15 December 2008

Gold isn't in backwardation, the USD is in contango

A lot of confusion on gold going into backwardation. I wrote about this in October in this blog where a commentator got confused. Recent articles by Professor Fekete have spawned more confused comments, see Brad Zigler's article for an example (and also my comments to it).

People get all confused about it because they aren't thinking of gold as money. What was the Yen carry trade? Borrow JPY at bugger all, do an FX to sell JPY-buy USD and invest the USD at a higher rate and pocket the difference in interest rates but have exposure to the FX rate. Interest rate differentials exists for all currencies and they are not arbitraged away because there is risk to the change in the FX rate, the FX rate being the "price" of that currency in terms of another. An alternative way I look at it is that differences in interest rates exists because of the markets assessment of the risk of one currency inflating or deflating relative to the other, wiping out the profit from the interest rate differential.

Lets assume USD rates of 2%, AUD rates of 4% and an exchange rate of 0.65.

1. You borrow USD 650 at 2%, which means you have to pay back USD 663 in 1 year.
2. You sell USD 650 / buy AUD 1000 at 0.65 now.
3. You lend AUD 1000 at 4%, which results in AUD 1040 in 1 year.
4. If the FX rate doesn't change, you then sell AUD 1040 one year later for USD 676.
5. Repay USD 663, leaving profit of USD 13.

If you ask a bank for a 1 year forward AUD/USD FX rate, they do steps 1 to 3 and then calculate

4. In one year's time you will have AUD 1040 but owe USD 663, so the FX rate that this equates to is 0.6375.

Now there is nothing stopping you from borrowing AUD at 4% and selling it for USD to invest at 2%, but as you are negative cash flow you really need a big move in the FX rate to come out ahead. This means that the lower interest rate currency tends to have more borrow and sell pressure on it because the higher interest rates of the other currency mean you have a bit of a "buffer" if the FX rate moves against you.

Anyway, just think of gold as a currency (ie money) and the lease rate as the interest rate on gold(money). Therefore, one can borrow gold at lease rate, sell it and invest cash at LIBOR. Therefore the difference in these two interest rates is your profit, assuming no change in the gold/USD FX rate (ie the USD gold price).

For 1 Dec 08 for 1 month at LBMA:

Lease Rate = Gold Interest Rate = 1.69875
LIBOR = USD Interest Rate = 1.91125
GOFO = 0.21250

All this tells me is that there is a slight advantage to borrow and sell gold for USD, but the small advantage does not seem to outweigh the risk of the gold/USD price moving against you (ie up). If gold interest rates go higher than USD rate then what? Well to me this "backwardation" as it is called, just means that there is a slight advantage to borrow and sell USD for gold, as long as you don't expect the gold price to drop.

Probably worth noting here that as at 1 Dec you could have borrowed gold at 1.7% and sold it for AUD, investing the AUD cash at 4.25%. So this means that while USD gold may be toying with backwardation, AUD gold is firmly in contango.

Now interest rates for currencies change all the time and go above and below each other all the time. When that happens it is noteworthy but not exclaimed as extraordinary. Why is it different for gold? Well in my AUD/USD example we are talking about fiat currencies.

In the USD vs gold situation, however, we are not talking about "equal" currencies - one cannot be created, the other can. Think about it, in regards to my earlier comment that "differences in interest rates exists because of the markets assessment of the risk of one currency inflating or deflating relative to the other."

We are so used to talking of 1oz = xxx dollars when it should really be $1 = xxx ounces. Then you see that gold hasn't went into backwardation, but that USD has went into contango. Ouch, my brain hurts, but that is to be expected as we move into a world where you price things in ounces, not dollars.


  1. Excellent Bron,

    The important thing is that the gold cannot be created, so having its interest rate higher than that of fiat is very worrying. If gold is in backwardation in one particluar currency, but not in another, then one can imagine the centre of futures trading hopping from country to country over years and years and countries with the highest carries prevailing. Note the growth of exchanges in China and India for gold.

    Hop frm country to country until it all falls down some time.

  2. That is an interesting idea, of gold hopping from country to country. The question is if the USD is the first currency to become worthless (or to be more accurate, backwardation causes people to realise, finally, that it is worthless), will gold-other currencies contango be able to exist for too much longer once that happens?

    I mean, if USD-gold backwardation shows the fiat USD emperor has no clothes, won't people quickly ask if the AUD emperor and other currenices also has no clothes as well?

    It would be interesting to see if faith in other currencies will continue if the USD falls.

    Best be clothed in gold, I say.