability to cause short term reductions in the price of the yellow metal. It is a moot point whether this effect will continue. It depends on when and how fast QE is unwound. If you are a short term investor in gold, these sharp fluctuations are problematic, unless you are short. For longer term investors, the question to consider is how long will these dynamics persist?
By Matt Olsen, head of manager research and Deputy CIO, van Eyk Research
*** This article originally appeared in the July issue of the van Eyk View iPad magazine. You can download the issue from iTunes here.