More to gold price than meets the eye

Explanations for the most recent drop in gold prices generally begin and end with Ben Bernanke’s recent comments regarding the possible end to quantitative easing. 

If gold was rising due to loose monetary policy, then monetary tightening means it’s time to get out of the gold trade — or so the mainstream logic runs.  

Conversely, gold supporters hold the day of reckoning is yet to come when runaway inflation exposes the hollowness of fiat currency and gold rises to untold heights. They argue the recent sell-off is little more than a buying opportunity. 

Time will tell if that is the case, but for now there is no harm in broadening the discussion beyond these two well-trotted out axioms.  

A good place to turn when looking for alternative explanations is with one of the few prognosticators that accurately predicted the financial crisis of 2008: Nouriel Roubini.

Roubini’s thoughts on the gold price cover the three macro theories for the recent fall in prices. 

The first is that investors are factoring in a declining risk of a global meltdown. While things still aren’t great, talk of the U.S. falling into a depression or even Europe splitting up now seem to be behind us, and those calmer nerves are bad news for gold.

The second — and the primary reason for many —  is a decline in inflationary fears. Despite unprecedented amounts of quantitative easing in the U.S. and Japan, inflation hasn’t yet appeared over the last five years. According to the J.P. Morgan Index, global inflation peaked at 4% in 2011 and has fallen steadily since. Roubini says this is because economic growth has been so weak that the dominant underlying current has been deflationary pressure, and no amount of increased liquidity was able to spark meaningful inflation. 

The last factor Roubini points to is the mildly positive effect that loose monetary policy has had in restoring at least some measure of growth in the global economy. While that growth isn’t anywhere near pre-2008 levels, it is enough to coax investors to turn to securities tied to corporate earnings, such as corporate bonds and dividend paying equities. 

And while that is all well and good, Roubini fails to touch on the mechanics of popular trades involving gold that can push around the price — the micro factors. It is precisely with such micro factors that things can get quite interesting. 

The first relevant theory to consider comes by way of UBS Financial Services director of floor operations Art Cashin, who blames the carnage in the gold market on an unwinding of structured products. 

Cashin argues that many trades were established while gold was holding in and around the US$1,600 per oz. price from late last year into the end of March. The feeling on the Street is that many a structured contract was built during that time, with floors around the US$1,530 per oz. mark and caps at the US$1,800 per oz. level.  

When gold fell below US$1,530, the contracts terminated and left the issuer holding a position in gold just as prices were falling. Their reaction was to liquidate positions, putting further downward pressure on the gold price. 

But Cashin is admittedly short on specifics of such trades, so for a more intricate and detailed analysis, let’s turn to Financial Times Alphaville blogger Izabella Kaminska.

To understand Kaminska’s theory, however, some familiarization with the gold carry trade is necessary. 

The gold carry trade was popular for years before the financial crisis and was blamed by many gold bugs for being one of the chief methods of artificially suppressing the gold price. 

The trade begins with a central bank holding gold reserves lending gold to a bullion bank (well-known bullion banks include Barclays, Goldman Sachs, J.P. Morgan and Citibank) and charging the bullion bank a small lease rate for its trouble. The bullion bank then turns around, sells the gold and buys higher yielding securities, such as long-term government bonds, with the proceeds. 

The trade suppresses the price of gold through the bullion bank’s selling action. The motivation for the suppression, according to gold pundits, is that central banks preserve the value of fiat currency — after all, the carry trade could never get started without central banks offering to lend out the gold to the bullion banks at low lease rates. 

Another factor influencing gold prices before 2008 was the popularity of producer hedging. The practice left the banks that provided the hedged financing with long exposure to the metal. Since banks don’t suffer long exposure to volatile assets for very long they hedged their exposure with short positions, which put more downward pressure on the gold price.  

Kaminska argues, albeit in an guarded manner, that after 2008 the fundamentals of the carry trade changed.

For one thing, miners began unwinding their hedge books, which  reduced the banks’ need to hedge with short positions, and consequently, reducing their demand for borrowing the physical gold needed to execute a short position. 

Such reduced demand for borrowing gold was one factor leading to lease rates falling and turning negative. That meant anyone holding gold could no longer charge a fee for leasing their gold. According to Kitco charts, the one-month lease rate went negative in early 2009, and only recently went positive again. 

We’ll discuss the implications of this positive lease rate later — but for now, it is important to recognize that the situation led to the dawning of new trade that would replace the traditional gold carry trade as the dominant trade influencing gold prices. 

Rather than leasing gold from central banks and immediately selling it, bankers piled into what Kaminska dubs the “gold-for-cash” trade — a trade that mirrors trades made in the repo market. 

In the repo market, securities dealers secure short-term financing by turning over collateral (usually a 10-year U.S. treasury) in exchange for cash and an agreement to buy back the treasury at a later date. How much they buy that treasury back for is determined by many factors — one of the major ones being how highly sought-after that collateral is. If the collateral is scarce and desirable enough the repo rate can turn negative, meaning the cash lender actually pays the borrower for the collateral. 

In the gold market, a cash-for-gold trade emerged where the monetary lender hands over cash to the borrower and takes their gold as collateral. The borrower agrees to buy back that gold in the future based on future prices. The higher the future rate at the time of expiration, the more the lender gets for the gold collateral. 

The implication of this emerging trade was the reverse of the pre-2008 and carry trade. While the earlier trade encouraged liquidation of gold and suppressed the gold price, the gold-for-cash trade encouraged holding gold and borrowing against it, which suppressed liquidation and supported the higher, post-2009 gold prices. 

At this point it is important to get a firmer handle on lease rates, as they are fundamental to understanding how this trade unwound and contributed to a demise in the gold price. 

In the gold-for-cash trade the lease rate is paid by the lender who is taking the gold as collateral. The greater the demand for the trade (i.e., the more the holders of gold want cash instead of gold), the lower the lease rate. That is, the borrowers will pay more to
the lenders for cash than they otherwise would if lease rates were positive.

Also contributing to lower lease rates was the state of rates in the money market. Since a lease rate compensates the lender of the gold for forgoing the yield on a money-market instrument that could have been purchased with the money that went into buying the gold in the first place, there is a positive correlation between money market rates and lease rates. As money market rates fall, holders of gold demand less lease rates as compensation, since they couldn’t earn much yield in the money market anyway. 

But there is a catch. At a certain point lease rates can become too negative, and at that point holders of gold would rather simply sell their gold (or “liquidate”), and invest in some higher-yielding asset. 

To avoid this, banks that are profiting from the gold-for-cash trade need to raise lease rates to entice borrowers back into the trade. 

Kaminska points out that such activity can be seen on price charts comparing lease rates to the gold price. Since 2009, whenever there was a decline in the gold price (due to liquidation), lease rates climbed to entice gold holders back into the gold-for-cash trade. 

The fact that the pattern persisted for four years argues for the idea that a good deal of gold liquidation was being suppressed via timely increases to the lease rate. 

But that all changed with the sell-off at the beginning of April. Rather than a rise in lease rates following a gold sell-off, the reverse happened: gold lease rates rose ahead of a sell-off and gold-price decline. 

The reason for this situation may have been that bankers were looking for more of the gold for cash due to an inability to make the more habitual money market trade. In March it was reported that there was a dearth of U.S. 10-year treasuries available as collateral. The same scarcity problem re-emerged in June before the second big sell-off. 

It could well be that banks couldn’t secure the U.S. 10-year Treasury as collateral, and so turned to the gold-for-cash trade as an alternative. When new issues of the 10-year became available, the need for the gold-for-cash trade declined and gold positions were liquidated, which sent gold prices lower. 

If there is a lesson for investors in all of those machinations it is to watch for the relation between lease rates and gold prices. If lease rates are not rising after a sell-off in gold, this could indicate that the gold-for-cash trade is off, which means less support for the gold price. Also, if lease rates are rising ahead of a decline in gold prices, it could mean that banks are building an unsustainable position in the gold-for-cash trade and that liquidation, or a correction, is imminent. 

Another little-discussed contributing factor to the sell-off in June, one that investors have no control over, was the CME Group’s decision to increase margin requirements on gold trading by 25% to US$8,800 per 100 oz. contract. The CME Group is the operator of the New York Comex Exchange where gold futures are traded.

That meant any investors who couldn’t quickly raise cash for increased margin calls were forced to liquidate their position, even if they remained bullish on the metal. 

To help get a read on true investor sentiment, separate from forced selling due to increased margin, we can turn to the U.S. Commodity Futures Trading Commission’s Commitments of Traders report. 

The June 18 report shows gold producers have decreased their short positions by 6,678 contracts (each contract is for 100 oz. gold) and increased long positions by 3,787 contracts. Swap dealers have also increased long positions by 4,480 contracts while money managers have decreased their collective long positions by 6,853 contracts, although they remain net long with 112,281 long contracts versus 73,330 short contracts. 

It all means that a case can be made that the future market reflects some bullish sentiment amongst “in-the-know” investors, despite the recent decline in gold prices. 

But whatever conclusions investors will draw, it is important to realize the array of factors that are feeding into the gold price at any one time. The more that investors can stay abreast of such factors, the better chance they will have at being prepared for what may lie ahead.