Update On The Negative GOFO: Gold Has Finally Bottomed

by: Dave Kranzler

In our office, we tried to buy physical gold right when it got down to right around $1200-1250, it's been 8 weeks and we still haven't received our order of physical gold so I think what that means is there's a huge run on physical right now... - Comex gold trader from Graphite Capital - Bloomberg Interview, sourced from the TF Metals Report.

About a month ago, I published an article that explained the significance of the Gold Forward [GOFO] rates published by the LBMA and why the negative GOFO rates likely marked a bottom to the big, 2-yr gold price correction: GOFO and Gold. Please note that since the negative GOFO rate appeared (July 8), the price of gold has risen $104. The GOFO rate has now been negative for a historically unprecedented 27 days in a row, including a 3-day period in which the 6-month GOFO went negative. When gold bottomed in 1999 and 2008, the negative GOFO rates lasted only a couple of days. The presence of negative GOFO rates for 27 days in a row not only signifies the degree to which the demand for gold which can be physically delivered to the buyer significantly exceeds the unhypothecated supply, it also marks the start of the next big move higher for gold.

Furthermore, I would argue that the duration and degree of the negative GOFO rates will translate into an even bigger and longer move higher in gold than that which occurred after the bottom in 2008, when gold moved up approximately 270% from bottom to top in a little under three years.

First, I want clarify some confusion about the GOFO and the gold leasing rate. Most analysts are incorrectly referring to the GOFO as the gold leasing rate [GLR]. In fact, there is a subtle but distinct difference between a dollar/gold swap and a gold lease transaction. Technically, the GLR = LIBOR - GOFO. GOFO is the rate paid on a dollar/gold swap. In other words, someone with gold needs to borrow dollars short term and uses the gold to collateralize the loan, thereby achieving a lower interest rate on the dollar loan. The market sets the rate for that swap and the LBMA publishes the rate (link above).

A gold lease transaction, on the other hand, is one in which a Central Bank leases out its gold to a bank, the bank pays the lease rate to the Central Bank and takes the gold and sells it in the market. The bank then gets use of the cash from the sale proceeds. In general, gold lease transactions are much longer in duration than dollar/gold swaps. The gold lease transaction was started as a "carry trade" of sorts when gold was in its 20 year bear market that started in 1980. The lessee leased the gold from a Central Bank, paid a small rate of interest then sold the gold and used the cash for higher yielding investments. When the lease term expired, the bank could repurchase the gold at a lower price, making money on the sale/buyback plus "carry" on the cash, and return the gold to the Central Bank.

A dollar/gold swap might appear to look like a lease transaction when the GOFO is negative, because the entity with the gold is swapping out its gold in exchange for cash collateral up front and is being paid a rate of interest on the gold for the swap. But a dollar/gold swap is not a lease. In a lease transaction, the entity with the gold does not receive any cash up front, but must bear the market risk of the gold being returned when the lease expires. As you can see, a lease transaction, because there is no collateralization of the gold loan, involves counterparty risk that is not embedded in a dollar/gold swap. In fact, in a bull market for gold, the lessee will lose money on the back-end of the lease transaction, as it will have to buy the gold back at a higher price. If the lessee defaults on the lease, the lessor does not have the benefit of cash collateral. In a dollar/gold swap, the both sides of the transaction have collateral.

What the long stretch of a negative GOFO rate tells us is that the market is currently "starved" for gold that can be delivered to buyers who are demanding delivery. Besides the negative GOFO, evidence abounds. The SPDR ETF Gold Trust (NYSEARCA:GLD) has been literally drained of over 440 tonnes of gold - about 34% - since mid-December. This is gold that has disappeared from sight, which means it has likely been delivered to private buyers keeping their gold in a private vault. To put this amount of gold drained from GLD in perspective, the annual global mining output of gold is approximately 2400 tonnes, and will be lower this year because many mines have been mothballed due to the price decline.

In addition, the registered gold warehouse inventory of the Comex has declined from 2.1 million ounces in mid-April to just 852k ounces of gold as of yesterday (August 9 inventory report). "Registered" gold is the gold at the Comex that can be delivered to buyers. Furthermore, the total inventory of gold on the Comex - registered plus gold that is safekept at Comex depositories - has been drawn down from a little over 11 million ounces at the beginning of 2013 to just under 7 million ounces as of yesterday - over 36%. It would seem that both the GLD and Comex gold have disappeared down Alice's rabbit hole.

Clearly there is a shortage of deliverable physical gold and the significance of the negative GOFO rate is that the gold coming from both GLD and the Comex is not enough gold to satisfy the demand for delivery coming from the buyers. The counterparties who are being called on to deliver gold are thus having to resort to swapping dollars to borrow gold and pay for the ability to borrow the gold in order satisfy delivery demands. At some point a much higher price for gold will be required in order to induce sellers to help balance out demand and supply. In fact, in the previous two times that the GOFO went negative in the last 14 years, it marked a significant bottom in the price of gold. Here's an update to the chart I posted in my original article (linked above):

Unless my eyes deceive me, it looks like there's already been a pretty sharp rally from the point in time when the current negative GOFO rate appeared. I know that I've been early on my bottom-call, but I'm confident I have the timing correct this time around. As a trader, we can make money if we're right a little more than 50% of the time. As investors, we can make a lot of money if we can catch the middle 2/3's of a big move, without worrying about whether or not we've perfectly timed a bottom when we buy and a top when we sell. Given that the 4 largest commercial traders of Comex gold - primarily the three biggest banks who keep Comex gold vaults, JPMorgan, HSBC and Scotia - are now at a record net long position in Comex gold contracts based on this CFTC report, I have good company in my view of where gold is going. Using the chart of above, and if I'm right that the next move in gold will be bigger than the move gold made starting in 2008, I can make a lot of money on the gold, silver and mining stocks I started to buy when I first made my bottom prediction back in February.

If you want to invest in a long-term move in gold, the first thing to do is to buy some physical gold and silver and keep them under lock and key yourself. I recommend 1 oz. gold/silver eagles (or maple leafs or Austrian philharmonics) because sovereign-minted bullion coins are the most "liquid" for smaller investors. You can also "index" the rate of return on gold with GLD. If you want to make a more aggressive play, Powershares DB Gold Double Long ETN (NYSEARCA:DGP) offers 2x the daily rate of return on gold and VelocityShares 3x Long Gold ETN (NASDAQ:UGLD) offers 3x the daily ROR on gold. Conversely, if you disagree with my view, the best alternatives to express a bearish view are PowerShares DB Double Gold Short ETN (NYSEARCA:DZZ), which is 2x the inverse of the daily rate return on gold or VelocityShares 3x Inverse Gold ETN (NASDAQ:DGLD), which is 3x the inverse of the daily ROR on gold. One caveat on shorting gold right now: India is about to enter its biggest seasonal gold buying period of the year, which lasts through mid-December. If I'm right that the negative GOFO is an indicator of a shortage of physical gold, the Indian buying season has the potential to create a historic short-squeeze in the price of gold.

Disclosure: I am long UGLD. The hedge fund I co-manage invests in physical gold, silver and mining stocks. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.