The Price Of Gold Is Headed Much Higher - Here's Why

Includes: GLD, IAU
by: Dave Kranzler

The Basel III Accord (BA3) is scheduled to be implemented starting in January 2013. As part of this agreement, gold will be elevated to a tier 1 bank reserve asset. Because of this, gold will be de facto reasserted into the global financial system as a currency. This should add a new dimension to the ongoing bull market in gold and silver, as banks globally now have incentive to accumulate and hold gold as a valuable, liquid asset which can be leveraged as an operating asset.

The BA3 is the latest iteration of a global regulatory standard that governs bank capital and risk exposure. To summarize, BA3 will require banks globally to hold a higher amount of capital as "reserve" capital. This reserve capital is what theoretically buffers banks from the volatility and risk embedded in holding business assets. Reserve capital is the foundation upon which the fractional banking system rests. You can read a good summary of what BA3 does here: Basel III Accord.

The most interesting aspect of BA3 from my perspective as a precious metals investor is that it elevates the reserve status of gold from Tier 3 to Tier 1. A Tier 3 asset can only use 50% of its assessed market value to count as part of a bank's capital reserve valuation. This is typically for illiquid, hard to value assets like OTC derivatives. With a Tier 1 asset, the bank can count 100% of the asset's value toward its reserve calculation. The Tier 1 status is used sparingly for the most liquid, easy to value assets in the world: cash, coins and highly-rated sovereign-issued bonds (Treasuries, etc) -- and now gold.

That BA3 elevates gold to the Tier 1 status is highly significant to precious metals investors because it de facto imbues gold with currency status. Furthermore, it unequivocally differentiates gold from the general basket of "commodities," into which gold had been tossed since 1974, with the introduction of Comex gold futures.

In order to understand why this could be a signal that the price of gold is headed much higher, it helps to put use of Tier 1 assets in the context of global banking system liquidity mechanisms. The primary short-term liquidity funding mechanism is the repo transaction. Briefly, when a bank needs capital for short-term liquidity purposes, it engages in a repo transaction with a Central Bank. What happens is that the bank puts up collateral and receives a like-value amount of cash at a slight discount in order to build an "interest" charge into the transactions. When the term of the repo expires, the bank remits 100% cash and gets back its collateral. Since this is basically a swap of what is considered a largely riskless asset for short-term use of fungible cash, you can understand why only cash, coins and triple-A sovereign paper -- and now gold -- have been accepted as collateral for repo deals.

Up until recently, the ability to use assets below Tier 1 as repo collateral was limited in scope. But the ongoing financial distress of banks, especially in Europe, has created a severe shortage in repo-worthy collateral. Most repo-eligible assets are continuously pledged to Central Banks as soon as they become available. This is a well-documented problem and has forced the ECB and the Fed to consider using riskier assets in an attempt to avoid a banking system liquidity crisis.

Enter the newly minted "Tier 1" gold as a banking asset. Although it is the case that not a lot of banks actually own gold as part of their balance sheet, gold's availability as a liquid Tier 1 asset, among other characteristics, will make it quite valuable as a balance sheet asset for banks.

This is where it gets interesting.To the extent that a bank can hold and use gold as a repo-ready reserve asset, gold's value as repo collateral increases 100% with every dollar the price of gold increases. Think about that for a minute. If banks can convert lesser quality assets into the ownership of physical gold, they'll be incentivized to accumulate gold because it can be used for the purposes of repo funding and business lending.

If my analysis is correct, the price of gold will go higher from sheer demand/supply dynamics, but also because it will be in the entire global banking system's best interest from a balance sheet standpoint for the price of gold to move higher.

The purpose of this analysis was to lay the framework for a fundamental reason outside of the mainstream thinking as to why the price of gold is headed much higher. Look at it as an "information edge" that has not been discussed in public forums. Now the question is, how can we take advantage of this "information edge" besides the outright buying and safekeeping of physical gold?

My next article will discuss some ways in which you can take advantage of the next move higher in gold. GLD is the most basic way, but I will also discuss some leveraged versions of GLD, plus some hedging strategies. In addition, I will present a couple of ideas on junior mining stocks that are considerably undervalued.

Disclosure: I am long physical gold, as is the hedge fund I manage. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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