I delayed posting in its regular Sunday spot to see if there were any additional pressures in gold prices over the weekend. Sure enough, gold sold off again seemingly in tandem with Japanese financial events. Both gold and silver were sold hard right at the open, bringing in a morning London fix well below the April lows – before rallying back.

There was more volatility in the JGB market as yields rose despite assurances more than a week ago that Kuroda and the Bank of Japan would use extreme liquidity if needed to offset volatility. The fact that yields are rising, as is volatility, likely means that Japanese banks are feeling the pressure of holding a massive store of JGB’s with inventory maturities far into the future. Not only would profitability be affected (should anyone actually care about mark-to-market), but so would liquidity.

Any increase in JGB volatility beyond some unknown threshold will force liquidity counterparties to re-evaluate and re-adjust haircuts – no cash lender is going to accept an instrument falling in value without forcing greater risk back to the borrower (bond owner). That ties up liquidity into collateral re-assessing.

If this interpretation is correct, then it may relate to gold as collateral in an increasingly fragmented liquidity market. Despite the pledges of nearly every central bank to flood the world with enormous amounts of erstwhile-dead currency, there are no means to create flow without collateral (again, unsecured lending is no longer operable outside megabanks). Banks that are closest to central bank operations (primary dealers in the US fed funds market) certainly have cash to lend, but only to acceptable counterparties with acceptable collateral. That includes gold.

In a fragmented market, the distribution of collateral is extremely heterogeneous. Since, however, there is a lot of cash needing some use at those “preferred” banks, collateralized lending rates drop significantly (especially with talk of the ECB deposit account running down into negative rates). So the published rates continually decline making it seem as if market liquidity is rising when in fact only a small segment of the overall system is actively partaking in liquidity flow. In other words, the lower these rates fall, the more disjointed the global system which means that effective liquidity is actually inversely proportional to lending rates.

In terms of gold lending/leasing, we saw this very clearly in October/November 2008. The movement in gold lending rates (the gold forward rate, GOFO) mirrored the Fed funds market. Despite conventional wisdom that liquidity was absent everywhere during the panic, the Fed funds effective rate persistently traded below, often far below, the Fed funds target. That meant that banks and financial institutions (like the GSE’s) had cash available, but were not lending it broadly.

In gold lending, starting in early October 2008, GOFO rates dropped precipitously alongside gold prices. There was a large and growing supply of cash available for lending with gold as collateral just as fear and counterparty risk perceptions were rising particularly against remaining US banks (such as Citigroup). Cash was not circulating as the Fed intended, it was only flowing to those with acceptable collateral, including gold.

ABOOK May 2013 Gold Forwards 2008

By November 14, only a few days after TARP was changed to a bank “recapitalization” scheme, 1-month GOFO had fallen almost to zero. On November 20 and 21, 1-month and 2-month GOFO rates were below zero. The near-zero lending continued for a few additional trading days until the Citigroup rescue was announced.

Again, despite panic in most lending markets, there was a surplus of cash available for gold arrangements, largely in the shorter maturities. That it coincided with a smash in gold prices is not surprising given a large increase in gold leasing activity appears as if a large additional supply is dumped on the gold market.

Since 2011, fragmentation has been a huge problem in Europe. Given the behavior of GOFO rates in 2013, coinciding with various central bank programs, it seems that a large supply of cash is again available for borrowing with accepted collateral from accepted counterparties. If QE’s around the world are supplying that surplus of cash, then we would expect a decline in published interest rates. However, these rates are not indicative of actual liquidity, but, again, only more evidence of desperate fragmentation.

ABOOK May 2013 Gold Forwards 2012-13

This latest decline in forward rates, again to near zero, coincides with the recent decline in gold prices after April’s rebound. On May 8, 2013, gold was $1,468 at the PM London fix, and 1-month GOFO was 0.156%. Both of those were off slightly from recent highs, Gold prices were $1,471 on April 26, and GOFO was 0.19% on April 17. The morning of May 9, the day the yen finally devalued through 100, GOFO fell 6 bp, and has been below 0.05% since May 10. Gold prices have fallen over $100 during that period.

I have little doubt that the “contributors” to the LBMA survey that establishes the posted gold forward rate, 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, are having little trouble accessing gold forwards at these low levels. The question is whether or not the rest of the marketplace is able to do so as well.

I think the best way to understand these interbank lending rates is that they are the floor of where the best “quality” institutions can borrow. But in terms of relating that to the wider markets, the lower the floor, the worse the spread is likely for second and third tier banks and borrowers. The more cash available at the bottom, the less there is for everyone else. Like with so many other aspects of finance, those that have little need for excess liquidity can access an ocean of it. Those that are more desperate have little ability to acquire it – but when they do we have no direct knowledge at what cost or in what quantity outside of secondary and tertiary indications in places like gold prices.


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