Brian Kelly (founder and CEO of Kanundrum Inc, a private investment firm and research boutique) recently posted an article on Seeking Alpha called Misinterpretation of Gold Lease Rates and Why Gold Could Rise. In the article he says that “lease rates reported in the press are a derived rate and actually represent the amount that can be earned from the gold carry trade” and goes on to posit a relationship between lease rates and gold prices. Unfortunately it is Brian who has misinterpreted lease rates, and has done so quite badly.
The gold carry trade involves borrowing gold at, say 1%, selling the gold, and then investing the cash at, say 3%. If the gold price doesn’t change, you earn a net 2%. The bigger the net difference the more carry trade return you can earn (assuming a stable price) and therefore more attractive short selling of gold should be – as long as there is an expectation that the gold price won’t rise too far to wipe out the profit from the interest rate differential.
The point of a carry trade is, therefore to “capture the difference between the rates” (see Currency Carry Trade for a further explanation). The question then is what are the two “rates” and what represents the net difference. The formula Brian mentions in his article is Lease Rate = LIBOR – GOFO. He therefore assumes that the net difference is the lease rate. However, that same formula can be restated as GOFO = LIBOR – Lease Rate. Which is the net difference?
Regrettably for Brian, it is GOFO, not the Lease Rate. How can I be so sure? Well when I worked in the Perth Mint’s Treasury and we borrowed gold, we were charged the Lease Rate, not GOFO. But don’t take my word for it. I quote from a booklet titled “A Guide to the London Bullion Market” issued by the London Bullion Market Association (who you would think would know what they are talking about): “Forward rate = Dollar interest rate – metal lease rate”
Therefore the fact is that it is GOFO which represents the “amount that can be earned from the gold carry trade”. GOFO is the measure of the net difference, “the amount that can be earned from the gold carry trade”, not the Lease Rate.
As a result not much store should be put to Brian’s subsequent analysis about the relationship lease rates and the gold price. The chart below shows the relationship between the real “carry trade” indicator (I’ve chosen the 6 month GOFO rate) and the spot price. I take a more longer-term strategic view and looking at the chart there is no clear relationship or correlation that I can work with. For example, in 2002-2003 GOFO was low and the gold price rising. But 2004-2006 GOFO was rising but the price also went up. I don’t see any tradable signals one can rely on.
Brian has also developed what he calls the Kanundrum Model of Markets, which explains the way people and markets behave. Below is a summary of his key “stages”:
Discovery – Stage 1
Stage 1 of any emerging trend is first characterized by a change in direction. It is usually preceded by a surge in volume as the asset makes a new low. This is the stage where major investors are establishing new positions.
Disbelief/Confusion – Stage 2
Price retreats after the initial surge and often the retreat is significant. Investors who did not buy when they heard that Stage 1 investors were buying believe that this is the time the Stage 1 investors are going to be wrong.
Belief and Proof – Stage 3
In this stage the asset makes its largest price move. It is by far the most important part of the trend for an investor to be a part of. Volume is huge and price moves are beyond what anyone expects. This part of the trend usually lasts much longer than anyone expects. This is also where almost every type of investor has a reason to be involved in the trade.
Complacency – Stage 4
Price begins to retreat from the unbelievable prices achieved during Stage 3. However few participants are concerned. Market participants are accustomed to the asset price and many investors use the pullback to add to or establish new positions.
Mom and Pop – Stage 5
The price begins to move back up and individual investors invest. The price moves may be less than during Stage 3 primarily because individuals do not have the buying power that larger professional investors have. As well, Stage 1 and Stage 3 investors are taking profits.
In this blog post dated 13 October, Brian believes that gold is currently in Stage 2: Disbelief/Confusion. Now I’m not so sure about his model and the stages one has to choose from but it is an interesting and fun way to view the market. Using his model, I would suggest we are in the middle of Stage 4 (see chart below). What stage do you think we are at?
The gold carry trade involves borrowing gold at, say 1%, selling the gold, and then investing the cash at, say 3%. If the gold price doesn’t change, you earn a net 2%. The bigger the net difference the more carry trade return you can earn (assuming a stable price) and therefore more attractive short selling of gold should be – as long as there is an expectation that the gold price won’t rise too far to wipe out the profit from the interest rate differential.
The point of a carry trade is, therefore to “capture the difference between the rates” (see Currency Carry Trade for a further explanation). The question then is what are the two “rates” and what represents the net difference. The formula Brian mentions in his article is Lease Rate = LIBOR – GOFO. He therefore assumes that the net difference is the lease rate. However, that same formula can be restated as GOFO = LIBOR – Lease Rate. Which is the net difference?
Regrettably for Brian, it is GOFO, not the Lease Rate. How can I be so sure? Well when I worked in the Perth Mint’s Treasury and we borrowed gold, we were charged the Lease Rate, not GOFO. But don’t take my word for it. I quote from a booklet titled “A Guide to the London Bullion Market” issued by the London Bullion Market Association (who you would think would know what they are talking about): “Forward rate = Dollar interest rate – metal lease rate”
Therefore the fact is that it is GOFO which represents the “amount that can be earned from the gold carry trade”. GOFO is the measure of the net difference, “the amount that can be earned from the gold carry trade”, not the Lease Rate.
As a result not much store should be put to Brian’s subsequent analysis about the relationship lease rates and the gold price. The chart below shows the relationship between the real “carry trade” indicator (I’ve chosen the 6 month GOFO rate) and the spot price. I take a more longer-term strategic view and looking at the chart there is no clear relationship or correlation that I can work with. For example, in 2002-2003 GOFO was low and the gold price rising. But 2004-2006 GOFO was rising but the price also went up. I don’t see any tradable signals one can rely on.
Brian has also developed what he calls the Kanundrum Model of Markets, which explains the way people and markets behave. Below is a summary of his key “stages”:
Discovery – Stage 1
Stage 1 of any emerging trend is first characterized by a change in direction. It is usually preceded by a surge in volume as the asset makes a new low. This is the stage where major investors are establishing new positions.
Disbelief/Confusion – Stage 2
Price retreats after the initial surge and often the retreat is significant. Investors who did not buy when they heard that Stage 1 investors were buying believe that this is the time the Stage 1 investors are going to be wrong.
Belief and Proof – Stage 3
In this stage the asset makes its largest price move. It is by far the most important part of the trend for an investor to be a part of. Volume is huge and price moves are beyond what anyone expects. This part of the trend usually lasts much longer than anyone expects. This is also where almost every type of investor has a reason to be involved in the trade.
Complacency – Stage 4
Price begins to retreat from the unbelievable prices achieved during Stage 3. However few participants are concerned. Market participants are accustomed to the asset price and many investors use the pullback to add to or establish new positions.
Mom and Pop – Stage 5
The price begins to move back up and individual investors invest. The price moves may be less than during Stage 3 primarily because individuals do not have the buying power that larger professional investors have. As well, Stage 1 and Stage 3 investors are taking profits.
In this blog post dated 13 October, Brian believes that gold is currently in Stage 2: Disbelief/Confusion. Now I’m not so sure about his model and the stages one has to choose from but it is an interesting and fun way to view the market. Using his model, I would suggest we are in the middle of Stage 4 (see chart below). What stage do you think we are at?
The mom and pops I see in the paper and the ads I hear on the radio are about selling gold...
ReplyDeleteI'm very curious:
ReplyDeleteWhy do you think there was such an incredibly sudden rise in the lease rate?
Who leases gold?
Do these people then hedge short in the futures market?
Thanks for the interesting posts
There is only one real source of gold to be lent out and that is central banks. The belief is that they have pulled back on lending their gold out because they are as risk adverse as everyone else about the ability of borrowers to repay loans. Another view is that it is just a factor of the screwed up financial markets that has LIBOR unusually high (lease rate = LIBOR - gold forward rate).
ReplyDeleteThere are really only two things you can do with borrowed gold: 1. use the physical to fund your work in progress inventories (eg mints or jewellery manufacturers); 2. sell it, invest the cash and then hope the gold price drops so you can buy back the gold later at a cheaper price so you can repay your loan and pocket the difference.
I can't see any significant change in 1. Maybe 2 is occuring and that's why the price has dropped, but that would require balls of steel (or support of the central banks, if you tend to conspiracies) in this market to short gold big time.
does the Perth Mint borrow gold from a Central Bank or a Bullion Bank?
ReplyDeleteIf you look at the Mint's annual report you will see that it does borrow in precious metals, which come from bullion banks. This occurs because there is not enough metal from the Depository business to cover the requirements of the Mint and AGR Matthey. Before the Depository business, all precious metal inventory of the Mint and refinery was funded by borrowings from bullion banks.
ReplyDeletemore details on the topic
ReplyDeletehttp://www.grin.com/e-book/164552/the-gold-lending-market