The Arbitrageur: Gold Sea Change

 |  Includes: GLD, SLV
by: Keith Weiner

The gold/silver ratio is the price of gold divided by the price of silver. It may be thought of as the price of gold in silver terms. Today, this ratio is around 58; it takes about 58 ounces of silver to buy one ounce of gold.

I think this ratio is likely to move higher. This means it will take more silver to buy an ounce of gold, or alternatively, one ounce of gold will buy more silver.

International Basel bank regulations have been proposed to allow banks to hold gold as a "Tier 1" asset. A similar rule change within the US was proposed by the Fed, FDIC, and Office of the Comptroller of the Currency to allow banks to hold gold as a zero risk-weighted asset. Since the onset of WWI, governments have been increasingly hostile to gold. The US government created the Federal Reserve in 1913. After WWI, Real Bills were not allowed to circulate internationally as an additional punishment for Germany. And by the 1920s, governments saw gold as a threat to their plans. By 1933, as we all know, the US citizen was prohibited from owning gold and was forced to do business in paper scrip. The US Treasury bond replaced gold as the "risk free asset". In 1971, Nixon defaulted on the international gold obligations of the US government and we entered the worldwide regime of irredeemable paper. By 1975, there was a futures market in gold, to put gold in its place next to frozen orange juice and pork bellies.

Today, of course, people have rediscovered that the promise to pay is not free of risk.

For whatever reasons (we can only imagine the desperation and panic) they have decided to allow this first incremental step towards the re-monetization of gold. I don't know how often a proposed new rule is enacted and then quietly dies, but the fact that this one was proposed by Basel and three US regulatory agencies at the same time convinces me that it is a Done Deal. Banks will now have another asset that they can hold without "opportunity cost" (i.e. over-allocating regulatory-defined reserves).

I would go farther and speculate that the banks and regulators have discussed the idea that the gold price is rising inexorably. If the banks can get some gold onto their balance sheets now, then they take advantage of the rising price to re-capitalize themselves.

In any case, this is just a lead-in to the main point. When these changes become law, banks will begin buying gold. This is new demand for gold at the margin, and thus the price will rise. Speculators are not stupid, and so they will front-run the banks. Gold will get more good press, and so average people will go out and buy gold. It is logical to think that some banks may even try to front-run the front-runners and buy gold in anticipation of the rule taking effect.

Given gold's price performance this Spring and Summer, I think it fair to say that this process has not yet begun. I have no idea how long it will take for this proposed rule to become law, though looking at the macro environment I do not think it will be years.

In any case, this is yet another reason to be bearish on silver (priced in gold). While some arbitragers may try to resist the rising gold/silver ratio (maybe), I think they will be swamped under by the large new marginal demand for gold. This is a sea change, not an earnings report for a gold mining company. Gold miners produce a small amount of gold relative to total stocks accumulated from all of history, and one miner is only a small part of that, and a change at one miner would typically be only a part of that one miner's production. So if the gold price rises because a major gold miner is going to produce 10% less gold this year, the gold-silver arbitrageurs will correct the gold/silver ratio and/or speculators may push the price of gold right back after the move.

But this looks like a very different animal. This looks like a sea change, if I am correct to think that the major banks and banking regulators all over the world have agreed to go down this path.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I have long-term holdings of gold and silver.