Gold Liquidity Play a Setup?

Oct.21.08 | About: SPDR Gold (GLD)

By Brad Zigler

Our central bank may want you to buy gold. Well, indirectly, at least.

Three-month gold forward rates slipped below 2% over the past couple of trading days, a development of no small significance. A forward rate is the vigorish charged by a central bank lending gold reserves.

Gold, as a vault asset, is essentially inert. It doesn't earn interest. In fact, when you count the security measures required to safeguard the metal, there's actually a cost to carry it. Lending it for even a modest sum recoups carrying costs and may even earn a little extra for the bank.

Gold borrowers include the Federal Reserve's primary dealer network -- the cadre of banks that buys government debt at auction and wholesales the paper to secondary institutions.

Once borrowed, the gold can be sold to raise cash which, in turn, may be lent or used to buy securities. Lowering the cost to borrow gold, then, is one of the tools a central bank can employ to stimulate lending activity.

There's a big impetus to borrow metal now. Just look at LIBOR. The London Interbank Offered Rate is a dealing bank's return for lending funds to other institutions. LIBORs shot up recently as bank-to-bank lending ground to a standstill. Three-month LIBOR, for example, is now north of 4%, making the gold lease proposition a better-than-2% deal. Not bad when you consider the lease spread averaged only 40 basis points (0.40%) this year.

Fed Funds market offers liquidity, too, though it's necessarily limited by the size of lenders' excess reserves. The target rate for Fed Funds may have ratcheted down to 1.50% by the Fed, but the rate at which excess reserves have been actually swapped has been a lot lower recently. That's a drag on gold leasing. If Fed Funds start trading at a rate higher than the gold forward rate, leasing will likely boom.

Gold Lease Rates

Chart: Gold Lease Rates

So, how does all this translate into you buying gold? Well, banks have to sell their borrowed gold in order to raise funds. The dealing banks, in effect, become short-sellers of gold since they'll eventually have to return the borrowed metal to the central bank. And, as with any other short sale, a decline in gold's price would produce the ideal outcome - a trading profit.

Banks are going to need buyers for their borrowed gold. They can deal gold through futures or off-exchange, but in any case, they'll need buyers. And later, when their leases run to term, they'll need sellers to tap into in order to retrieve metal.

Here's where you may come in: You buy gold to provide liquidity to the banks, then stand ready to sell it to them - or their agents and intermediaries - when they need to cover their shorts.

Or not.

In the worst case scenario, there's an intervening scare in the financial markets that spikes investment demand for gold. That, in the extreme, could set the stage for a short squeeze with the dealing banks caught in the middle.

There are a lot of "ifs" in that chain of events, so don't take this as gospel. It could happen. Whether it does is another matter.

Now, where'd I put the Windex? I need to polish my crystal ball.