WGC publishes guidance paper!

 

Understanding the gold carry trade! 

Gold deposit rates, a guidance paper are just published by the World Gold Council (WGC) is the market development organisation for the gold industry. WGC say, ‘we provide insights into the international gold markets, helping people to understand the wealth preservation qualities of gold and its role in meeting the social and environmental needs of society. Here is the choicest part; related parts would be carried here time to time. 

It is hard to examine gold lease rates without first understanding the gold carry trade. The gold carry trade once played a significant role in the gold lending market and constituted a large part of the demand to borrow gold. However, as market conditions changed over the years, the risk of the trade increased while its profitability declined. This reduced demand for borrowed gold and may be one of the leading causes behind the decline in gold lease rates.

Under the gold carry trade, a trader, typically a bullion bank, hedge fund or other financial institution, borrows gold at the gold lease rate, sells the gold and invests the funds in higher-yielding instruments. At loan maturity, the trader sells the higher-yielding asset and buys back the gold to close its position with the lender. The ‘carry return’ of the trade is the spread between the higher-yielding asset and the gold lease rate.

If the trader invested the funds at the London Interbank Offered Rate (Libor), the ‘carry’ will be the GOFO rate. Put another way, the gold lease rate can be derived from the difference between Libor and GOFO. 

Derived gold lease rate = Libor – GOFO The gold carry trade incurs one major risk. As the trader has effectively sold the gold short, an increase in the price of gold at loan maturity would result in a loss of profitability. 

The gold carry trade thus only makes sense when the price of gold is expected to remain stable or decline. If the difference between US dollar interest rates and the cost to borrow gold (represented by Libor and the derived gold lease rate above) is wide, the carry return appears more attractive and there may be an increased uptake of the gold carry trade, leading to more gold borrowing demand and higher gold deposit rates for central banks. 

The gold carry trade proved to be a particularly profitable strategy during the late 1990s, when gold prices were falling and higher-yielding assets, in particular yen-backed securities, were rising. During this time, the gold carry trade added supplies to the market and gold prices fell, reinforcing the negative sentiment towards gold. Gold lease rates were volatile, but also elevated. 

Market conditions changed however after the CBGA in 1999 this was followed by the 9/11 terrorist attack in 2001 the bursting of the dot-com bubble, and, from 2001, the end of a protracted period of US dollar strength all of which contributed to more positive price expectations for gold. Against this backdrop, carry trades incurred greater risk and frequently proved unprofitable. 

As such, both the demand to borrow gold and gold lease rates fell. It is worth noting that speculators also use the gold borrowing market to bet on price declines through the sale and subsequent repurchase of gold at a lower price. When supplies dry up and speculative pressure rises, gold lease rates can jump. This has happened in the past and could, of course, happen again, particularly if sentiment turned negative on gold.