Gold is ready to take off again, and this time banks will drive it

Gold looks poised for another run after a period of consolidation and the rules set by the Basel Committee on Banking Supervision could provide additional fuel to the bulls.

This forecast is based on the past behaviour of gold prices at a technical level and the tailwinds that the Basel rules will provide to the price of gold at a fundamental level. Remember that past performance is not a guarantee of future price action. Let us first look a key fundamental factor that will support the price of gold : Basel III.

For those new to Basel, it is essentially a committee of central bankers from around the world that sets regulatory and capital standards for commercial banks. The standards are not binding, but most national central banks and commercial banks adopt it. Basel III, which is the third iteration of capital and regulatory standards, has reclassified gold as a Tier I asset. This may sound like Latin to non-banking folks, so let’s clarify a bit. When Basel I was released, commercial banks needed to have a capital adequacy ratio of 8 percent, which meant that for every $100 of loans or other assets a bank held, it would need owner capital of 8 percent.

Now the owner capital is divided into several tiers. So, for instance, government bonds were treated as Tier I capital and had a weight of 100 percent, which means a $100 bond would be given $100 value when calculating capital adequacy. Under Basel I and II, standard gold was treated as Tier III capital and given a weight of 50 percent. So, for capital adequacy purposes, $100 worth of gold would only be given a value of $50. Now in Basel III, gold is treated as Tier I capital, which means that gold will given its full value when calculating capital adequacy ratios.

Basel III goes into effect on 1 January 2013 and we believe that demand from commercial banks would drive up prices. Of course, banks are not going to jump in to buy gold on New Year. Their demand has been around for some time as they have slowly begun increasing gold reserves, with a lot of demand coming in from central banks. As of January 2013, the value of gold reserves already held by banks will double for capital adequacy purposes. This will prompt gold bears to state that banks would begin selling excess gold reserves and push prices down. However, it’s more likely that banks would reduce other assets like government bonds and cash to move to a more trusted asset like gold. Gold has always increased in value unlike cash and government bonds.

As governments and some central banks inflate the currency, the portfolios of banks will eventually increase. This requires them to add more capital, using money that could be invested for better returns in higher risk assets. Gold, on the other hand, rises as soon as a government or central bank announces a policy of monetary inflation. By holding gold as reserves the need for adding more cash to maintain capital adequacy ratios is drastically reduced or obviated.

For instance, let’s take a look at ICICI Bank. It’s asset size increased to Rs 4,73,600 crore in March 2012 from Rs 3,44,600 crore in March 2007 - a 37 percent increase. Gold, on the other hand, rose from around $770 to $1,680 during the same period, an 118 percent increase. Had ICICI Bank held all its capital in gold, it would have exceeded the capital requirements many times over. Put differently, it could have used its cash to invest in higher risk assets for a better return instead of locking it up in more capital. That’s the power of gold. It is bound to increase bank demand for gold due to its enhanced position in the capital structure.

Technical Analysis

Now, let’s take a look at what the gold price is telling us. ( See gold chart here )But before we do, we have to admit that gold did not hit the down target of $1,350 that we had predicted in our article on 14 August 2012. It fell from $1,965 to $1,530 but then rallied from there. That prediction was based on the fact that gold had entered bear territory with a 20 percent fall. However, the yellow metal went a little deeper into bear territory and then rallied. A 20 percent fall is considered bear territory. Technical analysis can be proven wrong by the market sometimes and investors should be ready to get out with a small loss if the trade does not work out.

Right now, with the Basel III impetus, it is likely that gold will break out higher. Gold usually has a consolidation period of 16 months before it begins its upward march. The chart shows that the consolidation areas with the blue ellipses. On two occasions gold resumed its rally after approximately 16 months. Now that gold has completed 16 months in a sideways movement, it may break out next month.

Also notice the blue line, which is the 12-month moving average, which calculates the average prices over the year. During periods of consolidation, price moves below the average and then above to continue the rally. You will notice that gold fell below the average and is now above it. So it’s possible that the long consolidation period is now over and that gold is getting ready for another upswing.

Nifty

A quick note on Nifty before we conclude. ( See Nifty chart here)

The broadening formation that we have been talking about in the previous articles is still intact on the Nifty. The index is also in the resistance zone we marked last week and shown on the chart by the two red horizontal lines. Bulls should have booked their profits, or at least some of it, by now. Aggressive bears can short at this level with a stop a little above the resistance zone.

Notice that last Thursday the Nifty formed a bearish candlestick shown by the blue arrow. It’s called a hanging man, which has a long bottoming tail with very small body. This candle is considered bearish when it appears after a rally. The bearish candlestick is confirmed if the price closes below it. Hence in the case of Nifty closes below Thursday’s low, it will confirm the bearish candlestick.

George Albert is Editor, www.capturetrends.com