On gold, the Fed and the BIS

In this article, we will comment on the impact of the most important central bank and the bank of central banks on gold. The most important central bank is of course the Fed, not only because many central banks hold part of their gold reserves in the vaults of the Fed, but also because the recent FOMC statement moved gold last week. The Bank of International Settlements, the BIS, is the bank of the central banks. According to many web-sites and e-mailed newsletters, the BIS should be responsible that the price of gold would double overnight on January 1, 2013. In both cases, there is a major lack of understanding from our point of view. The FOMC statement should not be negative while the BIS would not be positive for gold.

According to Sir Karl Popper, one example that proofs a theory being wrong would be enough to falsify the whole theory. Developed primarily by economists from the Chicago School, it is now mainstream economic theory that financial markets would be information efficient. The reaction in financial and commodity markets after the release of the FOMC statement provide another example that markets are not always information efficient.

What caused the negative market reaction in equity and commodity markets had been the following lines of the FOMC statement: “In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.”

According to some comments made in the media, markets reacted negatively because they were surprised by the link of the highly accommodative stance of monetary policy to certain levels for the unemployment rate and the inflation outlook. This argument was especially given as explanation of the plunge of gold the next day in early Asian trading hours.  However, already the minutes of the preceding FOMC minutes highlighted that the FOMC discussed those links. Also several members of the FOMC referred to providing more guidance to financial markets and the real economy by stating explicitly at which levels of its two targets a change in monetary policy has to be expected.  Thus, if markets were really information efficient, this part of the FOMC statement should not have surprised many traders and investors.

Another argument had been that this link would have increased the uncertainty about the end of QE. Especially politicians of the Republican Party dubbed QE3 as “QE infinity” expressing their disgust of the Fed policy. However, it should have been clear to every professional investor or trader that QE will end someday. The FOMC provides now strong indications under which circumstances this would be the case someday in the future.

In addition, some commentators argued that markets would fear that the FOMC might end the period of exceptionally low Fed Funds rates earlier than the FOMC indicated in fall, when the members expressed their conviction that rates would be at the current level until 2015. However, this fear is also not justified as the FOMC states further. “The Committee views these thresholds as consistent with its earlier date-based guidance.” Therefore, nothing indicates that the FOMC has changed its assessment and intends to increase the Fed Funds rate before 2015.

But even in the case that the FOMC would have to hike interest rates earlier than currently indicated, would it be really a rational argument to sell gold? After the December 2012 FOMC statement, the markets know under which conditions an end of the current monetary policy would occur. It is either a fall of the unemployment rate below the 6.5% threshold or a worsening of the medium-term inflation outlook. In the case that a fall of unemployment is the trigger, this would imply that companies hire more workers. But companies hire only more staff if the demand for their products increases, which also implies that corporate profits will grow further. This would lead to higher stock market prices and the demand for risky assets would also lead to higher prices for gold. If on the other hands higher inflation is the reason for hiking interest rates, then gold should profit as a safe haven against accelerating inflation rates. Thus, there is no rational reason to sell gold only because the Fed might end its current monetary policy before 2015. The conditions for a pre-mature termination are favorable for gold and not negative.

Many web-sites and e-mailed newsletters contain statements that the BIS would make gold to a tier 1 asset with effect of January 1, 2013. The current risk weighting of gold were 50% and thus, the new rules of the BIS would lead to banks buying gold and thus prices doubling overnight as the New Year will begin. This is nonsense! If the price of gold would really double on the basis of a BIS decision, it would double as soon as the decision is made public at latest and not only at the date the measure would become effective. Otherwise, there would be an arbitrage opportunity that many smart hedge funds and banks had already exploited.

A first warning that this story is probably wrong could be got by a search at Google for BIS, gold and tier 1. Among the list of web-sites returned, we did not find the internet site of the BIS. Strange, isn’t it? Normally you would expect that this site should be at the top of the list because it would be the official source for any change of the gold’s role in banking supervision. Also a search at the BIS web-site did not lead to any result supporting the claim made on many web-sites and e-mailed newsletters. In the best case, this story is based on a misunderstanding. In the worst case, it is an intentional misguiding of investors by snake-oil salesmen.

January 1, 2013 should be the start date for new rules of banking supervision, also known as Basle III. One part of Basle III is the definition of banks’ capital. This consists of equity capital and retained earnings. In a broader definition, also some hybrid financing instruments are counted as capital. However, in no case is gold part of banks capital! Banks might have some liabilities to deliver gold in the future. But those liabilities are not equity capital. If banks hold gold, then it is an item on the asset site of the balance sheet.

One part of the already existing bank regulation is that assets have to be backed by capital. Various assets have different percentages, the risk weighting, which are counted against the capital of banks. If all assets had a 100% risk weighting then banks could not be leveraged and all assets had to be funded by equity capital. The risk weightings range currently from 0% (government bonds) to 150%. If gold had to be backed by 100% instead of 50%, then the costs for banks to hold gold would increase. This would not be an incentive to buy gold, but to reduce the gold holdings. There are also provisions for liquidity holdings, but also in this case, gold should retain a 50% RSF (Required Stable Funding) weighting.

Another subject is the counter-party credit risk and the role of gold as eligible collateral. Under Basle II, gold is one of the eligible financial collaterals under paragraph 145. This paragraph will not change in Basle III. Also the haircut of 15% of current market value will not change under Basle III.

Most of those web-sites and e-mailed newsletters promoting gold based on changes in the BIS rulings are based in the USA. However, Basle III is probably not being implemented in the US. Thus, US banks have no interest in pushing the price of gold higher under the Basle III accord.