Misinterpretation of Gold Lease Rates

Brian Kelly (founder and CEO of Kanundrum Inc, a private investment firm and research boutique) recently posted an article on Seeking Alpha called Misinterpretation of Gold Lease Rates and Why Gold Could Rise. In the article he says that “lease rates reported in the press are a derived rate and actually represent the amount that can be earned from the gold carry trade” and goes on to posit a relationship between lease rates and gold prices. Unfortunately it is Brian who has misinterpreted lease rates, and has done so quite badly.

The gold carry trade involves borrowing gold at, say 1%, selling the gold, and then investing the cash at, say 3%. If the gold price doesn’t change, you earn a net 2%. The bigger the net difference the more carry trade return you can earn (assuming a stable price) and therefore more attractive short selling of gold should be – as long as there is an expectation that the gold price won’t rise too far to wipe out the profit from the interest rate differential.

The point of a carry trade is, therefore to “capture the difference between the rates” (see Currency Carry Trade for a further explanation). The question then is what are the two “rates” and what represents the net difference. The formula Brian mentions in his article is Lease Rate = LIBOR – GOFO. He therefore assumes that the net difference is the lease rate. However, that same formula can be restated as GOFO = LIBOR – Lease Rate. Which is the net difference?

Regrettably for Brian, it is GOFO, not the Lease Rate. How can I be so sure? Well when I worked in the Perth Mint’s Treasury and we borrowed gold, we were charged the Lease Rate, not GOFO. But don’t take my word for it. I quote from a booklet titled “A Guide to the London Bullion Market” issued by the London Bullion Market Association (who you would think would know what they are talking about): “Forward rate = Dollar interest rate – metal lease rate”

Therefore the fact is that it is GOFO which represents the “amount that can be earned from the gold carry trade”. GOFO is the measure of the net difference, “the amount that can be earned from the gold carry trade”, not the Lease Rate.

As a result not much store should be put to Brian’s subsequent analysis about the relationship lease rates and the gold price. The chart below shows the relationship between the real “carry trade” indicator (I’ve chosen the 6 month GOFO rate) and the spot price. I take a more longer-term strategic view and looking at the chart there is no clear relationship or correlation that I can work with. For example, in 2002-2003 GOFO was low and the gold price rising. But 2004-2006 GOFO was rising but the price also went up. I don’t see any tradable signals one can rely on.



Brian has also developed what he calls the Kanundrum Model of Markets, which explains the way people and markets behave. Below is a summary of his key “stages”:

Discovery – Stage 1

Stage 1 of any emerging trend is first characterized by a change in direction. It is usually preceded by a surge in volume as the asset makes a new low. This is the stage where major investors are establishing new positions.

Disbelief/Confusion – Stage 2

Price retreats after the initial surge and often the retreat is significant. Investors who did not buy when they heard that Stage 1 investors were buying believe that this is the time the Stage 1 investors are going to be wrong.

Belief and Proof – Stage 3

In this stage the asset makes its largest price move. It is by far the most important part of the trend for an investor to be a part of. Volume is huge and price moves are beyond what anyone expects. This part of the trend usually lasts much longer than anyone expects. This is also where almost every type of investor has a reason to be involved in the trade.

Complacency – Stage 4

Price begins to retreat from the unbelievable prices achieved during Stage 3. However few participants are concerned. Market participants are accustomed to the asset price and many investors use the pullback to add to or establish new positions.

Mom and Pop – Stage 5

The price begins to move back up and individual investors invest. The price moves may be less than during Stage 3 primarily because individuals do not have the buying power that larger professional investors have. As well, Stage 1 and Stage 3 investors are taking profits.

In this blog post dated 13 October, Brian believes that gold is currently in Stage 2: Disbelief/Confusion. Now I’m not so sure about his model and the stages one has to choose from but it is an interesting and fun way to view the market. Using his model, I would suggest we are in the middle of Stage 4 (see chart below). What stage do you think we are at?

James Turk says there is no shortage ...

... of wholesale precious metals, that is. In this GATA dispatch, James Turk says "So far the London and Zurich markets continue to operate without problems, but I sense some strains are developing" and "we are giving retail investors the opportunity to buy alongside big institutional firms operating in these markets and to gain the advantages of these markets -- deep liquidity and transparent pricing"

This is what I have been trying to say all along - physical metal in the wholesale markets is not in shortage, it is the conversion of that metal into retail coins and bars that is causing a shortage of retail product, pushing up their prices.

He goes on to note that his clients "are purchasing metal based on the spot price in London and Zurich for both gold and silver. Thus they are able to buy metal without the huge premiums now being charged on eBay, for example, for fabricated product like coins and small bars"

The unfortunate thing for precious metals is that because people don't trust Mr Turk's system or ones like it, they are "wasting", in a way, their purchasing power on premiums instead of on the metal itself. If the spot price for bulk silver is $10 p/oz but is $14 p/oz for retail silver, then those who spend their $14 on a GoldMoney type system create demand for 1.4 oz whereas those buying retail forms only create demand for 1.0 oz.

Could it be that the reason the silver price (or gold) is not as high as some would like is because all this demand to spend fiat dollars is not being fully channelled into silver but partly spent on premiums instead?

I am a strong advocate of holding physical metal, but once you have a reasonable stash if you want to make an impact on the price maybe continuing to pay incredible premiums may not be the way to go. Of course it does come down to trust in these systems, so I understand why people may not want to buy stored metal. However I can't help but think that a lot of dollar buying power is ending up as profit in the hands of coin dealers instead of into silver and gold itself.

FUD Update

In the FUD blog of 31 August, I suggested two scenarios. I was leaning more towards scenario 2, which was that Mints/Refineries would gear up in “a few months” (fact is industry bar production in sizable quantity is not like turning on a tap) and meet retail demand.

With the credit crisis becoming hot topic since then, scenario 1 (retail market going nuts) is happening quicker than I expected. Manufacturers will respond to this, but it will take time. But, if the retail shortage continues and starts to register on the general public's mind, combined with uncertainty about banks and holding cash, the fact is that after years of poor gold prices in the 1990s, as a whole the industry does not have the capacity to meet the sort of volumes that would from mass market/general public interest in coins and bars. Premiums above spot (and spot means, by definition, the price for wholesale 1000 oz silver and 400 oz gold bar) will increase dramatically as a result. Scenario 1b then becomes a possibility.

See this SilverAxis blog for some comment on the retail market situation.

I would also recommend this other blog from SilverAxis on the US Monetary Base.

Gary North article on Silver & Hommel

http://www.garynorth.com/public/3992.cfm

Note: the label does not apply to Gary North, but to the subjects of his article.

Update:

15 Sep Additional from Gary: http://www.garynorth.com/public/4002.cfm
16 Sep Hommel's reply to Gary: http://silverstockreport.com/2008/shortagefeedback.html

Reply to a Reply

From the start, I’d like to direct readers to my About This Blog. As I say there, my blog is not a Perth Mint mouthpiece and all my comments are my personal opinion and not endorsed by the Mint in any way. If you have a question about their operations or a complaint, ask them directly yourself, I am not their complaints department.

It is also probably important to be clear that I am bullish on gold and silver, although I take a long term view. If you sense I’m taking a bearish view that may be because I am a contrarian personality type and thus have a tendency always to look at the other side of any dominant view (and challenge my own views), as I believe the truth usually lies between the extremes.

Jason writes: I also think its normal for there to be shortages of silver and gold when inflation is raging out of control, and when the markets are manipulated, but I suppose we don't agree on reasons like that.

The comments I’ve made don’t exclude inflation or manipulation as factors. It is unfortunate that many have no confidence in COMEX; thankfully Australia does not have any precious metal futures markets. All I’m looking to do is to contribute some additional things to consider that no one else in the “gold internet community” talks about. Some of these factors may be important to the shortage of (retail) silver, some not so. It is just extra information that I hope fills out the picture, as no one knows everything.

Jason writes: That's insane. Right downstairs, they often run out of 100 oz. bars, and reportedly have no 1000 oz. bars for sale.

I asked our Shop if they have 100 oz bars and they said they have them available, so instead of relying on Jason’s “reportedly”, all I can say is that if you want to buy silver, ring our Shop up and buy it. Once your money clears, they'll ship. At the end of the day, my words and Jason’s words don’t matter – actions speak louder than words. And the only action that matters is delivery. Period.

Jason writes: Besides, that's a lie. Wholesale quantities in silver are 1 silver futures contract of 5000 ounces, which is about 1/6th of a tonne, not 20 tonnes! Further, I note that Nigel did NOT say he would SELL 20 tonnes of silver. He only wants to "deal" in that, minimum. He probably needs to buy that much to pull his fat out of the fire, as I will explain below.

The definition of “deal” by Encarta Dictionary within Microsoft Word is “an agreement, arrangement, or transaction, usually one that benefits all the parties involved”. This includes BOTH buying and selling. But to be clear, Nigel will SELL physical 1000 oz silver bars. Also, what I said was "he will do deals for a minimum". I did not say that "the wholesale market only deals in this minimum", you read that into my statement. That is just his minimum. He is the Treasurer for the whole Mint, not a retail bullion dealer; this is the deal size he operates at. Of course trading occurs in the wholesale market for quantities lesser than that. My point was that bulk quantities of silver are available in the over the counter (OTC) spot market. They are, and Nigel will supply them. Period.

Jason writes: AGR Matthey closed their silver operations!

Incorrect. AGR Matthey have not closed their “silver operations”. I quote from a letter dated 18 August 2008 to AGR Matthey’s customers:

“The Board of AGR Matthey has taken the decision to exit the jewellery business. AGR Matthey will no longer manufacture jewellery products in Australia or New Zealand. … The industrial business (medical and brazing alloys) will continue. … Arrangements are being made for fine gold grain (minimum order quantity 1 kilogram) to be made available through Perth to wholesale customers with delivery via Brinks premises on the eastern seaboard, provided there is sufficient demand. Larger secondary refining customers may be serviced through the refinery in WA.”

AGR Matthey refines around 10% of worldwide mine production and silver is a by product of that refining. It is not reliant on sourcing gold or silver from the general public. Australia is a net exporter of precious metals – in 2006/07 Australian mine production was 1674 tonnes with 431 tonnes of refined silver exported according to ABARE. Logically this means that there is enough silver to meet domestic demand.

Since the rest of your article with its “might have been” type speculations hinge on this error of fact about AGR Matthey, they are also incorrect and thus don’t warrant a response.

The Perth Mint’s unallocated facility is not the be all and end all of the organisation; the Mint sells bars, coins, numismatic products, unallocated storage, allocated storage, and an Australian Stock Exchange listed gold product – however customers want to buy their precious metal, the Mint strives to service it. Is the Mint perfect? No. But everyone who works there is passionate about precious metals and supporting the industry and is proud to work there. And so am I.

Jason Hommel Reply

Jason Hommel has made some comments to my blog of 31 August that I think are important. His questions/statements are in italics and my replies below.

Yes, but where do you sit? Where are those 1000 oz. bars that kitco and perth can't seem to be able to find for customers who want them? Why do Perth/Kitco have a shortage of 1000 oz. silver bars?

It may not be clear from my blog that I work at the Perth Mint. I have updated my profile to include my LinkedIn profile and “About This Blog” link to be clear in what capacity I do this blog. I have also included a picture of my favourite new coin, it is a Good Fortune coin.

When I say that wholesale bars are available, it means in wholesale quantities. I cannot speak for Kitco, but I went upstairs and spoke to the Treasurer and he will do deals for a minimum of 20 tonnes of silver and 1 tonne of gold. Call Nigel Moffatt on (08) 9421 7403. Price will be on a deal-by-deal basis.

Depository have 1000 oz and 100 oz silver bars in stock for their clients to convert to allocate or collect. If you are a Depository client you have their contact details.

I also walked downstairs and spoke to the manager of our retail shop and they sell 100 oz bars for silver value + $74 per bar. They don’t really deal in 1000 oz bars because they are odd weight which doesn’t work well with their retail computer system and they are bulky, but I assume that most would rather 100 oz than 1000 oz anyway. Call Cathy or Liselle on (08) 9421 7428.

(Aside: while you may define collusion as something illegal, others may define it as anything that is against free market principles.)

The definition I used came from an online dictionary. See http://en.wikipedia.org/wiki/Collusion for another definition. The key elements are “secretive” and “fraud”. It does not mean “against free market principles”.

I would like to trade bullion in a free market manner, but it seems most everyone else want to "lock in" a guarantee of some sort or another.

I think it is entirely in keeping with free market principles that person A and person B have the freedom to enter into any agreement they see fit that does not hurt anyone else’s rights. There is nothing stopping person R (for retail buyer) from offering a higher price to A to secure supply of A’s silver. Anyway, even if A has committed to supply silver to B, there is nothing stopping B from selling that so acquired silver to R via auction or at a higher price.

The agreement between A and B may restrict A from supplying to R (which was all I was trying to explain) but not B from supplying to R. I therefore do not see any fraud being perpetrated against R or any restriction of the free market. In the end, the silver ends up in someone’s hands and they are free to auction it off to the highest bidder as you have recommended.

It's been my experience that people in the industry, the coin dealers, over-value their own direct personal experience, and have trouble seeing the big picture. They see the public selling silver to them, and thus, from their view, there is a "glut" … where public buying increased ten fold, and they've been turning away customers, and trying to buy from refineries, instead of sell to them, in all of 2008.There is an expression used to describe such a viewpoint. They can't see the forest because the trees are in their way.

I suppose I agree with you, but not sure this is a problem. The coin dealers operate at the end of the precious metal industry value chain so deal in “trees”, that is their business. You are exactly right, they either see net buying or net selling and either net buy or net sell from/to their source of product one step up in the value chain. This is good because it sends a signal about the volume of demand back to that source. I don’t know that they need to see the forest to do their job properly.

FUD. Fear, uncertainty, doubt.

“FUD. Fear, uncertainty, doubt. Salesmen, politicians, markets thrive on it and create it whenever possible” - TinyTim, 28 Aug 02:12 PM, comment on Sorry, There Is No Silver Conspiracy

A fine little dispute has recently been stewing on the net around what is happening in the gold and silver market, prompted by the heavy correction in their prices. I’ve been following it here:

The Disconnect Between Supply and Demand in Gold & Silver Markets – James Conrad, 18 Aug
Gold Refining Squeezes Silver Bar Production? – Jason Hommel, 21 Aug
The Strange Case of Dr. GLD & Mr. Bullion – Graham Summers, 22 Aug
Ignoring the Free Market Causes Shortages – Jason Hommel, 23 Aug
The Disconnect Between Supply and Demand in Gold and Silver Markets, Part II – James Conrad, 25 Aug
Sorry, There Is No Silver Conspiracy – Otto Rock, 27 Aug
Independence Day: Decoupling Gold and Silver from the Dollar – James Conrad, 27 Aug
The Great Gold, Silver Conspiracy Explained – Mike Shedlock, 27 Aug
How to Explain Fiat Currency to Silverbugs – Otto Rock, 28 Aug
Conspiracy Theory Psychology – Mike Shedlock, 28 Aug
Gold Sale Spurs Manipulation Talk – Mike Shedlock, 30 Aug
Where are the insider admissions about gold? Right here – Chris Powell, 30 Aug

People seem to sit on either end of a number of propositions (doesn’t seem that shades of grey or agnostic positions are accepted), some agreeing with all, some disagreeing with all, some picking and choosing:

• There is a shortage of retail forms of gold and silver.
• Prices for retail forms of gold and silver are high.
• COMEX price is different from retail prices, therefore COMEX price is “fake”.
• Conspiracy to manipulate the gold and silver markets (by bullion banks for profit, by bullion banks on behalf of central banks).
• Etc, etc

A lot of the hype stems from the interpretation that because it is difficult to get hold of retail forms of gold or silver (e.g. 1oz coins, 100oz silver bars) that there is a “shortage” of gold and silver. I think it has now been accepted that there is no shortage of gold and silver in the wholesale markets (that is, for 400oz gold and 1000oz silver bars). This should be obvious if you consider the fact that miners churn out 2000+ tonnes a year. What we have is a shortage of retail forms. It is also worth noting that demand and supply is also localised in the gold and silver markets. So you really need to be specific instead of just saying “shortage” – you need to indicate of what form and in what location.

Anyway, this is understandably frustrating for the retail buyer and naturally leads to questions, and attempted answers, as to why this has occurred and why manufacturers are not responding, say by auctioning off the limited quantities they have, or increasing production. I mean, they are profit seeking entities, are they not? Why would they be missing out on extra profit from all this demand?

Now one thing I can agree on is “profit seeking”, these businesses are not going to pass up profit. So how to explain their behaviour? For those who are puzzled, they only explanations can seem 1) they are idiots or 2) they are part of some conspiracy. Let me suggest an alternative explanation (and I use gold here to also include silver).

The gold industry's production capacity, distribution networks, and client base is set up to service a certain ratio of retail versus wholesale volumes. This is to be expected - if you are making big dollar decisions on equipment you will do so based on past demand patterns. There are long-term relationships in place with major distributors and clients. Production processes are set up to service this demand and with a bit of flexibility to service the shifts in this demand in response to price movements.

Now I don’t doubt for a moment that the demand has increased for retail forms of gold – there is plenty of proof of this in the above articles and discussion forums. With a sort of fixed production plan at the source manufacturers and some lead time/delay from source to end buyer, it is not surprising that retail coins and bars can run out from time to time. Now don’t get offended if you are a retail buyer, but in the big scheme of things all of your purchases added up are not that important volume wise. So the initial response by the industry is, short-term blip, it has happened before, production will catch up with demand, backlog orders will be cleared and thing will be back to normal before too soon. From my side of the fence, I’ve seen these surges in demand occur (plenty of times without running out of stock) and then subside. This is the nature of the market, it responds to prices, or drives them. It is difficult to compare this market to other goods (eg milk), because their prices don’t fluctuate like precious metals. When demand is stable, so are prices and so is supply.

OK, so based on past experience, people in the industry don’t get all excited when they run out of small coins and bars. This explains their lack of response to the initial demand. Then the demand continues, and the backorders increase, delivery times increase. Why does the industry not respond now? Well they are still not sure if this increase in demand will be sustained. Also consider that they don’t spend their time reading all these commentaries or watching ebay, so they don’t see the initial increase in premiums. The price signals are not getting through. But even if they are aware of the increasing interest in retail forms of gold (and increasing prices), they still don’t response. Why?

Manufacturers of gold and silver have long-term customers who buy in volume. Maybe the price they are receiving from these customers is lower than what they can sell their retail products at, but they have a difficult decision. Sure they could sell to retail buyers, or make their long-term customers compete at auction for their production with the retail buyers, but they worry that when the demand declines (as they have seen occur in the past) you retail buyers won’t be there anymore but their long-term customers will, and they will remember how the manufacturer “screwed” them and they will either take their business elsewhere or screw them back in turn. So the manufacturer, based on past experience of the fickleness of retail demand, decides to continue to supply their long-term customers. You also have to consider that some may have supply agreements, either for volume or at a price, that they cannot break.

Some manufacturers may have relatively flexible production processes and can switch production capacity to retail forms, but there is still a cost involved. Again, the delay in responding may be a result of the executives of these firms not being sure about the longevity of the demand and switching capacity also means that they have to cut back on some other products, products that they supply to their long-term customers.

What about putting on extra capacity? As you can imagine, capital expenditure decisions and bringing on new capacity is not like turning on a tap, there is a big lag in getting additional the machines delivered and operational. Again, the question that executives in the refineries and other manufacturers would be asking themselves is whether the increase in retail demand is permanent or temporary. If temporary, they don't want to waste money on capacity that will be left idle.

Given the above, the question then becomes: how long before the industry responds? This is hard to say. I see us at a crossroad - the future will take one of two paths:

Scenario 1

Given the natural conservatism described above and the continuing retail demand we see continuing shortages of retail forms of gold and silver, probably occurring in a stop/start fashion as one supplier catches up and then another runs out. This erratic supply increases premiums for retail bars and coins. This fans further hysteria about "shortages", driving more retail demand. Industry executives see the demand and premiums and finally see profit and decide to ramp up production. During the delay in getting capacity online (some quicker than others depending on how their production process are set up) the hysteria continues, increasing retail physical demand.

The retail shortage “story" is picked up by more commentators and increasingly by mainstream media, who in their ignorance create the perception of a shortage of wholesale physical. Fanned on by retail dealers who are making a killing from marking up bars and coins, conspiracists who think this will be the straw that will break the (short) camel’s back, and those who recommended investors into gold and silver, this drives average investor and speculators into the ETFs (because they are comfortable with this investment form and don’t have any idea how to buy physical even if they wanted to) which drives the gold price even higher. Eventually capacity will come online and retail bars and coins are supplied and stories of shortages dry up. Now there are two possible end games:

a) The hysteria process reverses as product is easily available. Perceptions change, there is now "oversupply" of gold, talk of similarities with the 1980s bubble, demand contracts and price drops, savagely. Lots of egg on certain faces.

b) Product is easily available but that has no effect. Retail demand is at a new level and remains there, the “shorts” have been broken, gold has moved to a new “level”, reclaimed its inflation adjusted price. The public are aware of the gold and silver again, distrustful of fiat currencies. A new Golden Age has dawned. Lots of egg on certain faces.

Scenario 2

Retail demand for gold and silver, while significantly higher than in the past, is not significant compared to the wholesale physical market to really move the physical spot price. Combined with the possibility that suppliers may be more flexible in production capacity than we suspect, product is brought onto the market in a few months. "Shortage" stories dry up, retail demand drops. Lots of egg on certain faces.

Either way, someone is going to be wrong. Unfortunately, only time will tell so we will have to wait to find out who. The second half of 2008 will certainly be interesting.