Gold: Safe Haven For Who?

by: Evariste Lefeuvre

While the IMF reiterated the attractiveness of gold as a safe haven in its latest Global Financial Stability Report, the technical picture is still precarious, with technical analysis suggesting a potential fall to $1530.

According to the IMF:

Demand for non credit instrument such as gold is largely driven by perceptions of its store of value, with less regard to its market risk. Heightened uncertainty also bolstered the perceived safety of gold. Since the crisis, reserve managers have reversed their long-term position as net sellers of gold, and have turned into net buyers. At end-October 2011, the official sector accounted for 22% of the global holdings of physical gold.

To sum it up: Gold is a safe haven not because it behaves well when risky assets are going down but because it is a store of value. The renewed interest of gold by central banks is considered as a sign that gold remains a 'safe asset'. Note that selling gold is highly constrained - less than 400 t/year collectively - by the Central Bank Gold Agreement / Washington Agreement enacted in 1999 (currently in its 3rd version).

Gold might fulfill some of the prerequisites for a safe asset. The question is whether it's enough to appeal to central banks or private investors. The long run correlation of gold with inflation and real interest rates is loose (see charts below), so it is difficult to consider it the ultimate store of value.

(Click to enlarge)

The IMF message also suggests that gold should not be considered a safe haven or a safe asset in the efficient frontier sense. (See for instance the unstable and rather positive correlation with the S&P 500 since the early 2000.) On the contrary, as a store of value it could be alluring for capital preservation - a reason why it was managed passively by central banks for a long time. But if there is any economic agent able to face negative equity, it's the central banks

Liquidity is another reason investors hold gold for. Gold swaps provide liquidity to the gold market (market liquidity) and funding liquidity to gold holders. In a swap transaction, gold will be used as collateral in exchange for currency (USD), with the USD receiver paying the gold offered forward rate (GOFO).

Central banks have used gold swaps to enhance their gold holding returns, pocketing the spread between the Libor and the GOFO (difference between spot and forward gold price), namely the gold lease rate. Before and during the Libor crisis in 2008, the incentive for central banks to be long gold swap (lending gold and paying GOFO) was high.

Since then, the lease rate has been negative: The rationale for central banks to lend gold has vanished. In the meantime, many private investors managed to secure USD funding through gold swaps with Central Banks (CBs were ready to act as gold receivers, as Libor rates went below GOFO). This explains why there is an incentive for private investors to hold gold (as a means of accessing liquidity) when the portion of traditional government bond safe assets dwindles due to the loss of their AAA. Could it be that banks borrow gold not as a portfolio strategy but just as a means to provide liquidity to the market?

In conclusion:

  1. Gold does not share all the properties of a safe haven asset, in particular because it suffers from the spillover of the 'assetification' of commodities. As a result, the correlation with risky assets, although lower than that of copper or oil, is positive.
  1. As a funding liquidity provider, gold deserves the status of safe haven for private investors and banks. From a central bank perspective. However, gold's attractiveness remains limited as the only incentive to go for gold swaps is to enhance its gold holdings returns (Libor>GOFO) or to provide liquidity to the market in periods of stress (GOFO>Libor).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.