Negative GOFO – no Harbinger for Rally in Gold

It was the big headline in a market report that gold forward rates (GOFO) were negative for the first time since the collapse of Lehman Brothers in 2008. While this information is correct, it should suggest that this marks again a turning point for the price of gold. While Lehman Brothers went bankrupt on September 15, 2008, it was only 44 days later that gold reached its low at 680$/oz and started the rise to the new all-time high at 1920$/oz on September 6, 2011.  However, the 1month gold forward rate turned negative only in November 2007. The sequence of events is similar this year. Gold reached a new low in late June and then recovered before GOFO rates turned negative. But the similarities end here.

Negative GOFO rates imply that spot gold with delivery after 2 business days is trading higher than the price for gold fixed today for delivery in 1, 2, 3 or 6 months. The 1 year gold forward rate remained positive last week. Thus, the gold market turned from contango (the normal state in this market) into backwardation, which is unusual for the precious metals. In other commodity markets, backwardation is often explained by the concept of convenience yield. However, this concept does not apply for gold and silver as there is an active market for lending these two precious metals. Moreover, gold forward rates can not form freely in the market. They are bound by money market interest rates and the lease rates in the market for lending gold. Arbitrage could set in, if the following identity equation is violated:

            Gold forward rate = money market rate – gold lease rate.

The money market rate is normally the US dollar LIBOR for the corresponding duration of the gold forward.

This identity equation also helps to explain why the gold forward rate turns negative. Either the LIBOR rate has to fall or the gold lease rate has to increase or there is a combination of both factors.

In 2008, immediately with the collapse of Lehman Brothers, the 1mth gold forward rate increased as the LIBOR rate, which includes bank risk, rose stronger than the gold lease rate. However, already at the end of September, the forward rate reached its peak and turned around. This was triggered by a jump in the gold lease rate. But from the middle of October, both rates fell. Due to the Fed policy, the LIBOR rate fell stronger than the gold lease rate, which remained above 1.25%. The 1mth LIBOR was briefly below the gold lease rate in November 2008, which caused the negative gold forward rate.  

However, in 2013, the 1mth LIBOR rate showed a downward bias, but the overall range was just less than 2 basis points. This is not enough to explain the negative gold forward rate of -0.11% on Wednesday. Thus, unlike in 2008, the movement of the gold lease rates was the responsible factor for the backwardation in the gold market.

The crucial question is thus, which factors drive the gold lease rate. Our quantitative research identified two factors, which explain around 85% of the movements of the 1mth gold lease rate since January 2012, the price of gold and the gold inventories in CME warehouses. The chart above shows the weekly gold lease rate and the spot gold price. It is obvious that the gold lease rate also started to increase when gold resumed its downward move leading to the low in late June. Hedge funds not only sold physical gold they held via ETFs but also sold gold short in the physical market. As those deals usually have to be settled after 2 business days, the hedge funds have to lend the gold from institutional holders. This demand already led to a steady increase of the lease rate.

The next chart shows the development of the gold stocks held in CME warehouses together with the gold lease rate and the model estimate of the lease rate. As long as the inventories are abandoned, hedge funds being short physical gold don’t have to worry about covering their shorts. They could meet the obligation to return the gold lend by buying in the spot market or by purchasing futures with expiration before they have to make delivery. Then, they can take physical delivery from the long future and meet their obligation to return the gold back to the lender. However, if inventories fall rapidly, the risk increases for the borrower to obtain gold right in time by purchasing a gold future and take delivery. But also the risk for the lender increases that the gold will be returned at the agreed date. Thus, lenders get hesitant to enter new lease agreements and/or demand higher risk premiums for lending gold.

After the speech of Fed chairman Bernanke last Wednesday, following the release of the FOMC minutes, the gold lease rates came down. As an immediate tapering of the bond purchasing program got less likely, also the short speculation against gold declined, which contributed to the decline of the lease rates. The US dollar weakened against the major currencies and also the bond markets recovered. However, it remains only a question of timing that the Fed will reduce the volume of being bonds. Thus, the medium-term outlook for a firmer US dollar against the major currency remains intact. Therefore, the upside potential for gold appears to be limited and the negative gold lease rate is in no way a harbinger for a rally in the gold market like after the collapse of Lehman Brothers. On the other hand, as long as gold inventories held in CME warehouses decline, the risk for selling gold short increases. This might limit also the downside risk for the gold price. However, all in all, the risk for gold appears to be more biased to the downside despite the recovery last week.