Tuesday, August 25, 2009

Some Thoughts On Prof. Fekete's 'Dress Rehearsal For The Last Contango'

his most recent article Prof Fekete continues to sound the alarm about the shrinking gold basis. Although I don't totally agree with the professor on his overall historical/economic analysis I do think the gold basis, and it's secular diminution, is important to follow.

Simply, the Gold Basis is the price difference between the nearest liquid futures contract and the spot price. As there is no spot price per se, just the daily London Fixes, we need to look at the GOFO rate from the LBMA. This is the rate for a cash-gold swap. In normal times, if you need cash and have gold as collateral you can swap the two at a lower rate than borrowing at LIBOR. This makes sense as the person swapping the cash for gold now has a strong piece of collateral in hand that they have the option of using how they see fit. From this we can calculate a rate to borrow gold outright by subtracting the GOFO from LIBOR(this is the rate you see on Kitco). This is the equivalent of borrowing cash at LIBOR, and then swapping it for gold at a lower rate.

But, we are not in normal times and shorter term gold lease rates have been negative. This can indicate a number of things, which we won't delve into here but the important thing to realize is that the major reason for this is the drop in LIBOR, the high price of gold and the lack of speculative interest to sell physical gold into the market(or a glut of lendable gold). The fact that GOFO is trading above LIBOR allows us, despite the professors warnings, to defer our worries about a potential backwardation. The nominal drop in the GOFO is certainly worrying when viewed over a long period of time but most of the recent move has to do with the drop in the opportunity cost of such a trade. Simply, the rate at which you can buy gold and sell it forward drops as the rate at which you can lend your money at LIBOR does. In fact, recently the short-term interest rate has dropped so much, and/or the desire to sell gold unhedged into the market has dried up, that a premium to carry*(negative lease rate) has appeared. Now there is an incentive to buy physical gold and sell it forward rather than to lend at LIBOR, indicating a glut of metal sitting around to be swapped\lent (or decreased demand for it)... you can get paid a risk-free rate now simply to hold gold, assuming you can do it in a cost efficient way. (note: for most of this analysis we are not factoring in actual carrying costs in order to keep it as simple as possible)

We should start to worry when this condition reverses and gold gets back a discount to carry* (positive lease rate), and this rate starts to increase. This will indicate that a glut in gold has gone and now their is a dearth of metal as the gold market is offering a cheap method of financing for gold holders by selling their metal into the market and buying it forward, essentially borrowing from the gold market or swapping gold for cash. Either the demand for selling uncovered gold into the market increases, the supply of gold to lend/swap decreases, or the market begins to distrust the futures contract for forward delivery. All three are somewhat related but the last two are key; as the GOFO relative to LIBOR drops more than it "should" it sends a signal that gold is either going into hibernation or that gold delivery promised in the future may be suspect, or both.

Despite protestations by mainstream authorities Gold is still considered by many as a default currency; it will rise when the market feels uncertainty about major fiat/credit regimes, as it is a rare form of money that is an asset and not a liability, one that is internationally recognized as a store of value, and one time medium of exchange. This is just a fact, whether people like it or not. During the deflationary portion of the current credit crisis when the USD price of EVERYTHING (except treasuries) cratered the USD price of gold stayed flat to slightly up, showing it's re-emergence as a competing currency. Central Banks and some Governments still have large hordes of Gold for just this reason; in case their micro-managed fiat/credit systems implode there needs to be some Plan B.

With this in mind we need to accept the professors idea that for Gold to serve the international payments system it must be free-flowing, at an adequate price - this price is the basis relative to the prevailing level of interest rates(assuming, of course, gold is not the monetary unit). As the basis drops (relative to rates) there should be an incentive to sell gold into the market, buy it back forward, and invest the proceeds, which should keep the basis in line. But if gold has been slowly going into hibernation or if the gold futures market is becoming less and less trusted as a future delivery mechanism(for a host of reasons) this drop in basis won't elicit the necessary selling of metal and the basis will continue to fall.

It is for this reason that we must watch 1) the basis relative to interest rates and 2) the nominal level of the basis as it heads towards 0. The former let's us know where we're going, the latter lets us know when we are there. Once gold goes into backwardation, and remains there, it doesn't matter what the nominal interest rates are as they can't be less than 0. At this point, even if interest rates are at .0000001% the gold market will be offering "riskless" profit for those willing to dump gold hoards on the market and buy them forward. But when a riskless profit appears for any length of time we can be almost certain that it isn't riskless, and in this case its a signal that gold has "disappeared" and won't come back until the future is, and the futures are, purged and revitalized.

* These terms are my creation, and they exclude actual storage/transport/fees cost of carrying. They are just used to show whether the market is charging or paying(with respect to interest rates) a holder of gold who has sold it forward. When lease rates are positive the market is charging a carrier of gold on top of the storage/transport costs, when they are negative the market is paying the carrier of gold an amount which may or may not account for the storage/transport cost.