The End of the Gold Carry Trade

David Fink

A gold carry trade has been in effect for over 10 years. Central banks, with hoards of gold, would lease the yellow metal to investors at a paltry 3% per annum. These investors would borrow the gold from the bank and sell it on the open market.

At the same time, they would buy futures to repurchase the gold at a later date, locking in the current price. With the proceeds from the sale of gold, they would invest in anything that could yield more than 3%. If the fund manager invested in a 10yr government bond, usually yielding around at 5%, he made some money while taking on no risk. As long as the Treasuries yielded you more than the cost to lease the bank’s gold, this was the easiest money you could make!

Why would the banks do this? They have thousands of tons of gold bars in their vaults. Better for those bars to collect 3% a year than lots of dust. The carry trade benefits a lot of players. The banks make out, and the investors make out.

The only people who didn’t do so well were the gold-bugs. The carry trade resulted in added selling of gold by the investors, putting downward pressure on the yellow metal. Anybody long in gold got pinched.

This trend is beginning to reverse itself.The past two months have seen the biggest global coordinated interest rate cut ever. The Fed rate is at 1%, with the smart money projecting it to be half that by year end. The European Central Bank slashed rates to 3.25%. The Bank of England has rates at 3% -- the lowest in half a century! Even Japan has lowered its rates from virtually nothing to literally nothing (.3%)! All of these cuts are resulting in negative real interest rates. Inflation is expected for 2008 to be around 3%. 10 year US Treasuries are yielding as low as 3.1%. that means if you borrow gold at 3% to make 3.1% on your risk free security, you are not making much. Even in a period of low inflation, the real return on your money is negative.

In order to generate the returns required to make borrowing gold worthwhile, the investor will have to hold riskier assets than government debt. The problem is that nobody wants to invest in assets that are riskier than government debt. The whole reason why there is a credit crisis in the first place is because nobody trusts any institution that isn’t owned, backed, or financed by government debt. So where does that leave the investors?

It leaves them looking elsewhere for that easy return.

Investors will reduce the amount of gold they borrow, and there will be less gold dumped on the market. Consequently, there will be less downward pressure on the price of gold. At $803/oz, gold up almost 1% over the past 12 months. From the day before the market shock began in September to today, gold is up 8%. Is there any stock or commodity that can make this claim?

Gold is real money. It is the best hedge against inflation, and it is not backed by any debt. You cannot ‘bankrupt’ the value of gold like you can a company or a house. With the great majority of risk-free assets yielding next to nothing, look for big funds to take some of the money they usually reserve for Treasuries and put it into gold. Gold provides the same safety as US government debt. Its performance over the last 12 months and throughout the current crisis illustrates this.

Pricewise, there is little room for government debt securities to rise. Gold can triple in value and still trade cheaper than its inflation adjusted all time high. As long as interest rates remain at or near all time lows, look for the downward forces of gold to ebb, and the upward momentum to build