Several months ago, I drew your attention to the importance of the shifts in short term interest rates, and in particular in Libor. Libor rates are crucial for the understanding of gold lease rates, which, historically, have been negatively correlated to gold prices.

Gold lease rates can be understood as the difference between Libor and gold swap rate, which is expressed in annual percentage difference between the spot and forward prices. Low Libor usually means low gold lease rates, or even, as has been the case recently, negative lease rates. In a negative lease rate environment, market participants can still borrow gold, but will charge the lender for the operation, largely offsetting the storage costs. The fall in the borrowing costs is, therefore, negatively correlated to gold prices – a unique case among commodities. In base metals, the cost of borrowing increases as price rise because inventories are depleted and the physical metals is at a premium. This could be understood as one of the factors determining the mean-reverting character of “scarce” commodities.

But gold is, famously, devoid of any ‘mean-reverting’ level. There are no liquidity shortages here and low interest rates result from ample liquidity held at Central Banks and among other large holders. This ample liquidity allows jewelers to finance their inventory at the (lower) gold lease rate and avoid currency risk. But when the lease rates rise, the cost of holding this inventory rises as well, and the stock holders push the product into the market, which predictably depresses the gold prices. The relationship can also be illustrated by the legacy of hedging by gold mining companies, which has been progressively shaken off by the corporate boards. In the process, the lending market has shrunken, even though bullion banks offered ever lower lending rates. The de-hedging process has, therefore, been associated with low interest rates and higher gold prices. Note, by the way, that the CEO of AngloGold Ashanti – the holder of the last sizable hedge book – announced earlier this week that the process of dehedging will be accelerated. The market had hitherto anticipated an orderly expiration of the contracts over the next 5 years.

In the conditions of market stress, gold lease rates are a fairly reliable as a near term leading indicator of the gold prices. When the TED spreads pulled up the lease rates to a multi-year high of nearly 2.7% on October 10, gold subsequently dropped a record 22% over the next two weeks. On December 5, 2008, lease rates began their inexorable descent, contracting by 41% by the year end. During this short period, gold jumped up 16% and has not seen sub-$800/oz prices since. On the other hand, the collapse of US Libor in summer 2009 was accompanied by a drop in the lease rates and largely prefigured strong momentum in gold prices, observed between September and December. Three month gold lease rate hit a multi-year low (-0.16) on December 18 and began to climb since.

But the US Libor is not only significant for gold lease rates. The relative level of short term rates determines the choice of the funding currency for carry trades. Thanks to the ultra-low interest rates during the last 15 years, the Japanese Yen has served as the quintessential funding currency. After the Yen hit an all time high of Y79 to USD in April 1995, monetary authorities agreed to prop up the dollar, opening two and half years of the first Yen-carry-trade period. This led to an even stronger current account surplus in Japan and when the Yen strengthened again in 1999, Mr Sakakibara found it very difficult to convince US Treasury Secretary Larry Summers that further interventions to weaken the Yen were in the interests of the global economy (or US economy, for that matter). However, the Yen carry trade resumed in 2001, with unorthodox qualitative easing introduced in Japan for the first time. Against the background of strengthening Euro, Japan could grow again through strong exports and a market of around $1 trillion worth of carry trades evolved, lasting until 2008, when the Dollar and the Yen strengthened suddenly.

Since at least the summer of 2009, there has been much verbal speculation about the size of the new “Dollar carry trade”. Mr Zhu Min of Bank Of China (and now IMF) stated in Davos that, at $1.5 trillion, the size of this trade dwarfed the Yen carry trade of the previous decade. The problem is that we have no robust data to rely on and many commentators argued that the size of this trade could be half of what Mr Zhu Min had alluded.

Why is all this relevant? Because as of last week (March 4), US Libor has notched above Japanese Libor for the first time since August 2009. The Japanese currency is, again, the cheapest to borrow for those market participants who are keen on placing the funds in, say, Australian dollar assets. The Yen tanked on the news and gold wobbled, losing over 3% over the week. Incidentally, if the wall of Japanese money bids up AUD once again, Australian mining producers (including gold miners) will suffer.

Although the trade-weighted dollar has remained stable, the erosion of carry trade pressure on the greenback removes one of the supporting factors for the gold price. Also, since the third week of January, 3-month lease rates are again in the mildly positive territory (albeit trading lower again). All of this exposes gold to near term weakness and the questions are being raised about how far from the physical clearing price we are. Unconfirmed reports cite buyers’ interests at around INR 50’000 per ounce (current Rupee gold price is around 50’490/oz), but March is not a strong market for physical offtake. Beware…

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Tags: de-hedging, dollar carry trade, gold borrowing, gold lease rates, Japanese Yen, Libor

With the GFMS figures out now, it has been confirmed what we suspected since October – global investment demand for gold outstripped jewelry demand for the first time in three decades. The traditional relationship between the price driver – the Comex trading, and price floor (determined by the physical demand) has been transformed by the success of the ETFs and increased interest in other gold investment products. In the first quarter of 2009, gold price advanced in synch with the strengthening dollar as record volumes of gold had to be stored to respond to the 13moz worth of new ETF demand. Then, in September, the gold option volatility skew suddenly flattened, the market went short gamma and – most unusually – never corrected after record increase in net long Comex positions. The goal posts of this market had shifted.


Investment demand is a game changer. Just witness the spectacular success of the new platinum ETFs in the United States since the beginning of 2010. In just two weeks, the market added the equivalent of 30% of last year’s global ETF demand… The picture for palladium is even more dramatic. There is little doubt that the autocatalyst and jewelry demand will have to respond to new price range and the PGM market may be testing how far the spread tolerance can go between the various market participants.


Platinum has a track record of taking some shine off gold. The market is about a tenth of the size of the gold market and the white metal lives a constructively schizophrenic life as an industrial and investment product at the same time. Although precious metals also tend to affect each other’s fortunes, an argument could be constructed on the basis of anecdotal evidence that the PGM ETF rush has led to some ‘gold fatigue’ among investors wobbling unsteadily into 2010.

But the clues to gold’s fortunes in 2010 have to be sought elsewhere. Yes, ultimately, gold market specific expectations will play the determining role – expectations surrounding central banks’ intentions, further growth of investment demand, recovery (or not) of Indian jewelry demand and the liquidity of the secondary market. Yet, I would argue that some of the main drivers of the gold market will come from the outside – determined by the broader risk perceptions, the shifts in the currency market, the anticipation surrounding relative interest rates and the bond market performance. Here is a short list of signals which may have consequences for the gold market.

1. Pay a close attention to the decisions surrounding the phase out of qualitative easing in the US. Although Bank of England has already begun to sell corporate bonds, the exact exit by the US monetary authorities remains uncertain. Any indication that the market could benefit from a significant drop in liquidity could be damaging to commodity market and to gold.

2. Watch the spread between US and Japanese 3-month Libor. Although carry trades are notoriously under-reported, there is little doubt that the spell of ultra-weak dollar since last summer correlated with the 3-month Libor falling below the levels of two classic funding currencies – JPY and CHF (Swiss National Bank has since intervened in the markets to weaken the currency). Any indication that the short end interest rates recover in the US could strengthen the dollar. And when it happens – while you may not necessarily be tempted to sell your gold jewelry or knock out your gold teeth just yet – you’d do well buying Japanese stocks.

3. Follow inflation-linked bonds. Any indication that US TIPS offer 2% or higher would mean a global recovery and possibly further inflationary pressures. How gold recovers will depend on market expectations for real rates going forward.

4. Further intervention by emerging markets in foreign exchange markets. Towards the end of 2009, emerging markets spent $150bn strengthening the dollar (and renminbi). Renewed bout of dollar buying would be gold-negative, ceteris paribus.

5. Treasury market balance in government budget deficit countries – not least in the US, UK, Japan and Euroland. The irony of 2010 is that the countries with the highest debt/GDP also enjoy the highest sovereign debt rating. But the demand for $4 trillions of new issuance from the G7 nations will depend on the appetite for other funds, velocity of money and inflation expectations. Any indication that Central Banks are reluctant to foot the bill could lead to rate spikes, affecting real interest rate – to which gold remains eminently sensitive.

These five signals are not mutually exclusive. It is also important to keep in mind that many of the arguments could function counter-intuitively. With 36% of investors based overseas, a US bond sell-off could initially be damaging for the dollar, yet the resulting increase in yields could dampen interest in commodities, including gold. On the other hand, an intervention by ECB to weaken the Euro (now less likely) could initially help the dollar, but the long-term effects would be liquidity-boosting – and therefore positive for risk assets and commodities.

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Tags: ETF, FX, GFMS, gold price drivers, interest rates, Libor, platinum, Treasury market