In normal times, the term structure of commodity futures strip is upward sloping -- that is, in contango. The rationale for the steepness is the cost of carry driven by interest rates, cost of storage and insurance minus an unobservable "convenience yield" (proxy of the availability of the commodity). For the curve to invert and get backwarded the convenience yield has to increase significantly, which happens in periods of economic booms and supply scarcity.
Gold is a special case as its cost of storage is very low. For that reason, the contango is always very low. This is important since the difference between the future (forward) price and the spot price defines the GOFO (gold forward offered rates). The GOFO is also called the gold swap rate.
The GOFO rate is commonly seen as the rate at which market makers are ready to lend gold for U.S. dollars on a swap. GOFO is the (direct) cost of borrowing dollars using gold as collateral. Said differently, GOFO is the interest rate charged on a USD loan backed by gold (the gold lender pays the GOFO). Given that this loan is secured by gold, generally, the rate is (or at least should be) below the Libor, which is the rate of unsecured borrowing/lending. This is clearly visible in the chart below that shows Libor, GOFO, and the spread between both series.
The spread is called the lease rate. It is a derived rate and is the difference between Libor and GOFO. It was high and positive throughout the 1990s at a time when gold prices were low and declining. It stabilized at a very (positive) and low level when the bull market started in early 2000 before turning negative in the aftermath of the financial crisis. The evolution of the lease rate is linked to monetary policy and the state of the gold market.
Central banks play a key role either in providing liquidity to the gold market or funding liquidity to private holders of gold. Throughout the 1990s and 2000s, central banks sought to enhance their gold holdings with gold lease operations: entering a gold swap (paying GOFO to the gold borrower) and then investing the proceeds for the duration of the transaction. As central banks are risk-averse investors, they can invest in Libor of the same maturity.
This defines the lease rate (Libor-GOFO). Contrary to a gold swap, which is mostly a repo operation, a gold lease is a unilateral transfer of gold that does not result in a cash flow in the opposite direction (the CB has a claim on the borrower that is charged at Libor). The borrower is likely to sell the gold on the market and is required to repay it at the end of a predetermined period (the volume of gold has to be returned, regardless of the price). As there is no free lunch, if the gold borrower sells gold and invests the proceeds, she will get Libor - Lease = GOFO.
When the lease rate is positive, central banks have an incentive to be on the lending side of the trade: lending gold and pocketing the Libor-GOFO spread. This was the case in the 1990s and 2000s. Yet, following the implementation of non-conventional monetary policies in the aftermath of the financial crisis, the spread turned negative. The incentive for central banks was to be gold receivers, as the lease rate was negative. This was a rather welcome situation given that many private institutions (banks or shadow banking actors) had limited access to overnight or short-run refinancing despite the apparent easing in the interbank market. Central banks therefore turned from (gold) market-liquidity enhancers to funding-liquidity providers (see this article).
Things have changed over the last few months:
- For the first time in years the lease rate is durably positive.
- This move is not driven by higher Libor rates (in spite of the threat of Tapering, the liquidity in the money market remains plentiful) but by a sharp and lasting fall in the GOFO rate.
From its definition, the lease rate is driven:
- Positively by the overall trend and level of interest rates fixed by central banks who manage to drive the Libor. There is a limit of the impact of yields as higher interest rates increase the opportunity cost of holding gold, hence a downward pressure on spot prices which increases the contango (GOFO).
- Positively by the hedging activity. When gold producers hedge massively, the supply is increased (the counterparty of the hedge buys forwards and hedges by selling spot gold that has been borrowed to the central bank).
- Negatively by overall trend in gold prices. A lease operation is nothing more than a carry trade. If gold prices fall or remain stable during the transaction period, then the incentive to enter a lease operation is high. When the trend is up, the carry can easily be lost (remember that in a carry operation gold is borrowed, sold, and bought back at the end of the transaction).
As of today, Libor remains capped by forward guidance in spite of the forthcoming tapering, as hedging activity has not picked up and gold prices have declined. By construction, a decline in gold prices comes along with a higher lease rate. The lease rate is a good proxy of the convenience yield of gold (remember that the higher the convenience yield, the more backwarded is the future curve). If the lease rate increases because of relative scarcity and the Libor is pegged, then GOFO has to decline. This is what happened in the spring. The recent increase in gold prices has not triggered a decline in the lease rate, and the GOFO continued to trend downward.
The GOFO rate is generally seen as a good and synthetic indicator of the supply/demand conditions in the physical market for gold. Episodes of negative GOFO are rare and they seldom last more than a few days. They are considered by many analysts of early signals a forthcoming bull market for gold.
Why? Because if GOFO is negative, as it is today, it means a backwarded futures curve, or a signal that inventories are strained. Demand may also be picking up significantly for jewellery (Asia) or safe haven purpose (EFT inflows have not picked up yet). The reason why GOFO turns negative is due to the fact that the request of physical delivery that is addressed to bullion banks can only mostly be met with gold swaps (or by buying spot and selling forward, which has the same impact on the GOFO). A negative GOFO means that long cash investors/banks are ready to pay to swap their holdings with gold.
In addition, it can be shown that the lease rate is a proxy of the convenience yield of gold. What is puzzling currently is that the rise in gold spot prices has not changed the shape of the futures curve, which remains in contango. This suggests that the pressure on gold spot price will not ease quickly. Given the current momentum of gold prices, the strain might continue until prices reach a short run resistance at 1414 USD (retracement of 38% of the downtrend since October 2012 top and medium-term bearish channel).
The current movement in gold from wholesale investors to small retail investors as a mechanism of "buying on dips," is fairly typical in this sort of market. This demand should continue the exports out of the U.K., and towards Asia and Latin America (gold physical premium have soared). In addition, the decline in gold prices should lead to a drop in scrap and also serve to stabilize gold prices.
Bottom Line: The recent trend in both lease rate and GOFO is clearly a bullish signal. I would not be surprised by a further increase up to 1414 USD in the short run. But this is not enough to modify my medium-run bearish outlook as the major driver of gold remains real interest rates. The latest FOMC minutes suggest that the Fed will taper, even though the inflation environment remains friendly. This is clearly bearish.