Disruption ahead for the gold market?
Ned Naylor-Leyland, Head of Gold & Silver, discusses recent market dynamics for monetary metals and the potential impact to the gold market from new Basel 3 regulatory rules.
Gold had its worst month in four years in June and is almost the same price as it was a year ago. That seems somewhat counterintuitive given all that the central banks have done in the interim. Last year, starting around September, gold and silver began a big move as the market became obsessed with the pace at which rates could be raised rather than cut, and with the determined view that inflation is transitory and not permanent. Those two issues are still very pertinent today and potentially bullish for gold.
Another issue we have been watching closely is the changes to Basel 3 global financial regulations and their potential impact on the gold market. The new rules, which take effect in January, will raise the long-term funding requirement against gold trading to 85% from the current 50%.
The world’s central banks are fully allocated to gold because they hold the physical metal in their reserves and in many cases have repatriated their gold ahead of this change. But most daily trading of gold takes place in the unallocated, or over the counter, market in London. Unallocated gold is digital or paper exposure to the price of the metal.
The bullion banking system which operates this market is now being told that by January next year they are going to have to fully allocate with physical gold or close those positions down. The LBMA, or the London Bullion Market Association, which represents the bullion banks in London, is up in arms about the changes and pleading for clemency, but they will not get it because the period to challenge the changes has passed.
If you are a customer of a bank and you own unallocated or paper gold and you get closed out, you are going to seek physical gold. The bullion banks that sell unallocated gold are going to have add real gold to their reserves. Also, central banks such as Bolivia’s leased gold to the bullion market so in some cases physical gold was double counted. This practice will stop with the new rules.
We think there is a chance of material disruption to the bullion system due to the Basel 3 changes, and that is something we are watching closely.
EM debt will stay very attractive even if Treasury yields rise
Alejandro di Bernardo, Credit Analyst, Fixed Income, says EMD is now at the cheapest it has been versus US credit in the last five years, adjusted by rating.
There was strong performance in emerging market debt last month on the back of lower Treasury yields, although emerging market debt didn’t pick up as much as US high yield, given the strong dollar performance in the latter part of the month. When we look at spreads in emerging market high yield, which are around 100bps over US high yield, we can see space for emerging markets to catch up with developed markets.
Recent events in Latin America included Colombia being downgraded to BB+ from BBB, which was highly anticipated by the market and so didn’t result in a significant sell-off in Colombian bonds. They are now 50bps inside Brazilian bonds which is arguably fair given Colombia’s better fundamentals.
Elsewhere, Argentina avoided default by paying $430 million to the Paris Club. One of the things we are watching there are local polls ahead of mid-term elections to spot any shift in politics. In Peru, meanwhile, Castillo won the presidential run-off and the market is pricing in a pragmatic government. We are more cautious, especially for the mining sector, as the tail risk is significant and in our view is not reflected in valuations.
Overall, our preference in emerging market debt continues to be for short duration high yield bonds. Developed market spreads are reaching levels last seen before the 2008 crisis. If we adjust by rating, emerging market debt is now at the cheapest it has been versus US credit in the last five years, so we think it continues to be a very attractive asset class even if we see higher Treasury yields.
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