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Due to increasing financial repression by governments and banks, there is more and more to be said for owning physical gold. The value of gold lies mainly in the fact that it falls outside the financial system and therefore cannot be seized as easily as, for example, bank balances. That's what Joseph Wang, former Federal Reserve trader, says in an interview with Paul Buitink. In that interview, he also explains how the repo market works, what bank reserves are and what role the central bank plays in it, topics he also covers in his book Central Banking 101.
Wang explains how the U.S. central bank had to intervene during the corona crisis to support liquidity in the bond market. Many market participants needed money and at the same time tried to sell their government bonds. But because the main traders did not have the balance sheet capacity to buy all that, panic arose in the market. Even U.S. Treasury prices started to fall at that time. To support the market, the Federal Reserve acted as lender of last resort, by opening the repo counter and putting government bonds on its balance sheet.
Wang explains that the market uses U.S. Treasuries as a form of money, because under normal circumstances these bonds can be very easily lent out on the repo market for cash. Even the re-lending of government bonds is common, a practice that traders rehypothecation call.
Wang explains that before the 2008 financial crisis, there were only $50 billion in reserves in the banking system. If banks did not have enough reserves, they had to sell assets. Due to central bank purchase programs, there are now $3.5 to $4 trillion in reserves in the system. As a result, the vulnerability of the banking sector has decreased, but the Moral hazard in the financial system.
Wang expects central banks to become even more active in supporting the market in the coming years. For example, the Fed is still active in the repo market, even though it has been almost three years since it had to actively intervene to prevent an infarction in the financial system. By buying government bonds and corporate bonds, central banks support the market, a policy that Wang says has been especially beneficial to wealthy people who own a lot of financial assets.
According to Wang, the U.S. dollar is still the most important currency. Many countries hold dollar reserves, as this currency is the most liquid. Also, many emerging markets borrow in dollars, because there is often more money available in the dollar market and interest rates are usually lower. The risk of borrowing in dollars is that emerging markets could be squeezed if the value of the dollar rises.
Another risk of holding dollar reserves became visible when Western countries decided to freeze Russia's foreign exchange reserves. According to Wang, this indicates that holding foreign exchange reserves also carries a counterparty risk. Countries that want to reduce this risk will therefore try to trade more with other currencies in the coming years and hold more reserves in, for example, physical gold.
