Outlook For Gold is Finely Balanced

Junior miners and lease rate trade offer upside

Originally published in the January 2010 issue

As we enter 2010 the weight of expectation for gold prices is greater than at any time in several decades. The hyperinflation camp and fiscal terrorists believe monetary and fiscal excesses is creating mountains of freshly printed money which will cause an uncontrollable acceleration in goods and services prices (not to mention asset prices) and drive investors into the relative security of a finite currency such as gold. Then there are the deflationists who believe years of profligate debt accumulation has necessitated a full unwinding of cross-border and domestic debt obligations at a personal, corporate and government level. The deflationist argument for gold looks back to multiple periods in our history where severe deflation caused runs on banks and on issuers of fiat currencies.

Last year it looked as though investors portfolio preferences had shifted rapidly towards gold in a relatively small space of time. In fact, investor buying, central bank buying and gold producer buying took place throughout 2009, totalling around 1500 tonnes. It seemed to accelerate in the second half (recall that gold was flat on the year by May) simply because the buying was being held in check in the first five months of 2009 by the biggest surge in scrap gold selling since the Asian Crisis in 1997-98.

Turning to 2010, the extreme outcomes being envisaged by markets (hyperinflation, default-ridden deflation or a central banks crisis) will have to come closer into view than they did in 2009 in order to have a dramatic impact on the price of gold. Much investment demand has been to insure against these events and the further we navigate 2010 without signs of monetary crisis the harder it will be for gold to enter the bubble phase many are hoping for, although gold certainly satisfies all the pre-conditions for a price spiral.

Whether 2010 will be gold’s breakout year remains to be seen. If the market decides that the Fed’s doubling of its balance sheet and extremely accommodative monetary policy stance was just a short term measure then gold prices could be vulnerable. The market may look back at the Fed’s balance sheet growth and argue that the actions post-Lehman should be understood as temporarily moving the wholesale money market onto its own balance sheet. Banks with surplus funds lent them to the Fed by holding excess reserve balances, and banks that needed funds borrowed them from the Fed through the discount window. Foreign banks that needed dollar funding got it through their own central bank, which got it from the Fed through the liquidity swap facility. Banks that were short of collateral eligible for discount borrowed directly through the new commercial paper facility. Shadow banks that could not deposit in the Fed instead bought Treasury bills, and the Treasury deposited the proceeds at the Fed.

Once we think about the Fed’s balance sheet expansion in this way, the doubling seems in fact rather small. After all, the wholesale money market is much larger than the mere trillion or so that Fed took on. In this context, the doubling of base money supply and the emotive term of printing money may not have a hyperinflation ending after all. Having said that I think there are at least two much cheaper ways of gaining exposure to protection against a monetary crisis and a potentially explosive move in gold prices than simply buying expensive and time-decay prone long-term call options. In fact, the skew toward long term call options versus equivalent puts has been at extremely unattractive levels.



Junior gold miners
Shareholders have forced gold company management teams across the globe to de-hedge their books asthey demand gold price exposure. The positive view expressed by gold company management teams has reached fever pitch recently, in complete contrast to 10 years ago when most management teams thought gold prices would stay low and were irrelevant as long as they could lock in positive cash flows and then mine and explore successfully.

Late in November we had confirmation that Barrick Gold had aggressively bought almost 100 tonnes of gold in the past 3 months as opposed to the advertised time frame of 12 months. The de-hedging programs over the past seven years have provided solid support and fostered upward price action. Not only have gold producers been on the bid on any dips but the resultant positive price action has attracted a mix of other players to add to their gold exposure.

If de-hedging has been one of the main gold market themes of the past five years, we think the next five years will be dominated by the search for resources. The bullish outlook of managers of large gold companies will mean they will probably not stop at de-hedging in order to increase their gold exposure, but will now begin to seek out resources in the ground as a way of expanding their depleting reserves.

The biggest winners in this scenario will be takeover targets, particularly those junior gold companies, which own large, but undeveloped resources. Many of these resources are uneconomic at current gold prices due to their depth or perhaps their isolation or geopolitical location but at multiplies of today’s gold price they very quickly become economic and their viability will be vastly re-appraised by the market. The inherent optionality within these companies is much cheaper than buying gold call options in the open market. A disciplined and hedged strategy to take advantage of the mispricing between the cheap optionality provided by resource-rich gold companies and the relatively expensive route expressed by the premia investors are currently paying for gold price call options should perform well in 2010.

Gold lease rates
The second strategy is a lease rate trade to pay fixed and receive floating rates. It offers a very limited downside (35 basis points per annum) and a fantastic asymmetric payoff should lease rates spike higher.

If a central bank needs to monetise some of its gold reserves it can enter what’s known as a “gold swap”. This is no more than a foreign currency borrowing facility. It will borrow say USD and post gold as collateral for the loan. Upon maturity the central bank receives the same level of gold back and repays the USD back to the counterparty with an amount of interest known as the Gold Forward Offered Rate (GOFO). Normally the GOFO rate deemed acceptable by the counterparty is less than LIBOR because the counterparty has had the security and utility of holding the gold against the loan, as opposed to the LIBOR interbank market that is unsecured. Offsetting that benefit is the fact that the new holder of the gold has to pay for storage and insurance. The excess of LIBOR over GOFO equates to gold lease rates which can therefore be thought of as the rate people are prepared to sacrifice in order to hold physical gold under swap or under a direct borrowing arrangement.

Recently, deflationary pressures have driven general market interest rates significantly lower. In the absence of spot market stress or counterparty fears LIBOR and GOFO have converged and participants are demanding more to lend USD with gold posted as collateral (3-month GOFO is 0.37%) than a straight uncollateralised loan (LIBOR is 0.28%). It means that 3-month gold lease rates are negative 0.09%. Negative lease rates also indicate that gold price expectations may be about to become unhinged as an initial group of investors start to question the viability of fiat currencies and borrow dollars to buy gold forward for future delivery. These transactions effectively represent an unlimited short position in cash. In other words, the complete lack of shorts (borrowers) in the gold market has forced gold lease rates to turn negative. Rather than indicating a lack of physical market stress it may actually be pointing to the fears about one or more of the major fiat currencies. The early evidence of this will be if gold lease rates turn positive and accelerate rapidly.

Gold’s ultimate ascendance may be heralded by a bottoming and reversal of negative gold lease rates. We should expect this reversal to accelerate as the GOFO rate turns negative while the spot price of gold races ahead of the futures price due to overwhelming physical demand for bullion. The more counterparties’ value holding gold (gold’s convenience yield) the lower and more negative GOFO becomes. So the current dip into negative lease rate territory may just be heralding the onset of a fiat currency crisis ahead, and strangely enough, we might have to watch the Gold Forward Offered Rate for clues as to the health of our creaking Bretton Woods II monetary system.