Goldman on metal pawning | FT Alphaville

Goldman on metal pawning

Remember the negative gold lease rate debacle of the second half of last year?

Negative rates imply that banks are pawning gold in exchange for dollars. A move which happens to depress gold prices.

But it’s always been difficult to establish who was pawning what and when, and how prevalent the practice really was.

On Friday, however, Goldman Sachs came out with some thoughts on the matter. In short, it was prevalent. Very prevalent.

As they note (our emphasis):

In gold, the relationship between real interest rates and gold prices has opened up to the widest levels in the current cycle. This wedge between gold prices and real interest rates as measured by 10-year TIPS was driven by a substantial surge in the demand for US dollars during December. This demand for US dollars drove the gold lease rates to unprecedented negative levels as US dollars became increasingly more valuable than gold. This new demand for dollars was mostly from European banks using the gold market to source US dollar liquidity when their funding from the US money markets dried up, which created a significant amount of gold selling.

In turn, the re-convergence of gold and real interest rates is dependent upon how long this dollar-funding liquidity squeeze lasts, forcing European banks to source US dollars from the gold market. We believe that many European banks will likely exit or sell many of their US dollar based businesses in 2012, which will likely substantially reduce this US dollar demand from the gold market, taking the pressure off gold lease rates, and pushing gold prices back up in line with real interest rates. Further, following ECB’s aggressive action on funding through the Long-Term Refinancing Operation (LTRO), the near-term pressure on European bank funding has eased significantly. Accordingly, we are maintaining our 12-month target of $1,940/toz.

And here’s how that relationship between negative gold lease rates, gold prices and dollar funding pressures has played out in chart form:

In other words, much of gold’s under-performance in 2011 may have been down to gold pawning forces and the fact that gold was much less valued in the market than dollars.

But it wasn’t just gold markets which became exposed to “commodity repo” forces. Goldman notes much of the same was happening in copper and base metal markets too — though in these markets dollar funding needs translated into  plain old de-stocking:

In copper and base metals, it is a similar story with demand being temporarily weighed down by a substantial amount of de-stocking, primarily in Europe, reflecting a shortage in US dollars for working capital. In this case it was a little less direct.

As European banks either withdrew or sold US dollar based businesses, for which trade credits for commodity producers and merchants is a large portion, working capital available to metals merchants, producers and consumers was reduced, which in turn led to a sharp drop in inventory.

Initial data suggest double-digit declines in apparent European demand in late 3Q11 was likely largely on de-stocking, and anecdotal evidence suggests that the de-stocking was so great in the fourth quarter of last year that the apparent copper demand dropped by between 20-50% between August and December. The decline in end-use demand was likely far less, pointing to a significant amount of de-stocking. This dynamic appears to be isolated to Europe with very little evidence of it happening in Asia and the US.

On net, while we are not positive on European end-use demand in 2012, we believe that a simple recovery of apparent demand to end-use demand will likely help push copper prices back up to our 6-month target of $9,000/mt.

So, lacking financing from banks, merchants had no other choice but to de-stock for liquidity purposes, a fact which discharged a lot of supply into the market, driving prices lower.

Why couldn’t they have just pawned the metal China style? We presume largely because European trade finance houses weren’t keen.

Plus, in the Chinese commodity repo trade, the purchase of the commodities is linked to financing from the outset. It’s the financing demand which bolsters the commodity prices. In Europe, however, it’s the opposite. Existing supplies are either de-stocked for financing or pawned, driving prices lower.

Now, if only we could find out if something similar has also been happening in oil markets?

Related links:
Why gold forward rate inversion is important – FT Alphaville
Cash for gold, financial market edition
– FT Alphaville
Cancelled aluminium warrants turn Vlissingen into second Detroit – Metal Bulletin
Chris Cook: Naked Oil – Naked Capitalism