FT Alphaville cited John Kemp last week regarding increasing evidence that the so-called ‘cash for commodity’ trade (aka contango trade) might be getting crowded.
Which is interesting, given that peculiarities have been emerging in the world’s most consistent and established contango market: the gold market.
Among them, a clear deviation in the shape of the gold forward curve, in part linked to what seems on the surface a totally seized up and dysfunctional gold leasing market.
Lease rates as they stand now are negative — something that’s almost unprecedented in recent history. At least judging by the below chart:
And here’s the lease rate over a shorter duration:
So what gives?
It’s worth pointing out that according to Goldman Sachs, there was until the Lehman crisis an almost textbook “demand vs price” relationship between the amount of physical gold inventories held on the Comex and gold lease rates.
As they noted back in May 2009:
The inventory-demand curve is quite stable and downward sloping, with less inventories of gold being held on the COMEX as gold lease rates increase. Following the onset of the current financial crisis in the second half of 2007, however, the gold lease rate began to climb to a much higher level than would have been expected, given the level of physical gold inventories. That is, the demand for physical gold appears to have shifted outward in response to the financial crisis.
And as they went on to point out:
The link between the current financial crisis and the increased demand for physical gold inventory can be seen explicitly by looking at the correlation between gold lease rates in the recent period and the TED spread or the difference in (one-year) interest rates between LIBOR and the US Treasury. Because the TED spread is the difference in borrowing rates between financial institutions and the US Treasury, it effectively captures the degree of financial counter-party risk priced into the market.
As the degree of counter-party risk increases, so too does the demand for physical gold… the gold lease rates are well explained by the TED-spread and the level of COMEX registered gold inventories.
Given that the gold forward rate is set by Libor minus gold-lease rate, and that Comex inventories have an inverse relationship with that lease rate, what can one therefore presume about Comex inventories when lease rates go negative?
We refer back to Goldman:
COMEX inventories and nominal interest rates drive the shape of the gold forward curve, specifically the price spread between near- and long-dated contracts. High inventory levels place downward pressure on near-dated prices relative to long-dated prices, as the market anticipates inventories returning to more normal levels over time.
Which means, all things being equal, negative rates should suggest some pretty hefty Comex gold stocks.
And at first sight, that seems to equate perfectly with the overall Comex gold warehouse stock picture, as can be seen below:
The problem is: the ‘total’ picture of stocks is actually made up of two types of inventory. Gold that is registered and gold that is eligible. It just so happens that only ‘registered gold’ is available for delivery against futures, while ‘eligible gold’ is simply that being stored at the Comex by its owners.
And when those two categories are broken down, a very different picture begins to emerge.
First, Comex’s registered holdings:
Second, its eligible ones:
It’s worth bearing in mind that registered holdings make up about one fifth of total inventories, with the rest represented by eligible.
But there is also one other category that’s important to consider too — the proportion of eligible stocks being held for the iShares Comex Gold Trust, and how that’s changed in recent years:
Now, if you compare that to overall eligible holdings you’ll see that it almost magically tracks Comex’s eligible gold holdings up until December — the time that registered holdings struck a significant multi-year low. (Although we would add they have — equally magically — recovered since then)
Which brings us back to negative lease rates. These have, overall, been negative since about mid 2009.
To explain, we refer once more to Goldman:
The gold lease rate is the interest that must be paid (in our case in US dollars) to lease, or borrow, physical gold for a specified period of time. Consequently, this can be viewed as the explicit cost of borrowing gold to hold for a period of time or the opportunity cost of holding one’s own gold and not lending it out to another.
It seems then, as people increasingly opt to store their gold out of reach of borrowers — due to counterparty risk and other wealth preservation concerns– the amount of gold available for borrowing dwindles.
This essentially freezes up the leasing market because of the amount of stock entrapped in ETF holdings, funds and such like.
The Comex’s inventories echo this well. Yes, they are at all time highs, but the proportion of gold available for “purchase” is actually — on a historical basis — relatively low.
A golden risk transfer
To all extents and purposes then, there seems to have been a radical switch in risk perception. As things stand, the market is ready to compensate investors for the risk incurred from borrowing gold rather than owning it.
That is to say we used to pay for borrowing money from the bank – pledging gold as collateral. Now we get paid for borrowing money from the bank – pledging gold as collateral. We wonder why.
In which case, the Bank of International Settlements getting involved in the ‘cash for gold’ market might make perfect sense — especially if its real aim was to reset the stakes. We note three-month lease rates, for example, did coincidentally go positive over the supposed gold swap action.
The question now, though, is what happens if things don’t get resolved in the gold risk perception arena soon?
Gold backwardation might unfortunately be the answer.
(Update 17:55 – John Kemp notes that August-September, and September-October gold futures are currently trading in an unusual backwardation.)