There are currently three potential policy measures that would have a relevant impact in the commodities markets
Click here to read this article in pdf format: August 19 2012
What do USD money markets have to do with gold? Money market funds invest in short-term highly rated securities, like US Treasury bills (sovereign risk) and commercial paper (corporate credit). But who supplies such securities to these funds? For the purpose of our discussion, participants in the futures markets, who look for secured funding. They sell their US Treasury bills, under repurchase agreements, to money market funds. These repurchase transactions, of course, take place in the so-called repo market.
The repo market supplies money market funds with the securities they invest in. Now…what do participants in the futures markets do, with the cash obtained against T-bills? They, for instance, fund the margins to obtain leverage and invest in the commodity futures markets.
In summary: There are people (and companies) who exchange their cash for units in money market funds. These funds use that cash to buy –under repurchase agreements- US Treasury bills from players in the futures markets. And the players in the futures markets use that cash to fund the margins, obtain leverage, and buy positions. What if these positions (financed with the cash provided by the money market funds) are short positions in gold (or other commodities)? Now, we can see what USD money markets have to do with gold!
Let’s propose a few potential scenarios, to understand how USD money markets and gold are connected:
If money markets have liquidity, there is abundant cash to buy US Treasury bills (i.e. the repo market is more liquid), and to finance those who short commodities in the futures markets. This is negative for the spot price of gold. If money markets lack liquidity, shorting commodities becomes more difficult. This is positive for the spot price of gold.
If the US Treasury bills become riskier, on the margin, the incentive to buy them will be lower and either money market funds will reallocate the cash towards commercial paper or they will face redemptions from fearful investors. The repo market will then lose liquidity. This is positive for the spot price of gold.
Alternatively, if the rate paid by the US Treasury increases AND the risk of these bills is NOT perceived to be higher (something possible in these rigged markets with doubtful ratings), investors will be more eager to place their cash with money market funds (falling prey to an illusion) and the liquidity of the repo market will increase. This is negative for the spot price of gold.
Why do we bring this up? To be honest, it is not the first time we do so. We have introduced the topic in our letters of July 2nd, July 30th and August 6th. We bring this up today because we want to raise awareness on some measures under consideration by the US Treasury and the Federal Reserve, that will have a direct impact on the USD money market, and hence, the repo market and the price of commodities. These policies are:
1) Minimum Balance at Risk (MBR): Kills USD money markets = lowers liquidity in repo market = Positive for gold
This has been in the works since 2010, but is only now taking shape. On August 15th, Bloomberg had a post on this under the title “Fed’s Dudley backs money fund rules to protect US Economy”. If enforced, there will be a minimum balance, which holders of money market fund units will not be able to redeem, but after a lock period. Effectively, under distress, redemptions will be restricted. As well, there are other potential measures, like floating the funds’ Net Asset Value and capital requirements. But the MBR one is the most relevant: It will make market participants see money market funds as a risky investment.
Personally, we do not see the motive behind this move because if, as some deduce, policy makers in all honesty believe that the savings currently in these funds will be reallocated as a result to bonds or stocks (boosting asset prices), they are being naïve at best and utterly idiotic at worst. Whoever invests in money market funds does so to make an extra buck on liquidity. If he/she cannot make it, then the funds will simply remain in a chequing account. Would banks use these funds in the chequing accounts to lever up their investments? Into what? Money market funds? The recent experience in the Euro-zone (discussed further below) shows it is not the case. Banks will not lend more just because they have more deposits available.
In any case, this policy would drain liquidity from the repo market and financing positions in the futures markets (i.e. shorting gold, for instance) would be more expensive. This would be positive for the spot price of commodities.
2) Introduction of Floating Rate Notes by the US Treasury: Positive for USD money markets = Negative for gold in the short-term, positive in the long-term
We introduced this point in on August 6th, after reading a series of articles at Zerohedge.com. Floating Rate Notes are variable rate notes. If floating rate notes were issued and interest rates rose (either driven by the Fed’s policy or by the market) they would have a strong bid from money market funds, bringing liquidity to the repo market. This could continue supporting speculative shorts in the futures markets, which would be negative for spot commodity prices in the short term.
However, if these rates are seen to be sticky, the Fed would have to intervene, targeting rate caps. But to guarantee the cap on the price of a good, one has to offer unlimited supply of that good. If the Fed had to guarantee a cap on NOMINAL interest rates, it would have to offer unlimited supply of US dollars. It is now easy to see why, in the long run, issuing floating rate notes would therefore be positive for the spot price, in US dollars, of commodities.
3) Zero interest on excess reserves: Would kill USD money markets (just like it did in the Euro zone) = lowers liquidity in repo market = Positive for gold
After the July 5th decision by the ECB, to pay nothing on its deposit facility, Euro-zone banks’ deposits at the European Central Bank plunged (see below, source: Bloomberg), by the tune of EUR484BN!!!
Did this money go to stocks? No! To bonds? No! Where did it go then? To a chequing account at the ECB. In the process, the Euro money markets died and the repo market suffered heavily. We had warned here that this measure would only make Euro banks less profitable and hence, riskier.
Because commodities are not traded in euros, this has not impacted the commodities market. But should a zero-interest-on-excess-reserves policy be implemented in the US dollar zone, the effect on the repo market would be to drain liquidity, a negative for futures markets and a positive for spot commodity prices.
In conclusion, there are currently three potential policy measures that would have a relevant impact in the commodities markets. Forewarned is forearmed.
Martin Sibileau
August 19th, 2012 at 10:03 AM
Hi,
Can you explain why would the participants in the futures market sell short gold?
August 20th, 2012 at 7:15 AM
Martin -
A good article. While I understand the connection between money markets and gold, I am unclear as to whether the current size of the trade you mentioned above is large enough to conclude that the money market and gold are significantly linked. As you note, investors can use the money market to invest in any physical commodity. Is the current total gold position (funded by the money market) big enough to support your argument? M
September 2nd, 2012 at 4:12 PM
Dorky,
My apologies for the very late reply. By now, you know that the SEC will not touch (for now at least), the money markets.
My view is that the gold market is manipulated, via the futures market. All I am saying is that if the money markets became illiquid, that manipulation would be harder to obtain.
Why would participants in the futures market sell short gold? In terms of the manipulation, they would sell it short because the futures market allows them to leverage their position. Why the manipulation? Because the price of gold is seen as a key price in terms of inflation expectations.
M.
September 2nd, 2012 at 4:15 PM
M,
My apologies for the very late reply too. By now, you know that the SEC will not touch (for now at least), the money markets.
I think you misunderstood a key point: Investors do not use the money market to invest in physical commodity. The money market supplies the repo market with liquidity. And the repo market is used, among other things, to fund positions in the futures market.
All I am saying is that if the money markets are illiquid, trading in the futures markets will be more expensive. “They” know it and that’s why “they” won’t do it.
M.
November 11th, 2012 at 7:22 PM
Mr. Sibileau,
Have you factored the end of the FDIC insurance on transaction accounts and how that would affect the market rate of the Floating Notes? I have hard time to conceive that the Fed would want to have a flatter curve than it already has, since accoring to Thomas Tooke, a declining long bond yield is always deflationary. What is your opinion on the end of FDIC insurance?
I wonder if the Fed s aim is to reverse the 70s move from Lehman to create money market funds. The system of money market funds is that instead of having a run on bank risk, we have a run on bank and money market financing at the mercy of panic as well, hence the need to put the banking system in the middle to minimize the problem to a single point of failure as opposed to two.
Evidently today s prices of commodities are hardly the result of higher circulation in the US but of devaluation against commodities which are consumed mainly outside of the US. The quantity of wages in emerging world, and the quantity of money they have divided by the quantity of units gives us the price. There is also a big difference between a commodity which has no stock to use ratio constraints and commodities which have (soft commodities and Silver to some extent — which is very annoying for Gold manipulation BTW–).
November 11th, 2012 at 10:42 PM
Thanks for your comment. No, when I wrote this article I had not had the end of the FDIC insurance in mind. I understand that the insurance would drive institutional liquidity out of deposits. I am not so sure money would all flow into money market funds then, to earn a higher yield. I remember from my early years (I worked in corporate finance, at the treasury of a telecom company) that treasurers of non-financial institutions do not seek yield with their liquidity, but safety. And even if the insurance was no longer there, the majority of companies would still leave their monies in banks, both for convenience as well as because in the end, they know that if things got out of control, the insurance would come back.
With regards to what the Fed’s aim is…I confess I did think about this one too and I never got an answer for myself. Fighting the money market funds doesn’t make sense to me either. I think the move is political (i.e. a struggle for power) within the financial sector and Zerohedge.com wrote some articles about this suggesting a lobby from the Group of 30.
Regards,
M.
November 12th, 2012 at 1:08 PM
Mr. Sibileau, is it conceivable in your opinion that in fact most of the institutional liquidity forced out of deposits would actually end up into short-end treasuries?
The repo pricing is to me a circular pricing. The repo rate is high right now because of twist, but if institutions shift from deposits to treasuries, they might first boost supply for repo, hence a low repo rate?
Then there is the question of the new Treasuries pricing.
Is it conceivable that the same rate as the one they currently get on transactional account (0% I guess) would be split between negative rate on treasuries + positive rate on repos?
In other words would the new Treasuries be priced so that the Treasuries yield is net of repo rebate with a targeted total rate?
That could theoretically achieve the end of ultimate repression, steepen the curve without making the nominal cost of funding for the US Gov much higher. At the margin the savings on the short end could be used to steepen the long end and force corporations out of their cash and force nominal GDP up?
I have not thought about the unintended consequences of negative rates, evidently Hong-Kong dollar peg and precious metals might be affected seriously.
I confess I have not thoroughly considered the question and admit readily that there might be some shortcomings in my line of thought.
November 14th, 2012 at 2:29 PM
Hi,
Sorry for the late reply. Going to your 1st question: Yes, it is conceivable that institutional liquidity will leave deposits and end in short-end treasuries. However, and here I am a contrarian, I think this won’t happen.
The market is well aware that, should liquidity be an issue again, the government will be there to back deposits once more. My only concern in this regard is the European USD bond mkt (yankee market). If defaults began to arise, I think the market would price in the contagion in the US and am not sure there would be a flight to Treasuries.
With regards to your other observations on both rates and curve, I agree, but add this: If banks suffered from a drop in deposits, their demand for long-duration would also decrease. This would mitigate the steepening of the curve.
Regards,
Martin.