Gold forward rates continue to demonstrate severe gold strains. While GOFO across several maturities has risen slightly in the past few trading days, it remains negative out to 3-months.
It is important to remember both what GOFO is and what it is telling us. To the former, GOFO is not a market indication; it is a “fix”, or a survey of the “contributors”. That being said, if GOFO is negative then it follows that markets are severely strained for physical gold.
Negative forward rates simply mean that cash owners are willing to “lend” that cash on gold collateral at negative interest. Or, from the gold owner perspective, gold as collateral means getting paid to borrow cash. The only reason cash owners would be so upside down is to obtain metal because they are, or more likely have been for some time, short of gold.
The persistence of negative GOFO more than suggests that even at these negative rates, gold owners are less than enthusiastic about giving up their metal. For example, at today’s 1-month GOFO rate, you could “borrow” cash at -0.055% with the contract implication that your cash lender will return physical gold to you in one month’s time. The fact that 1-month GOFO remains negative indicates that there aren’t enough gold owners that believe in their counterparty’s ability to actually replace their gold at the end of the repo.
On July 10, GOFO was negative all the way out to 6-months; meaning gold owners were less than optimistic about getting gold replenished that far into the future (despite the knowledge of new production coming into the “markets”). To borrow a phrase from Paul Krugman and deconstruct it for proper usage, gold owners refused the collateral market’s offer of “free money”.
What is supremely odd about this shortage as it relates to interbank liquidity is the otherwise plethora of cash in the “system”. QE has taken care of the money stock “problem”, such that one existed. However, effective liquidity is far more about flow than stock, therefore the desperate need of collateral is not inconsistent with the appearance of overflowing cash (and interest rates that indicate as much). That is another feature of the Great Depression that has been duplicated by those that supposedly studied (to the nth degree) the Great Depression.
This fragmentation has been the most durable aspect of the crisis and post-crisis period, as it is evident not only in the geographical divide in Europe, it remains a fixture in US operations. The Fed as it is currently constructed (ideologically) cannot solve the fragmentation problems without abandoning core tenets of conventional monetarisms.
With persistent specials and fails in US treasury repos creating uncertainty in the liquidity flow system (including now the 3-year), the issue of collateral shortage will not abate. Yet unanswered in all these monetary mechanics is the other side of that equation, perhaps the most important – where or why is the demand for repo financing so stressed in the first place?
If the credit production levels of the banking system were shifting into overdrive repo stress in some form would make sense. In other words, if dealers were taking on huge new supplies of mortgage or consumer debt through new securitizations, you would expect that repo systems would see an uptick in activity leading to higher repo rates. But the opposite is occurring – rates are falling and specials are everywhere, from the US 10-year triple issue to gold (negative GOFO is very much like a repo special). Monetary policy that increases the money stock is actually counterproductive since it suppresses the main and published repo rates – too much cash seeking an outlet.
So in that very important sense repo and collateral strain is not coming from a phase shift into “recovery” or “boom” levels of credit production. That leaves the possibility that fragmentation across wholesale money markets is actually getting worse, not better. That should not be very surprising given the massive spike in volatility across the largest credit markets set against a fundamental backdrop of global retrenchment.
Central banks may be able to get some markets to respond via asset inflation, but liquidity dealers are far less susceptible since short-term financing is not party to the “wealth effect”. Liquidity dealers actually have to take their losses, so volatility spoils the fractioning of collateral chains. The more volatility and uncertainty creep forward, the more we should expect fragmentation to plague certain banks (outside the primary dealers), and thus the continued scramble for collateral (margin calls included, particularly as they related to swap activity).
Perhaps Chairman Bernanke’s show last week will “convince” credit markets that everything is fine, and that the tantrum of the past few months is overdone. But dealer financing and liquidity might not so easily follow the script. As much as the “taper” talk seemed to have caught credit markets completely unaware, the dramatic and historic bond selloff seems to have done the same at the FOMC. Leave it to policymakers to be so far behind the curve, and collateral markets to sort it out; implications in gold and all.
Click here to sign up for our free weekly e-newsletter.
“Wealth preservation and accumulation through thoughtful investing.”
For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, contact us at: jhudak@4kb.d43.myftpupload.com
Stay In Touch