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"Big Fun Lies Ahead" - Gold Market Comes to Life
(March 10, 2001) Things were hopping in gold this week as gold lease rates went from 1% to over 6%, and gold spot prices turned up sharply. Backwardation came to the gold market, short-traders began to feel a squeeze, and all the gloom of last month blew away like a morning fog.
Every other week or so we publish an article about gold on the Onlygold site: Occasionally a story about treasure, or a report on gold politics, and sometimes just a commentary about the current, and usually unfathomable, gold market.

The problem with gold market commentary is this: talk is cheap, and everybody’s an expert. Gold is just not like other commodities. Let’s say, for instance, you wanted to learn more about soybeans. You could find knowledgable experts talking about this year’s crop, the weather, the outlook for soybean consumption, new trends in soybean utilization, and other rational thought on the subject.

But with gold, you can hardly find an unbiased opinion - everyone's either for it or against it. So we always feel a little guilty about offering gold market commentary into such a crowded field: everybody and his or her brother or sister has an opinion about it.

Nonetheless, here we go again – this week in gold just had too much going on for us not to say something. We can’t help but feel that we are at an extraordinary juncture in the gold market. So much has changed since our last article about gold. At that time, we covered the overwhelmingly gloomy sentiment about our favorite metal as its price sank to $257.45 on February 16th.

That price was near a 21-year low for gold. Since then, gold has rallied back to close today at $270.80, which is an eight-week high.

Much of the change in gold has to do with gold lease rates. So let’s start with a little background about gold leasing.

It's important to realize that most of the world’s gold, outside of personal jewelry, is held by central banks and bullion firms. Rather than have their gold sit idle, earning no interest, many of these institutions actually lease out their gold. They ‘rent out’ the gold to known reputable parties who, after a set period of time, return the gold and pay the agreed-upon rate of interest, typically 1˝ to 3% per year. That’s not much return, but it beats making nothing on the gold.

Who leases gold, and why? Well, a jewelry manufacturer might obtain gold through a lease, make it into finished jewelry, and sell it. At the end of the lease period, the manufacturer buys the same amount of gold outright, paying cash with the proceeds from the jewelry sales. Then they return that newly-purchased gold to the institution that ‘rented’ them the gold.

Isn’t that risky if the price of gold goes up? Yes, it is. But in the past few years, this leasing of gold has been a good bet in a falling market. In fact, it has looked so much like a sure thing that speculative money has come up with a profitable variation.

An institution can lease the gold, sell it, and invest the money in something secure like Treasury bonds that pay a higher return than the lease rate. Supposedly this was one of the strategies of the hedge fund Long Term Capital Management before it so famously crashed and burned in 1997. When the strategy works, there's a locked-in profit - as long as the gold can be replaced at the same or lower price than it was sold.

For the past few years of falling gold prices, it's worked and worked well. It's called the gold carry trade, and it’s made a lot of money for funds, bullion banks, mining companies, and traders. But now, a squeeze is on.

Gold lease rates have gone from less than 1% to nearly 7% just in the past few weeks, reflecting a reluctance on the part of gold holders to enter into further leasing agreements without greater compensation for the risk they take. With lease rates soaring, gold for immediate delivery is now threatening to trade at a premium to gold for future delivery. This prevents traders from efficiently hedging short on forward gold contracts.

The contango, or premium normally accorded futures contracts in line with current interest rate, has almost disappeared over the past few weeks. Compare Friday’s close of April 2001 gold contracts at $271.50 with the same contract for April 2002 at $279.60. That's only a 3% annual carrying charge to invest in gold for future delivery. That indicates a lot of selling of gold futures, and a high demand for immediate spot gold.

Backwardation” is a word we’ve started to hear this month. Backwardation is the situation in which forward contracts actually trade at a discount to spot prices. We have seen backwardation extensively in the platinum markets over the past few years, as physical supplies were tight compared to traders’ expectations of future supplies.

How did this come to be in the gold market? First,look at the fundamentals of supply and demand. World gold demand is about 4,000 tons annually, and world mining amounts to some 2,400 tons annually. Gold scrap recovery is maybe a couple hundred tons a year. And central banks sell some gold from their reserves, but that gold is mostly absorbed by other central banks. So what has made up the shortfall while prices have stayed stagnant? Simply, the sale of leased gold onto the market. Which, by definition, can’t go on forever, as the gold has to be returned.

Furthermore, on the Comex last Tuesday, traders were net short some 5.1 million ounces of gold. That’s over a billion dollars in buying potential right there. And this Wednesday's bimonthly auction of gold by the Bank of England will be the last 25-ton auction. Word is that future auctions, when they are held, will be of only 20 tons per sale.

And on the technical side, you can make the argument that an important ‘double-bottom’ in gold prices has been established. Acording to Lenny Kaplan of Prospector Asset Management:

“…Prospects (for higher gold prices) remain extremely favorable. But in order to truly "light the fuse" we need to penetrate the brick wall of resistance at $270-$271. If we do, we will have traced out a true textbook "inverted head and shoulders" on the daily charts, and we will be off to the races.”

Editorially, we don’t like to make predictions about the gold prices, for a couple of reasons. First, the price of gold in dollars is one of gold’s least interesting aspects. Secondly, if we really knew what gold prices were going to do, we wouldn’t even have to work for a living.

But right now, so many portents for the gold market look favorable. If the chickens are truly, finally coming home to roost, then big fun may be ahead.


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