Misinterpretation of Gold Lease Rates and Why Gold Could Rise

As the credit crunch intensified and global financial panic set in, the gold lease rates soared to the highest level since 2001. However, what has been confused in the uproar about the absolute value of lease rates is the fact that relative lease rates are also quite high.

Many have mistakenly suggested that these high lease rates are the first signs of a coming short squeeze in gold. The flaw in this line of thinking is that the lease rates reported in the press are a derived rate and actually represent the amount that can be earned from the gold carry trade.  Many people look at the rates quoted on Kitco and assume that is the cost to lease gold, in reality that is the interest rate one would earn if one were to lease gold, sell it in the spot market and invest the proceeds at LIBOR.

The lease rate reported by Kitco and others is calculated using the following formula:

LIBOR – GOFO = Lease Rate

Where GOFO is the Gold Forward Offered rate, which is the rate at which dealers will lend gold on swap basis against US dollars.

An examination of the underlying rates in 2008 tells a completely different story:

Data Source: London Bullion Market Association

These charts illustrate that the gold carry trade has become more profitable as the financial crisis has unfolded.  While the spread between LIBOR and GOFO has increased the cost to lease gold has actually decreased.  At the same time LIBOR has increased creating the most profitable gold carry trade this year. In fact, the biggest spread occurred during the most recent equity market decline. This explains why gold has not traded to new highs while the financial markets melted down.

1999 and 2001 Lease Rate Spikes

In 1999, the gold lease rates began to spike in July as the GOFO rate dropped.  As the lease rates spiked, gold prices fell as would be expected since the carry trade was now more profitable.  It was not until September that gold spiked and that was not because of lease rates, it was because of the Washington Agreement which resulted in the Central Bank Gold Agreement.   

Sources: LBMA, Kitco.com

In the first quarter of 2001 gold lease rates began to climb and once again, gold fell until March 2001 when GOFO breached 1%.  What is even more interesting about 2001 is that gold prices increased 14% after the GOFO rate fell below 1%, while gold prices rose only 8% in the aftermath of September 11, 2001.  
 

Sources: LBMA, Kitco.com

In “normal” times gold would likely remain under pressure until GOFO breaks below 1% or breaks below the Fed Feds rate which currently stands at 1.5%   The Fed funds rate and the OIS swap rate are both important to watch since they represent alternative financing sources.  If the GOFO rate drops below either of these rates, banks have incentive to borrow gold and sell in the spot market in exchange for dollars.  While this action will initially put pressure on gold it also increases demand for leased gold.  This increase in demand for leased gold should result in a higher GOFO rate.  As the GOFO rate increases the carry trade becomes less profitable and money can be borrowed more inexpensively elsewhere. 

However, these are not “normal” times.  The most likely explanation for the low GOFO rate is central bank’s desire to stimulate lending.  While typically the profitability of the gold carry trade would be enough to cause the two rates to converge, the lack of confidence in the inter-bank lending market has most likely resulted in such a wide spread.  As banks begin to lend to each other, they will look for sources of funding.  The wide spread on the gold carry trade will be very enticing and should result in bullion bank shorts in gold. It is this action that has the potential to cause a short squeeze.  Coupled with increasing investment demand, the move up could be significant.

Disclosure: I do not currently have a position in Gold or GLD, but I may by Monday morning.

Comments

[CLH:]

yes gold may rise---and pigs may fly

2008 Oct 20 06:52 AM

[ussmls7:]

CHL,you are a lost cause,sell all of your Gold as cheap as the monsters of wall street want people to do so they can get it for penneys on the dollar,just like JP Morgan is doing to any bank or intity it can!

2008 Oct 20 09:16 AM

[Smarty_Pants:]

Interesting article on a topic which most probably weren't aware of (myself included).

It certainly appears that increases in GOFO precede sharp rallies in the price of gold, implying somebody is buying back gold that was sold after 'borrowing' it.

Does anyone know if the GOFO rate is publically published and if so, where? It could prove to be an interesting item to track.

2008 Oct 20 10:11 AM

[Brian Kelly:]

Smarty_Pants

GOFO rates are published by the London Bullion Market Association (LBMA) lbma.org.uk - under the current statistics tab, look for Gold Forwards

Hope that helps

2008 Oct 20 10:28 AM

[sumosama:]

yep, gold may actually get back to its highs of 1980!

2008 Oct 20 11:21 AM

[The Sane In...:]

Great article, I found it very interesting.

Although you mentioned it could create a short squeeze, that would only be if people were all nakedly shorting gold (or if their position ended in a net short on gold). However, I´m guessing that most people engaged in this carry trade are completely hedging out any risk of gold going up by buying gold futures. SInce they´re only using it to get cheap financing and take advantage of the spread between GOFO and Libor, it doesn´t make sense to open your self up for higher risk, especially since gold is seen as a reserve of value and prime for recessionary times.

I haven´t seen a huge difference in spot prices and futures prices, and I would imagine that we would see that if this was an extremely common trade. That trend would reverse at the end of the month, however.

I´m of the opinion that gold isn´t going to see its rise until people start attacking the U.S. dollar, which doesn´t look very likely to happen any time soon. However, that trend could change in a week with how volatile things have been and how merciless investors have been when they find a new ¨it¨ asset.

2008 Oct 20 01:40 PM

[GoldWize:]

Lets not forget that Merrill has predicted that gold should hit $1,500 within the next few years. I will state that I am a bull on gold. Why? From Econ 101, I know that with a substantial increase in the money supply.. will result in inflationary pressures. With inflation our current fiat currency will be worth less and less. We will continue to experience uncertainty in our economy? Where will people go? To gold, not only to preserve wealth but to preserve one's mental state of being.

2008 Oct 20 02:36 PM

[Poppa Bear:]

I think physical precious metals are really the only assets that are holding their value right now. The paper price of precious metals can drop but, you'll still get a much higher price for your physical PM's.

The premiums for gold keeps rising everyday. Six months ago you could buy gold bullion coins for $10 over spot, but now it'll cost you $80 over spot. You're actually lucky if you can even get your hands on physical PM's.

The following article will give you a good indication of what the very wealthy are up to.... www.bearmarketinvestme...

2008 Oct 20 03:31 PM

[chux08:]

Just do the opposite of CLH and in the world of precious metals investing you'll be fine. This guy is as predictable as the government...and just as dumb.

2008 Oct 20 11:47 PM

[GoldWize:]

Good points Brian,

When the market manipulation ends (after the US election) and
demographic patterns take hold (buying behavior changes as baby
boomers retire - starting in 2009) you will find no one will be
seeking the US dollar or EURO and gold and silver will be in great
demand.

If history is a guide, gold will be steadily advancing in the coming
months, once the hedge fund-liquidation ends; and when foreign
governments stop propping up the dollar to help the incumbent party
during November's US election. The recent back-sliding is not because
of the some inherent flaw in gold investing, but because hedge funds
and (some) government manipulation (keep people in dollars effort) are
selling... and selling big! Hedge funds are selling to cover margin
calls and short positions... and to retrieve cash for those bailing
out of their once precious multi-trillion dollar funds.

Here is what will happen in the coming six months. Once the election
is over (Nov), foreign governments will not be supporting a strong US
dollar policy. Instead they will be retaining gold and silver to
hedge against the coming economic winter and the falling reserve
currency (USD). Hedge funds will complete most of there short selling/
covering calls by the end of November... and to satisfying client exit-
demands (look for a few more periods when options expire). Then as
the US government and others inflate their currencies and try to
Keynesian-spend their way out of this economic down turn (Thanksgiving
through Spring), look for gold and silver to reach it's all time high
(I'm forecasting February highs).

Keep the faith!

2008 Oct 21 12:56 PM

[troubby:]

Gold price will soar after the election.

I think $825 by Nov Op Ex is very reasonable

2008 Oct 21 07:11 PM

[FoolsMetal:]

GLD has lost over 10% in the past 3 weeks. When will the fundas everyone is talking about kick in???

2008 Oct 21 09:05 PM

[Bron Suchecki:]

The formula Brian mentions in his article is Lease Rate = LIBOR – GOFO. He therefore assumes that the amount that can be earned from the gold carry trade is the lease rate. However, that same formula can be restated as GOFO = LIBOR – Lease Rate. Which rate is the amount that can be earned from the gold carry trade?

Regrettably for Brian, it is GOFO, not the Lease Rate. How can I be so sure? Well when I worked in the Perth Mint’s Treasury and we borrowed gold, we were charged the Lease Rate, not GOFO. But don’t take my word for it. I quote from a booklet titled “A Guide to the London Bullion Market” issued by the London Bullion Market Association (who you would think would know what they are talking about): “Forward rate = Dollar interest rate – metal lease rate”

See my blog for further comment goldchat.blogspot.com/...

2008 Oct 22 05:16 AM

[dr funkenstein:]

Bron is wrong. This commentary by Brian is correct. 99 out of 100 explanations of Gold Leasing are incorrect. Just because Bron works at the Perth Mint doesn't mean that he knows what he is talking about. Heck, the CEOs at every formerly respected Wall Street bank had no idea how their businesses worked. You think Bron knows how this works? Bron simply sees a rate that the Perth Mint pays to borrow gold. He doesn't know what this rate corresponds to.

Understandably, many people get confused on this topic because the label "lease rate" is very misleading. It should be called "carry rate" or simply "Libor - GOFO" like it is on LBMA's website: www.lbma.org.uk/stats/...

The Perth Mint does not borrow gold from Central Banks, they borrow gold from Bullion Banks. Bullion Banks borrow gold from Central Banks. Bullion Banks pay Central Banks GOFO to borrow gold. Then they turn around and sell the gold or they lend it to entities like the Perth Mint at a higher rate. The Perth Mint only sees this higher rate, which is the rate that Bron refers to.

another of the rare correct explanations on this topic: blanchardonline.com/pd...

think, think, it ain't illegal yet!

2008 Nov 19 03:47 AM

[Zeppelin73:]

That's not how it works. Bullion banks do not pay central banks GOFO. A central bank actually has two options:

They can either lease gold to a bullion bank at LIBOR-GOFO which involves a transfer of title of the gold to the bullion bank. This is a straightforward deposit. The central bank earns LIBOR-GOFO for the duration of the lease (typically 1 month). The bullion bank pays the central bank the lease rate.


Alternatively the CB can do a swap with another bank. This is basically a sale and repurchase. In this case there is still an exchange of physical, but the exchange involves a transfer of bullion for cash (usually USD). The gold is sold spot with the agreement that the central bank repurchases it at a forward date. While this seems like a loan, it is not - it's a sale and repurchase with title of the gold still being transferred to the leasing institution. The central bank invests the cash at LIBOR, but at maturity the CB repays the cash loan at GOFO - the rate at which the CB is willing to swap gold for USD.

2008 Nov 27 06:11 PM

[Bron Suchecki:]

dr funkenstein,

Firstly, I do know what I am talking about because I worked for many years in the treasury department of the Perth Mint. Secondly, the Perth Mint has leased from central banks and bullion banks. Anyway, don't take my word for it.

You say: "Bullion Banks pay Central Banks GOFO to borrow gold."

Your Blanchard pdf link documents says, on page 5: "A central bank loans a bullion bank some amount of gold with a lease rate"

Bit of a contradiction from your own souce document. Blanchard go on to say (with my comments in []):

"The carry return [ie GOFO] is the return on the bonds [ie LIBOR] minus the gold lease rate."

This is the same formula as the London Bullion Market Association (LBMA) : “Forward rate = Dollar interest rate – metal lease rate”. GOFO is a Gold Forward Offered Rate, not an interest rate for gold. The LBMA defines GOFO as "rates at which the Market Making Members will lend gold on swap against US dollars."

The key here is "on swap against". This makes GOFO different to gold "placed on deposit to earn interest ... and generically the interest rates applied to such lending of bullion are often referred to as lease rates." (LBMA, A Guide to the London Bullion Market, page 13). QED

May 15 03:45 AM