The End of the Gold Carry Trade

With yields on government debt at unprecedented lows, it is no longer profitable to borrow gold and exchange it for risk free securities.

A gold carry trade has been in effect for over 10 years. Central banks, with hoards of gold, would lease the yellow metal to investors at a paltry 3% per annum. These investors would borrow the gold from the bank and sell it on the open market.

At the same time, they would buy futures to repurchase the gold at a later date, locking in the current price. With the proceeds from the sale of gold, they would invest in anything that could yield more than 3%. If the fund manager invested in a 10yr government bond, usually yielding around at 5%, he made some money while taking on no risk. As long as the Treasuries yielded you more than the cost to lease the bank’s gold, this was the easiest money you could make!

Why would the banks do this? They have thousands of tons of gold bars in their vaults. Better for those bars to collect 3% a year than lots of dust. The carry trade benefits a lot of players. The banks make out, and the investors make out.

The only people who didn’t do so well were the gold-bugs. The carry trade resulted in added selling of gold by the investors, putting downward pressure on the yellow metal. Anybody long in gold got pinched.

This trend is beginning to reverse itself.The past two months have seen the biggest global coordinated interest rate cut ever. The Fed rate is at 1%, with the smart money projecting it to be half that by year end. The European Central Bank slashed rates to 3.25%. The Bank of England has rates at 3% -- the lowest in half a century! Even Japan has lowered its rates from virtually nothing to literally nothing (.3%)! All of these cuts are resulting in negative real interest rates. Inflation is expected for 2008 to be around 3%. 10 year US Treasuries are yielding as low as 3.1%. that means if you borrow gold at 3% to make 3.1% on your risk free security, you are not making much. Even in a period of low inflation, the real return on your money is negative.

In order to generate the returns required to make borrowing gold worthwhile, the investor will have to hold riskier assets than government debt. The problem is that nobody wants to invest in assets that are riskier than government debt. The whole reason why there is a credit crisis in the first place is because nobody trusts any institution that isn’t owned, backed, or financed by government debt. So where does that leave the investors?

It leaves them looking elsewhere for that easy return.

Investors will reduce the amount of gold they borrow, and there will be less gold dumped on the market. Consequently, there will be less downward pressure on the price of gold. At $803/oz, gold up almost 1% over the past 12 months. From the day before the market shock began in September to today, gold is up 8%. Is there any stock or commodity that can make this claim?

Gold is real money. It is the best hedge against inflation, and it is not backed by any debt. You cannot ‘bankrupt’ the value of gold like you can a company or a house. With the great majority of risk-free assets yielding next to nothing, look for big funds to take some of the money they usually reserve for Treasuries and put it into gold. Gold provides the same safety as US government debt. Its performance over the last 12 months and throughout the current crisis illustrates this.

Pricewise, there is little room for government debt securities to rise. Gold can triple in value and still trade cheaper than its inflation adjusted all time high. As long as interest rates remain at or near all time lows, look for the downward forces of gold to ebb, and the upward momentum to build.

Disclosure: Author holds a long position in SLV

Comments

[Francis Sch...:]

Difficult topic to understand. What I doubt however is that Gold offers the same safety as US government debt. If this is true, I would not even consider buying it. Don't we buy Gold because we don't trust the authorities, the fiat paper money and the debt issued by them? Having said this, it is not the first time that Government repudiates its debt and the odds are that they will do it again some day.

2008 Nov 24 06:43 AM

[ManAboutDallas:]

Easy to understand, francis. Just ask yourself this one single question:
Which has been around longer as the "go-to" store of value: gold, or the Federal Reserve and its joined-at-the-hip sycophant sock puppet the U.S. Treasury Department?

2008 Nov 24 07:02 AM

[SW Richmond:]

"...its joined-at-the-hip sycophant sock puppet the U.S. Treasury Department?"

Amen, brother. I am amazed at how willing the inside players have been to reveal themselves. The transparent and fearless self-dealing, the manipulation, the blatant lying, cheating, and stealing; just amazing.

2008 Nov 24 08:15 AM

[B. Ray:]

Good article providing clear picture about the put force on gold.

2008 Nov 24 08:22 AM

[User 30121:]

Amen David! And to those of poster francis schutte ilk, I FEEL SORRY FOR THEM! I REALLY DO! All they have to do is read the PM (precious metals) posts and they will learn what they need to do to EXIST in this world that the elitist, greedy bastards are shaping for themselves! Avoiding making any politiical statement here, what is happening, and will continue to happen in this world is that what you have will be taken away systematically until you have nothing of value. Your life style is being altered to suit THEM! Your ONLY way out is to OWN PHYSICAL GOLD AND SILVER. Then, you can dictate how you choose to live your life on your terms! francis, please WISE UP! And tell your family and friends to educate themselves on this topic..FAST! God bless us all!

2008 Nov 24 10:20 AM

[Yreakahigh:]

The leasing of gold by the central banks has me scratching my head. The “news” reports the sale or lease a week or two ahead and I never read who buys or leases the gold, price “they” lease it at and for how long. If it’s such a good safe bet, then it must be an all insider shuffling of paper. Can anyone enlighten me? It’s one of those old questions of “Who benefits?”

When Iran bought billions of dollars of gold a few weeks back, while gold was difficult to buy for the average investor, who was selling it to Iran?

2008 Nov 24 01:14 PM

[bearfund:]

All very reasonable, except that you wouldn't ordinarily want to buy securities with more duration than the length of your lease. At least not if you're genuinely looking to exploit an arb opportunity rather than make a directional bet on interest rates. If your lease is for 1 year, you wouldn't want to own Treasuries maturing more than 13 months out; if interest rates rise, your losses on the notes could erase much of your free money. Margins here are very thin, so if you bought the 10-year against a 1-year gold lease, a few ticks on the note would make this trade a loser. Now, if the Fed gave you a perpetual 3% lease, they might as well have given you a printing press. But I doubt those are the terms.

2008 Nov 24 03:03 PM

[Alex Stanczyk:]

"The whole reason why there is a credit crisis in the first place is because nobody trusts any institution that isn’t owned, backed, or financed by government debt. So where does that leave the investors?"

Great point. In reality any government is truly just a representation of the citizens of that country's wealth and ability to pay taxes. That is, after all, where a governments money comes from.

So really, people are buying US Citizens credibility to pay. Only problem there is US Citizens for the most part are in debt to the hilt, losing their jobs, and some are more concerned about putting the food on the table than buying Christmas gifts.

Gold on the other hand, requires no government to back up its value. It has had value for over 5000 years of human history. Not going to change tomorrow.

www.rapidtrends.com/bl.../

2008 Nov 25 12:15 PM