Why the Gold Price Moves

Gold has been seen as the ultimate store of value throughout the centuries. Its price did not depend on the state of the economy and would never go to zero. But that is only the start of what gold is now. It protects against inflation. It is the classic hedge against geopolitical turmoil. It is the means central banks (especially China) use to store value while uncertainty rises. It is the basic alternative to fiat currencies and the safeguard against the liabilities of third parties. And especially now, there is the possibility that the US could revalue its gold reserves. And on and on. So, after the 2007–2008 global economic crash, the Bank of International Settlements (aka the “central bankers’ central bank”) established the Basel III accord, a set of protocols that formed a benchmark that central banks and other major financial institutions were encouraged to follow to prevent them from taking on too much risk, the generally accepted main reason for the crash. Gold, of course, played a central role in the accord, and a number of central banks started to accumulate more gold.

The problem with accumulating gold is the same as the reason for doing so. It never lost its value, but then it never generated any greater value. So, it was rather a shock to discover that, because of the Basel III accord, it was actually possible to use the gold to produce a profit. This is the subject of a LinkedIn post by Clive Thompson, a highly-regarded, retired 47-year veteran of the Swiss banking system. The article will be the subject of this commentary. But first, here is a graph of the prices of gold futures.

Figure 1: COMEX gold front month prices

You can see the slight variations in the price of gold over the years. But there is one interesting feature. Starting around March 2024, the price of gold has been increasing much more rapidly than it did in years. It is difficult to determine the reason for this increase, and hypotheses abound. Thompson tackles this subject, declaring that none of the typical reasons given are correct; the answer lies in mathematics (by which he means financial calculations).

Basel III requires that banks hold a certain percentage of Tier 1 assets, essentially no-risk assets such as cash and highest-quality government bonds. But now gold is to be treated as a Tier 1 asset. Why would that have any effect on gold’s price? Of course, there is the increase in price due to increased demand from central banks, but that doesn’t account for this increase. After all, gold produces no income, while government bonds do. But stocking up on a single asset class—government bonds—is not wise, especially since they are based on fiat value.

Thompson breaks the ancient myth that gold produces no income, and even shows how this can be done within Basel III. The basic strategy is to take advantage of contango (the spot price is less than the futures price), which gold usually maintains. By buying gold at the spot price, and immediately selling short a futures contract, you exchange one Tier 1 asset (cash) for another (gold). Your required percentage stays the same, thanks to Basel III. You collect the contango, and simply wait for the futures contract to execute. And if the gold is in London, you have the opportunity to lease it out until the futures expiry date and make even more money, usually totaling more than 6%, more than a T-bill pays. So it makes sense to do this. The price of gold keeps increasing because lots of gold is being bought at spot price.

How does this affect traders? Retail traders are unlikely to use this strategy, because of the large amounts of capital needed to be involved in it, though hedge funds certainly can (and do). But the retail trader also can benefit from the increasing price of gold, especially since this is not tied to any of the “reasons” that the talking heads keep inventing. This has every chance of continuing as long as the Basel III accord continues.