Rising gold lease rates and the front-end backwardation

Gold lease rates have risen dramatically this year. In fact on the short end, lease rates are now higher than US dollar interest rates - which is quite unusual.

Source: KITCO (click to enlarge)

Part of the reason for rising lease rates this year is an increase in hedging activity ahead of the Fed's series of decisions on QE3. Investors, mining firms, banks, etc. who are long gold are selling gold forward contracts as a hedge against their positions. The providers of these forwards (usually dealers) hedge themselves in the physical market by borrowing gold for a fixed period and shorting it into the spot market. A forward contract provider thus becomes long a gold forward in the derivatives market (via forward they bought from a client) and short a gold forward in the cash market (via a combination of lease and a physical short) - thus fully hedged. The demand to borrow physical gold in order to short it is forcing lease rates higher.

One interpretation of this trend from an economic perspective is that gold lease rates to some extent mirror global real rates - if one thinks of gold as an international "inflation-free" currency (h/t Ed Grebeck). Gold lease rates move higher due to expectations of rising real rates. That to some extent explains why gold lease rates were negative last year.

The combination of much higher lease rates and low short-term dollar rates has created an unusual gold forward curve. Here is what the COMEX gold futures curve looks like now. The curve is quite flat in the front and even inverted in the first two months.

Note that the futures curve begins to rise in the first half of 2015, around the time of the Fed's first expected rate hike. The inversion in the front end (Aug-Sep backwardation) is highly unusual for gold (would only happen when lease rates exceed short-term dollar interest rates.) In fact this has not happened over a 4-week period at any time during the past 30 years - until now.

Source: JPMorgan

As long as hedging activity stays strong, demand to borrow physical gold will keep lease rates elevated. In the intermediate term this is probably a positive for spot gold prices because if the hedging activity slows, dealers will be covering their spot short positions and not rolling into new ones.

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Big inflows into gold ETPs generate a rally, but one should remain cautious

Gold lease rates declined across the curve in the last few days (flattening the forward curve somewhat). The bullish sentiment has forced some gold short-sellers out, reducing demand to "borrow" gold.

Source: Kitco

The bullish sentiment is visible in the recent jump in GLD shares outstanding, indicating significant inflows into gold ETPs.

GLD shares outstanding (Bloomberg)

Bloomberg: - Gold ETP holdings overtook France’s reserves on Aug. 21 after rising 90.4 tons this year to 2,447.1 tons, data compiled by Bloomberg show. Only the U.S., Germany and Italy hold more, International Monetary Fund data show. The IMF itself holds 2,814 tons of bullion, placing it between Germany and Italy.

Billionaire John Paulson raised his stake in the SPDR Gold Trust, the biggest gold ETP, by 26 percent in the second quarter and George Soros more than doubled his holdings, U.S. Securities and Exchange Commission filings showed Aug. 14. Investors will buy 150 tons through ETPs this year and next, Barclays Plc estimates.

In spite of the reductions in short positions and tremendous inflows into ETPs, gold has not yet reached a speculative frenzy such as the one that existed in the short euro positioning or investment grade bonds last month. Should gold become a "crowded trade", we would be able to see it in the futures markets net positioning.

Bloomberg: - The increase in prices and ETP holdings has yet to be reflected in speculative wagers in U.S. futures markets. Hedge funds and other money managers cut bets on a rally by 58 percent since the end of February, U.S. Commodity Futures Trading Commission data show. The net-long position fell 4 percent in the week to Aug. 14 and is near the lowest since 2008.

So far the long gold bet seems to focus primarily on global stimulus, particularly from the Fed (as well as the ECB and PBoC). And clearly not everyone is sold on this easing being timely or large enough to weaken the dollar sufficiently and generate material incremental demand for gold. In fact short-term downside risks to gold remain if the expectations of Fed's "QE3" prove to be wrong.

There is also talk that the Republican party is going to make the return to gold standard in the US part of their campaign agenda. According to some estimates, returning to gold standard would send gold prices to $10K/oz, which encouraged some recent retail buying.

WSJ: - The committee drafting the Republican Party's platform before next week's convention included a proposal to establish a commission exploring the United States' return to a gold standard.

Republicans in Tampa, Fla., citing President Ronald Reagan's commission "to consider the feasibility of a metallic basis for U.S. currency," this week included the creation of "a similar commission to investigate possible ways to set a fixed value for the dollar," according to language of the proposal provided by a Republican National Committee spokeswoman. The Reagan commission "advised against such a move," the proposal noted.

Doing so is a nice idea in theory but it simply can not be implemented. There isn't enough gold out there for the Fed to buy in order to support the USD monetary base ($2.56 trillion). And any attempt to do so will destroy the US international competitiveness. It is a purely political move on behalf of the GOP to appeal to Ron Paul's supporters (which is also a good idea, but is not going to translate into higher gold prices).

Chicago Tribune: - Instead of planning for a gold standard return, the Republicans are trying to placate supporters at next week's RNC and to gain more firepower in the party's promoting responsible U.S. fiscal and monetary policies in the upcoming federal elections in November, analysts said.

Minutes from the Federal Reserve's latest meeting suggests the U.S. central bank will adopt stimulus fairly soon unless economic conditions improve dramatically. Some expect Fed Chairman Ben Bernanke could use his speech at the central bank's gathering in Jackson Hole, Wyoming, at the end of this month to send a strong message to markets.

At the same time gold demand fundamentals (outside of the QE expectations and the gold standard idea) have been fairly weak.

Bloomberg: - Physical demand is slowing elsewhere, with sales of American Eagle gold coins by the U.S. Mint dropping 49 percent to 30,500 ounces last month, the lowest since April. The mint sold 21,500 ounces so far in August, data on its website show.

Gold imports in India, last year’s biggest buyer, are set to fall as much as 50 percent in the September to December period from a year earlier, Prithviraj Kothari, president of the Bombay Bullion Association, said Aug. 21. Local prices reached a record today, data compiled by Bloomberg show. That may crimp demand at a time when a below-average monsoon in the country threatens rural incomes.

Gold should be a part of a long-horizon diversified portfolio, particularly given the developed nations' central banks willingness to (over)compensate for their governments' inability to generate growth and improve labor markets. Japan and the UK central bank balance sheets are growing, the ECB is getting ready to do the same, and the FOMC seems to be "trigger happy" as well. But in the short-term, given the risk of "disappointment" from the Fed and even from the ECB as well as weak physical demand fundamentals (particularly from emerging markets), one should remain cautious.

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The relationship between gold lease rates and gold price

Since the post on gold lease rates back in December, a number of Sober Look readers have asked whether there is a long-term relationship between gold lease rates and gold price. Based on the weekly data available, there is none. The scatter plot below shows weekly moves in gold futures price vs. weekly moves in 3-month gold lease rates since 6/29/2007.

Source: Bloomberg

The R-squared, which shows the proportion of variance in gold price explained by moves in lease rates is 0.008. Daily data shows no significant relationship between the two either.

One would think that higher lease rates should provide support to gold price because a commodity that could be leased at a higher rate should be worth more. But that assumption is not supported by the data. In fact the recent moves demonstrate somewhat of an inverse relationship.

Recent data (source: Bloomberg)

The rationale for this inverse relationship is fairly simple. As more investors put short positions on, there is higher demand to borrow the metal (one needs to borrow an asset in order to short it), driving up lease rates. Many gold investors have been shorting gold using forward or futures markets to hedge their holdings. But dealers who buy forwards from these investors end up shorting physical gold to become neutral. The end effect is the same - large volumes of gold shorting should translate into higher lease rates. The recent weekly data shows a correlation of -0.6 (R-squared of 0.4).

Recent data (source: Bloomberg)

Whether this recent relationship holds going forward remains unclear. But based on historical data, the correlation should revert back to zero over the long run. 

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Gold lease rate turns positive

The gold lease rate (which Ed Grebeck of Tempus Advisors called the "real interest rate") has turned positive at year end. It's an indication of increased demand for shorting gold forward, likely driven by hedging activity at year-end. It will be interesting to see how gold forwards trade this week and if more shorting activity is in store for the metal.

3-month gold lease rate (Bloomberg)

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Busting the myths behind gold lease rates

Myths continue to surround gold lease rates, with notions such as market manipulation and government intervention rampant in the blogosphere. This may upset a number of people but the recent dynamics in gold leasing are actually fairly easy to explain. Here are the two key questions:

1. Why have gold lease rates been negative in recent months?

Recently as the usual sources for dollar funding (US money market funds) in Europe have been dried up, banks are resorting to some nontraditional approaches to fund their dollar based assets. Some borrow from the ECB via the Fed liquidity swap, others resort to borrowing euros from the ECB and swapping these euros into dollars for a short period of time via a currency basis swap.

A number of European banks hold gold as part of their asset portfolio. They haven’t been eager to sell it as they continue to be concerned about the stability of major currencies, particularly the euro.  They also enjoy the price appreciation gold experienced in recent years. However, they desperately need short-term dollars, so they lease out their gold. In a lease transaction typically a bank turns the gold over to a counterparty for say 3 months and receives gold “lease rate”. The counterparty in turn places dollars with the bank as collateral on which the bank pays “LIBOR-like” rate. Now the bank has access to dollars it needs. The demand for dollars has become so great, that banks are willing to accept negative lease rate, just to obtain term (1-12 months) dollars. Therefore negative lease rates is not a surprise.

2. Why have gold lease rates spiked recently?

As banks and other investors realized that gold prices can indeed drop significantly, many decided to hedge their positions by putting on gold forwards to lock in the price. A gold forward involves a future sale of gold at a fixed price. Whoever sold them the forward becomes long gold for future delivery. The forward provider will hedge her position by borrowing gold (via a lease) and selling it into the spot market. Now the forward provider will receive gold in the future on the forward contract and can deliver it against her lease, and is therefore fully hedged. Some market participants also entered into “naked” forwards to short gold as a speculative trade. All these forward transactions generated incremental demand to borrow gold, creating a spike in lease rates (though still negative.)

3m gold lease rates (Bloomberg)

One of the stories circulating on the web is that this spike in lease rates forecasts an impending improvement in gold price.  In fact the spike is saying that investors are nervous and are hedging or shorting gold.  With the precious metal down another 1% today, there is no evidence for this relationship between the two. And for those who are still looking for manipulation conspiracy theories in gold lease market, just remember your Occam's razor. Simple explanations must be exhausted first.

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