Lessons for gold in yen fiascos
By Stephen Wyatt
The gold market is precariously positioned and an unexpected wild price rally
with dire implications for hedge funds is very likely, right? To a number of
analysts, this is not right. There is so much gold in the vaults of central banks
and so many willing sellers that any hefty rally will be sold into.
And testament to the oversupply of gold is its price collapse to fresh 20-year
lows last week.
But to some, like Mr Peter Hambro, ex-deputy managing director of Mocatta
London and now chairman of Zoloto Mining, a gold miner in Russia, the risks
are clear and growing. Just as the "yen carry trade" sent Long Term Capital
Management and a swathe of other hedge funds scrambling for Fed protection
and sent the yen surging and bond market falling, so may the new "gold carry
trade" do the same to a number of other hedge funds, he argues.
And this sort of view is gaining some currency in some quarters.
The US-based Gold Anti-Trust Action group, GATA, has similar concerns
although it believes that the gold price is being artificially depressed by hedge
funds with the support of some governments.
There has been so much gold borrowed by hedge funds over the past year,
says Mr Hambro, that in the event of a gold rally, these funds would never be
able to acquire adequate gold at the right price to repay this borrowed gold.
The yen carry trade involved the borrowing of yen at, say, 2 per cent per year
and buying US Treasury bonds at 5.75 per cent, all the time leveraging up the
transaction. Some groups bought higher-yielding Russian bonds before the
Russian Government defaulted.
The problem here was that the dollar/yen currency exposure was not
covered/hedged. In late August, when the G3 decided to support the yen
around 147, suddenly the rising yen undermined the hedge funds. As they
rushed to buy the yen to cover their exposures, the yen suddenly accelerated
from around 138 ¥/$US to 111 ¥/$US in the first week of October.
Now, hedge funds are in a similar position with their "gold carry", argue some.
Just as no-one knew the extent of the yen short position of the hedge funds,
today no-one knows the extent of the gold short position of the hedge funds.
Some estimates are as high as 8,000 tonnes, but most analysts believe that
speculators could be short anywhere between 1,000 tonnes and 3,000
tonnes. Last week, gold analyst Mr James Cross at the FT Gold Conference
in London estimated total central bank gold lending at 4,000 tonnes. And this
gold is spread between forward selling gold producers and speculators.
The "gold carry" involves the leveraged borrowing of gold by a hedge fund from
a central bank. The cost of borrowing gold is currently around 1.5 per cent.
The hedge fund then sells this borrowed gold and with the cash proceeds to
invest in some form of government security, such as US Treasury bonds.
"Gold is 'fabricated' ... by people, firms, funds ... who sell gold that they do
not own and deliver a promise instead of metal," says Mr Hambro.
There are two reasons for hedge funds playing this game. The first is the hope
of buying the gold back at a lower price and redelivering itto the original
lender. This is the original vanilla speculative short gold play.
The second, argues Mr Hambro, is driven by the necessity of hedge funds to
demonstrate super-normal returns for their investors. This is the "gold carry"
part of the trade.
An investor (hedge fund) with $US1 million and solid credit can leverage this
into a gold tradeworth $10 million with any number of bullion bankers. Ten
million dollars worth of gold is borrowed at, say, 1.5 per cent. If the gold is
then sold, the money could be invested in US Treasury notes at, say, 5.5 per
cent. The net result is a return of $400,000, or 40 per cent per annum, on the
$1 million initially invested.
In the gold carry, unlike the yen carry, there is no currency exposure, but a
gold price exposure and an interest rate exposure. If the gold price rallied, the
hedge funds would have to repurchase the gold at a higher price and give this
back to the lender - ultimately the central bank.
The argument of the "gold carry" critics is that the rush by hedge funds to
cover their gold short position would be so great that the price of gold could
soar and hedge fund bankruptcies could eventuate.
The hedge funds are "staring disaster in the face", says Mr Hambro. If any
one central banker asked for their gold back now, "there is no chance that
they would get it back".
"It has all been sold to China and India and is proudly worn around the necks
of the beautiful brides. All the central bankers own is a paper promise from a
Master of the Universe," he says.
This sort of argument is, of course, music to gold miners' ears.
Many, and probably most well- recognised analysts in the markets, are not at
all convinced that such concerns are valid.
"There is a lot of gold out there," says Mr Alan Heap, commodities analyst
with Salomon Smith Barney. He says that central banks are very willing
lenders. After all, they still hold in their vaults a third of the gold ever mined.
Mr Robert Sleeper, of the BIS, said at the FT Gold Conference that a gold
price rebound "will take very few prisoners" among short positions.
Others suggest that gold producers and central banks would welcome the
rally and sell into it with relief - the gold producers to lock in future returns and
the central banks to "rebalance portfolios", converting non-income earning
gold into US Treasuries or Japanese bonds or German bonds.
In short, most analysts argue that the enormous mobilisation of gold by
central banks via their gold lending and selling policies will ensure adequate
supply, even into a short sharp covering rally by gold carry-playing hedge
funds.
afr.com.au
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