SPDR Gold Trust (GLD)

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What Is Driving Gold?
By: Adrian Day | June 11, 2021

The recent jump in the Consumer Price Index (CPI) generated a lot of attention, with consumers noticing a wide range of price increases while the Federal Reserve and its apologists insist it is only "transitory." This in itself is rather peculiar, given that the Fed has been seeking higher inflation for sometime: Should they not have taken a victory lap?

The arguments for April's CPI jump being short-lived are two: One, that last April's was abnormally low, given it was at the start of lockdown in many states, so the year-to-year comparison would inevitably be higher (the "base effect"); and two, that with many states now opening up, there is pent-up demand not yet met by increased demand.

Are higher prices only "transitory?"

The first is, in theory, absolutely true, but in the case of CPI numbers patently false, given that the absolute CPI level is well above (over 4%) that of several months before any COVID lockdowns. The second has more validity, but it may be a few months before we see if it is, in fact, true in reality. Different conditions are affecting different sectors and regions differently. Pent-up demand is evidenced in, for example, hotel room rates, while restaurants, for example, are slower to come back to full re-opening (whether because of lingering capacity restrictions or that many simply went out of business over the past year).

But commodity input prices are up across the board, more than the Producer Price Index, which, in turn, is up more than consumer prices, suggesting that there are higher prices ahead as these earlier-stage prices work their way through the supply chain.

Fed policy suggests inflation will move higher

One major factor suggests that inflation will be long-lasting, and that is Federal Reserve policy. The money supply is up at a 21% rate in the last three months—higher than the six-month rate—and nothing suggests that will change any time soon. The Biden Administration has various spending plans—COVID relief, infrastructure, fighting racism etc.—totaling $10–12 trillion. Much of this additional spending will come from the "Magical Money Tree," as the Federal Reserve indicates its willingness to monetize the debt. At the same time, there is no indication that the Fed will tighten meaningfully to fight the inflation it both wants and believes is only temporary. On the contrary, many Fed members have stated flatly that the Fed will not be too hasty fighting a temporary increases in prices.

Inflation is positive for gold, but even more positive is an inflation that the Fed refuses to acknowledge and will not fight.

Here comes Basel

Another major factor potentially contributing to higher gold prices the last few months has been buying from banks ahead of the implementation of the Basel III rules. We do not need to go into all the details of the new Net Stable Funding Requirement (NSFR) rules under Basel III, which come into force in Europe and the U.S. at the end of June (and the U.K. Jan. 1). In essence, the rules make changes to what assets are included in both the asset and liability side of the ledger. Physical gold moves to a Tier 1 asset, counted at 100% of value in calculating reserves. In and of itself, that would be a positive since banks could hold gold without a disadvantage over Treasuries and other assets.

Paper gold, as well as unallocated gold, now have a zero value, meaning that they cannot be used as a source of bank funding. Thus, the difference in valuation for physical and paper gold has been widened substantially, giving banks an incentive to buy physical. (Moving unallocated gold to allocated does not help the banks, since allocated gold is not a bank asset.)

Banks have likely been buying

The implementation of these rules is bullish for gold, though many commentators have, in my view, wildly exaggerated the potential impact. Banks will have other ways to come into compliance than converting all their paper gold to physical. Most banks have excess liquidity in any event, and they can increase their acceptable funding in other ways. But there will be some buying, and in all likelihood already has been.

Any bank buying ahead of the rules is time sensitive but not price sensitive, which could help explain why gold has moved up for three months with no meaningful pullback; there has been no more than two consecutive down days for gold over that period.

Since banks have until the end of the year to come into full compliance, this buying could continue, and once this bullion is purchased, it will not be readily sold. So this is a bullish factor, even if not quite as wildly bullish as some commentators are suggesting.

London's bullion forward market is at risk

The changes have a particular impact of the futures market, particularly the banks that are members of the London Billion Market Association (LBMA). Other members of the LBMA are producers and refiners, who want to hedge positions. At present, forward buy contracts are offset by forward sell contracts, and bullion banks have positions on both sides, netting out. The new rules require one side of the balance sheet to have contracts valued with a 15% discount, but excluded from the other side of the balance sheet.

It is unrealistic for bullion banks to buy physical to cover their contracts. Theoretically, this could stop most trading of forwards in bullion, leaving only a handful of large commercial banks. At the minimum, it would drastically shrink the market, including the swaps done with the COMEX futures market. The LBMA is seeking to be excluded from the new requirements. There is a possibility that the U.K. may grant that exemption, though the rules for other banks will not be extended again.

Nevada continues to hold promise for Barrick and Newmont

Barrick Gold Corp. (ABX:TSX; GOLD:NYSE, US$23.46) said it expects Nevada Gold Mines (NGM), which it owns jointly with Newmont Corp. (NEM:NYSE, 71.45) 61.5%/38.5% and of which it is the operator, to produce around 3.5 million ounces annually for the next 10 years. This year and next, production is expected to decline, followed by a boost in 2023 and fairly stable projection after that.
The Nevada operations consist of 10 underground and 12 open-pit mines, and 18 processing facilities. Reserves are 45million ounces, and NGM expects to replace reserves over the 10-year period. Nevada still has significant exploration potential, both in near-term extensions at North Leeville, Goldrush and Turquoise Ridge, longer-term exploration projects. On a standalone basis, NGM would be the third largest gold miner in the world, after Barrick and Newmont themselves. It represents 31% of the net asset value (NAV) for Barrick, 19% for Newmont. Barrick is a buy; Newmont a hold.

Implementation of Osisko's strategy moves stock

Osisko Gold Royalties Ltd. (OR:TSX; OR:NYSE, US$14.71) is on track to meet full-year guidance of around 80,000 ounces, with cash balance increasing to $119 million as of quarter end. (Cash at Osisko Development of around $186 million is consolidated on the balance sheet, but our number excludes that.) With several projects on which it holds royalties being advanced(Hermosa, by South 32, as well as Cariboo, San Antonio, and Windfall from other companies in the Osisko family), the company has a good pipeline.

New CEO Sandeep Singh is doing a fine job repositioning the company and explaining the strategy. Although he took over at a time when royalties were already expensive to acquire and they have become only more so, Osisko has the huge advantage of embedded royalties from Osisko Development, Mining, and O3. Some of these projects will take time, but they are all now being developed and financed separately. The ongoing large majority ownership of Osisko Development continues to hurt the stock, but the approach to reduce ownership has been well articulated, and the market has been responding as it is implemented. Already, OR's stake has been cut from 88% at initial public offering (IPO) a year ago to 75%.

After an almost 50% move since the beginning of March, the stock is no longer particularly undervalued on cash flow metrics, though at 0.8x NAV, and with a strong near- and medium-term growth profile, it remains attractive and we are definitely holding...

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