Gold Forward Rates Plunge

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Includes: GLD, IAU, PHYS
by: Acting Man

Negative GOFO Rates Become More So

The gold forward offered rate (GOFO for short) is a swap rate for a gold-dollar swap. If one owns gold and wants to borrow dollars, one can use one's gold as collateral for a dollar loan, and GOFO is effectively the interest rate one pays for this swap.

Implied in GOFO is the gold lease rate: one can calculate the gold lease rate (the rate at which gold can be borrowed) by deducting GOFO from LIBOR. With LIBOR close to zero on account of central bank manipulation of interest rates, a slightly negative GOFO rate often can be a mere short-term wobble due to interbank rates on dollars fluctuating near the "zilch zone." When discussing gold forward offered rates one must therefore take the level of LIBOR into account. However, in recent weeks GOFO rates have declined quite deeply into negative territory, pushing lease rates sharply higher. GOFO is now in negative territory six months out (the one-year rate is at a positive 3 basis points, which isn't a whole lot either).

This means simply put that the urge to borrow gold is currently greater than the urge to borrow dollars. Normally, GOFO tends to be positive, lease rates tend to exhibit an upward sloping yield curve and tend to be slightly lower than LIBOR (which is why small dips of GOFO into negative territory with LIBOR close to zero are not remarkable). These conditions are no longer intact though - the gold lease rate curve has a steep negative slope as a result of what has happened with GOFO recently and gold lease rates have risen far above equivalent LIBOR rates.

One, two, three and six month gold forward offered rates. Their recent steep plunge indicates that there is now a greater urge to borrow gold than to borrow dollars - a highly unusual state of affairs.

Backwardation in Gold is Highly Unusual

To the extent that GOFO rates are in negative territory, there is effectively backwardation in the gold market, which should normally not occur. It indicates that there is currently a shortage of readily available physical gold supplies. According to the LBMA:

"Traditionally gold interest rates are lower than Dollar interest rates. This gives a positive figure for the forward rate, meaning that forward rates are at a premium to spot. This condition is often referred to as contango. On very rare occasions when there is a shortage of metal liquidity for leasing, the cost of borrowing metal may exceed the cost of borrowing Dollars. In this scenario, the forward differential becomes a negative figure, producing a forward price lower than, or at a discount to, the spot price. This condition is known as backwardation."

(emphasis added)

The reason why gold should normally never be in backwardation is that all the gold ever mined still exists. If one compares the total supply of gold to annual jewelry and industrial demand, the outstanding gold inventory is theoretically big enough to supply these demand components for several decades. It follows from this that the vast bulk of gold demand is monetary, or investment demand.

Of course not all the gold ever mined is actually available for trading. However, one can probably assume that of the approximately 175,000 to 180,000 tons mined throughout history, between half and two thirds are out there in immediately tradable form (i.e., as bars and coins). Gold traded at the LBMA comes however in a very specific form, namely the London good delivery bar, a roughly 400 troy ounce gold bar (allowed weights are between 350 and 430 ounces), with a minimum fineness of 995/1000, which must bear a serial number, the refiner's hallmark and a stamp indicating the year it was manufactured. Also, its dimensions must be within certain parameters. This is also the form in which most central banks hold their monetary gold, and obviously the form used in the aforementioned gold-dollar swaps.

In recent years, a lot of gold has moved from Western to Asian countries such as China (for instance, Switzerland is exporting enormous amounts of gold to Asia). A chart of the rise in Swiss gold trading can be seen below:

Swiss gold trading over the years. The huge rise in imports and exports is directly related to surging Asian demand for gold. These charts are slightly dated by now, however, it is fair to assume that the amounts have continued to increase.

As can be seen, the tonnages are beginning to exceed the amount of gold that is newly mined annually. In fact, while Switzerland imports gold from the US, which is a sizable gold producer, most of its imports come from the UK. Other main sources of gold imports into Switzerland are Germany, Italy and the United Arab Emirates - since none of these are gold producers, they are presumably at least partly exporting gold from their existing holdings. The point we want to make is that gold is indeed "moving from West to East" to some extent.

This means however that refiners will alter the shape of the gold to suit Eastern conventions and tastes. To the extent that good delivery bars are recast, they will no longer be available for trading. The same goes for good delivery bars that disappear into central bank vaults due to repatriation and outright buying, as long as the central banks concerned are not, or no longer, in the gold lending business (for instance, Germany's BuBa has completely stopped its gold lending activities. It once used to be a big supplier of gold loans).

Nevertheless, even if the shortage is tied to a specific form of deliverable gold, it is very likely still telling us something about the state of reservation demand for gold at current prices. After all, it would be easy to relieve the problem by recasting gold into good delivery bars, but Asian buyers seem not very eager to send their gold back (on the contrary, they are still buying more) and evidently many Western gold holders also are sitting tight for now. Zerohedge has recently suggested that the problem may be tied in some way to the practice of rehypothecation of assets in repo markets, but we cannot independently ascertain if this is the case. The gold market is notoriously opaque after all, so one is forced to guess to some extent what might be happening. It is well-known though that fractional reserve banking is rife in the gold market, with gold claims and liabilities in the form of unallocated gold far exceeding actual physical gold holdings backing these claims. In other words, bullion banks have seen an opportunity to become "creative" with unallocated gold for their own benefit.

If a near-term shortage of physical gold exists (as the current backwardation clearly indicates), it is surely a sign that reservation demand is increasing. If for instance a gold holder wishes to alter the character of his gold claims by moving them from unallocated to allocated gold, or attempts to withdraw unallocated gold from London to move it to a location within grabbing distance, it would certainly also say something about his reservation demand, and if too many such demands are forthcoming, this might well pose a problem for fractionally reserved bullion banks in the short term. There is of course always the potential that a small problem could become a big problem at some point.

One month LIBOR is currently at 15.4 basis points (0.154%). The one month gold lease rate stands at 73.59 basis points (0.7359%). In short, the gold lease rate is now roughly 4.77 times the level of LIBOR, which is quite remarkable in a ZIRP environment.

Conclusion:

In the past, negative GOFO rates have tended to precede rallies in the gold price, often quite sizable ones. This by itself shows that there is a connection between gold backwardation and rising reservation demand: the only way to relieve the situation is by letting prices rise to a level where said reservation demand is less pronounced. In the current zero interest rate environment, the message of negative GOFO rates and rising gold lease rates is probably not as meaningful as it would otherwise be, but then again, short-term lease rates are at present quite a distance from their LIBOR equivalents. The recent moves in GOFO are certainly beginning to look rather unusual and are worth keeping an eye on.