Gold Prices Goes Backwardation, Borrowing Rates Soar to Highest Level Since 2009

Soaring gold borrowing costs in the backdrop of a reported acceleration in backwardation could most likely be symptoms of the mounting friction between Wall Street “paper” gold versus physical “real” gold

From the Economic Times (bold mine)

NEW YORK: The cost of borrowing gold surged on Tuesday to the highest level since January 2009, reflecting dwindling supplies from bullion banks after heavy liquidation and resilient demand for physical gold products.

The rates for lending out physical gold - mostly offered by bullion banks and central banks to institutional investors and manufacturers - have been near historically low levels over the past four years due to plentiful supplies.

Investors have lent out their big stockpiles of metal as prices have soared.

But that came to an abrupt end when supplies started tightening as institutional and speculative investors have unwound those long positions since the mid-April historic sell-off that has seen spot prices plunge 26 percent so far this year.

The implied one-month gold lease rate rose to 0.3 percent on Tuesday, their highest since January 2009 when investors scrambled for physical metal, seen as a safe haven investment, after Lehman Brothers collapsed.

That is up sharply from the 0.1 percent early last week. Rates have increased steadily from a negative 0.2 percent since September last year, but the gains have accelerated since April.

Even so, they are far off record highs of close to 10 percent seen in 1999 after European central banks agreed to curb gold sales and are still near historically low levels.

The recent collapse of gold prices came amidst a substantial decline in the inventories of the COMEX and gold ETFs (chart from Zero Hedge).

But in sharp contrast to Wall Street, demand for physical gold continues to be robust: Chinese imports of gold posted the second highest on record last May where gold spot premiums rose almost to "unprecedented levels", according to Mineweb.com. And even as official data on India’s imports may slow to reflect on recently imposed draconian gold trading curbs, gold smuggling has picked up according Mineweb.com. Emerging market central banks continue to substantially amass gold in April and May according to ETFTrends.com
 

What the above implies is that Wall Street Paper gold may have been depleting their inventories via lease or sale to the physical gold market. Differently said, the above represents the process of transferring physical gold from the West to the East or to the Emerging Markets. And this has been intensifying. Such dwindling of supplies in Wall Street are being ventilated on borrowing costs or on gold lease rates.

There is another very important related development. Gold prices are reportedly in accelerating backwardation—where future prices are trading below spot prices.

As the Wikipedia.org notes

A backwardation starts when the difference between the forward price and the spot price is less than the cost of carry, or when there can be no delivery arbitrage because the asset is not currently available for purchase

Backwardation has been rare for the gold-silver markets. Such backwardation is being expressed via Gold Forward Offered Rates (GOFO).

The Zero Hedge explains:

something happened that has not happened since the Lehman collapse: the 1 Month Gold Forward Offered (GOFO) rate turned negative, from 0.015% to -0.065%, for the first time in nearly 5 years, or technically since just after the Lehman bankruptcy precipitated AIG bailout in November 2011. And if one looks at the 3 Month GOFO, which also turned shockingly negative overnight from 0.05% to -0.03%, one has to go back all the way to the 1999 Washington Agreement on gold, to find the last time that particular GOFO rate was negative.

Before we get into the implications of this rather historic inversion, let's review the basics:

What is GOFO (Gold Forward Offered Rates)?

GOFO stands for Gold Forward Offered Rate. These are rates at which contributors are prepared to lend gold on a swap against US dollars. Quotes are made for 1-, 2-, 3-, 6- and 12-month periods.

Who provides the rates?

The contributors are the Market Making Members of the LBMA: The Bank of Nova Scotia–ScotiaMocatta, Barclays Bank Plc, Deutsche Bank AG, HSBC Bank USA London Branch, Goldman Sachs, JP Morgan Chase Bank, Société Générale and UBS AG.

When are the rates quoted?

The means are set at 11 am London time. These are the rates shown on the LBMA website.  To show derived gold lease rates, the GOFO means are subtracted from the corresponding values of the LIBOR (London Interbank Offered Rates) US dollar means.  These rates are also available on the LBMA website.

How are the GOFO means established?

At 10.30 am London time, the Reuters page is cleared of all rates. Contributors then enter their rates for all time periods. A minimum of six contributors must enter rates in order for the means to be calculated. At 11.00 am, the mean is established for each maturity by discarding the highest and lowest quotations in each period and averaging the remaining rates.

What are some uses for GOFO means in the market?

They provide a basis for some finance and loan agreements as well as for the settlement of gold Interest Rate Swaps.

The Zero Hedge says the any of the following factors or a combination of the above could be the drivers:

• An ETF-induced repricing of paper and physical gold

• Ongoing deliverable concerns and/or shortages involving one (JPM) or more Comex gold members.

• Liquidations in the paper gold market

• A shortage of physical gold for a non-bullion bank market participant

• A major fund unwinding a futures pair trade involving at least one gold leasing leg

• An ongoing bullion bank failure with or without an associated allocated gold bank "run"

• All of the above

The answer for now is unknown. What is known is that something very abnormal, and even historic, is afoot at the nexus of the gold fractional reserve lending market.

My guess is that the ongoing tensions seen at the fractional reserve gold lending are signs of the emasculation of Wall Street’s control on gold, a spillover of the current bond market rout, and additional symptoms of the escalating strains in the financial markets.

The payback time for the gold bulls nears.

Where are Germany’s Gold’s Reserves?

That’s essentially the question posed by James Turk of Gold Money below

Mr. Turk writes,

This gold has been entrusted to the Bundesbank and provides peace of mind knowing that it is there. But where is it really? And just as important, how much is there? Unfortunately, we do not know the answer to these questions.

The Bundesbank’s latest Annual Report states: “As of 31 December 2009, the Bundesbank’s holdings of fine gold (ozf) amounted to 3,406,789 kg or 110 million ounces. The gold was valued at market prices at the end of the year (1 kg = €24,638.63 or 1 ozf = €766.347).” The total value therefore reported by the Bundesbank on its balance sheet is €83,939 million. There have been, however, repeated claims suggesting that the Bundesbank's gold vault is empty. The reporting by the Bundesbank in its Annual Report does nothing to disprove these claims.

The Annual Report states that the Bundesbank owns €83,939 million of “Gold and Gold Receivables”. Surprisingly, it does not distinguish between these two fundamentally different assets, nor does it report how much of each it owns.

Clearly, gold stored safely and securely in the Bundesbank’s vault in Frankfurt has a different level of risk than gold that has been loaned out. Physical gold is a tangible asset, and therefore does not have counterparty risk. But a loan – regardless whether you are lending euros, dollars or gold – is only as good as the creditworthiness of the borrower. This lesson was learned the hard way, for example, by the central bank of Portugal. It had loaned gold to Drexel Burnham Lambert, and that gold receivable was still outstanding when this bank failed two decades ago.

By not reporting “gold in the vault” and “gold receivables” separately as two different assets, the Bundesbank is saying in effect that cash and accounts receivables are the same thing. Of course they are not, and their fundamental difference is made clear by Generally Accepted Accounting Principles, which highlights a deficiency in the Bundesbank’s Annual Report.

Are central banks being transparent? Or has central banks been using accounting entries to fudge their actual gold reserve holdings? Or to the point, has major central banks, as the Bundesbank (and Belgium), been short gold (via gold leasing)?

To me, these represent as more signs of the growing fissures of the paper money system. And fresh record prices of gold attest to such development.

Belgian Central Bank ‘Lends’ 41% of Gold Reserves, Growing Role of Gold as Money

Tyler Durden of Zero Hedge points to CLSA’s Chris Wood’s report noting that the Belgian Central Bank has lent out 41% of its gold reserves and that gold and silver coins as money have been making strides in the US.

From CLSA (via Zero Hedge) [bold emphasis mine]

Belgian central bank Vice Governor Francoise Masai reportedly told shareholders that about 41% of the central bank’s 216 metric tons of gold was on loan at the end of last year, and that the central bank earned a 0.3% return on its loans of physical gold to commercial banks last year. There are two points to note about this. The first is the puny annualised return earned on the gold leasing market. The second is the significant percentage of the central bank’s gold lent out. This is a reminder that the paper gold market is significantly larger than the physical market. Just like a run on a bank in a fractional banking system, GREED & fear suspects it will be very hard to settle all the paper claims to gold physically in a real scramble for the metal. This is why in a parabolic spike physical gold is likely to trade at a significant premium to paper claims. On this point GREED & fear should make it clear that the 25% of the global portfolio for a US dollar-denominated pension fund allocated to gold bullion is in physical gold.

Meanwhile, it is an interesting note that more than a dozen state legislators in America have now seen bills introduced that would make gold and silver coins legal tender in the respective states. Thus, gold and silver coins minted by the US government are now considered legal tender in Utah. Much of this activism is coming from Tea Party supporters. Financial sophisticates will scoff. But to GREED & fear it is a healthy sign that some people in America are thinking. For more on this popular movement to return to the monetary role of gold read an article published last week by the Los Angeles Times (“Pushing for a return to the gold standard”, 3 June 2011 by Nathaniel Popper).

Gold leasing is almost equivalent to short sales.

As John Hathaway of Tocqueville Asset Management L.P explains,

The gold that is being borrowed from central banks [and private sources] is being sold into the physical market where it is being consumed as jewelry. It is no longer in liquid, deliverable form. Gold loans will not be as easy to repay as the borrowed yen. The shorts are facing an epic squeeze.

Aside from Belgium, I would suspect that many of central banks of major economies could have also lent out (shorted) part of their gold reserves.

Aside from the lease-short sale dynamics, the emerging fissures in the paper money system will likely drive many EM economies as major buyers of gold. Chart above from IBTimes

And that’s what we seem to be seeing today.

From gold.org May report,

As of the IMF’s May release of its International Financial Statistics, several countries have reported additional purchases of gold. Notably, Mexico reported to the IMF that it acquired 14.8 and 78.5 tonnes of gold in February and March, respectively. This was a significant increase in its gold holdings, raising Mexico’s position in the table to the 34th largest holder of gold with 100.2 tonnes. In its press release, the Banco de Mexico indicated that its acquisition of gold was in line with prudent diversification principles of reserves management. Indeed, Banco de Mexico’s acquisition of gold was likely motivated by a need to diversify its rapidly expanding foreign reserves, which increased from approximately $75 billion to $120 billion between Q1 2007 and Q1 2011.

Additionally, Thailand also reported an increase in its gold reserves of 9.3 tonnes in March, raising its total gold holdings to 108.9 tonnes. This follows an acquisition of 15 tonnes in July of last year. Finally, Russia continues to regularly add gold to its reserves, adding 22.5 tonnes between January and March. Russia is the 8th largest holder of gold.

The latest statistics show no significant selling by the signatory central banks in Year 2 of the third Central Bank Gold Agreement (CBGA3).

So these incentives should continue to drive the actions of the central banks, which should account for a significant force for higher gold prices.

Also as previously explained, rising gold prices has gradually been changing the outlook of the public; once an outcast which economic ideologues disparaged as the ‘Barbaric relic’, now momentum favors more acceptance of gold and silver as money—as it had been for most of human history.

This time won’t be different.