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Gold Trends-The Nuances of GOFO
Gold message boards have been aflutter in recent weeks with GOFO rates once again dipping into negative territory. The gold bugs’ fire was further fueled when an article clumsily titled “Strange GOFO cry heralds trouble for gold” was published in the credible Financial Times, as opposed to the internet backwaters where articles on the subject usually appear. Clumsily titled because it goes on to explain why negative GOFO is actually good for physical gold, but trouble for paper gold. We’re here to say that GOFO rates dipping back into negative territory doesn’t herald much of anything, but rather reinforces underlying themes that have been in place for some time.
If nominal interest rates in the US have never been negative, and GOFO is supposed to trade near LIBOR: why have GOFO rates been negative twice in the past four months? Negative GOFO rates imply that buyers are willing to pay a premium for immediate delivery of gold. Historically, gold miners looking to hedge forward production would flatten the forward curve, but miners haven’t been hedging for quite some time. Beyond that, with prices down on the year, it’s hard to imagine that the demand for gold is so strong that buyers would be willing to pay a premium for immediate delivery. In our view, the huge selling of paper gold / gold derivatives and the unprecedented demand for physical gold from China have resulted in the anomaly of negative GOFO rates. These are not new themes, but do give important clues about what is really happening in the opaque market for gold.
This massive short position was accumulated trading the August 2013 gold future contract. However, by the end of July that contract came due for delivery and traders had to either produce a lot of physical gold or roll over their short position to the December 2013 contract (where the liquidity was shifting). Considering that the price of gold fell roughly $370/oz. between May 11th - July 9th and the vast majority of speculators have no ability to deliver physical bullion – rolling over their existing short position became the obvious choice.
When a short futures position is rolled forward there are actually two transactions that must take place. The existing short must be covered, or bought back, and the forward contract is sold, putting pressure on the forward curve to flatten. When a historically large short position is rolled in a relatively short period of time, there is a lot of downward pressure on the forward curve and some funky things can happen. This is what drove GOFO rates negative, and the chart below shows that GOFO rates remained depressed well after the peak CFTC short position (as the contract rolled).
These totals are staggering. If a made-up country started from scratch and imported 807 tons of gold, they would have the 8th largest official holdings in the world. Again, this is not a new theme. China has been expected to overtake India as the world’s largest gold consumer for a while now, but the scale at which gold is being sent to China is causing strange reverberations in the gold market, resulting in confounding statistics like negative GOFO rates. Since bottoming at -4bps on November 1, rates are now back into positive territory. Gold entering into backwardation (where immediate demand > supply) should be hugely bullish for gold, however, the anomaly has been largely an explainable one-off. The gold price has gone up with GOFO below zero, but not much.
Although negative GOFO rates don’t get us particularly excited, there is an even more obscure metric that is far more important to us: the gold lease rate. The gold lease rate is simply LIBOR minus GOFO. In other words, it’s the rate at which gold can be borrowed. Back in the 1990’s the gold lease rate market was much more liquid and active when gold miners hedged their forward production. However, since peaking in 1999 the global mining hedge book fell dramatically as miners looked to increase their exposure to rising gold prices.
Gold miners slashing their hedge books was a serious hit to demand for gold borrowing, and consequently, lease rates fell close to zero. Except for bullion banks, which specialize in borrowing/lending gold, the fundamental shift in lease rates had little impact on the markets, but did significantly alter what the rate represents. Today, the lease rate is more of a systemic risk barometer. In fact, since the early 2000’s, lease rates have had a strong correlation with a true barometer of systemic risk: US swap spreads (the difference in return from lending money to a bank vs. the US government: “the risk-free counterparty” – chart below). As mentioned earlier, in a vacuum, LIBOR should always be roughly 10bps (for storage) above GOFO for a duration of 3-months. Unfortunately markets don’t operate in a vacuum, and in 2008 during the Lehman bankruptcy lending markets froze. Banks wouldn’t lend to each other, and gold (the ultimate form of collateral) became a much more valuable asset to have on a balance sheet – increasing the cost to borrow gold dramatically.
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