'Carry Trades' Could Be Problem for Gold Market
By MICHAEL CASEY and JANET WHITMAN Dow Jones Newswires
Gold's relentless price slide in the past three years has spurred more investors to undertake what are known as gold "carry trades" -- essentially, low-interest loans using borrowed gold. But the trades could be a problem for the gold market if investors suddenly have to unwind them, as investors did with the popular carry trades involving the Japanese yen in the fall.
The gold carry trades involve borrowing gold from banks at prevailing low interest rates, selling or using it, then using the proceeds to buy higher-yielding assets such as Treasurys. The low borrowing rates, combined with weak gold prices, make repaying the loans inexpensive, even for manufacturers who must replace borrowed metal they have turned into finished goods.
But if the gold price spikes and borrowers are forced to cover their short positions, some say the effect could resemble the turmoil caused by the reversal in the yen carry trade, when the dollar nose dived and investors were forced to get out of high-risk assets. Treasurys, already under pressure from concerns over U.S. inflation risks, could be among those markets to suffer in the fallout.
Limited disclosure means no one can ever really know the full extent of the gold carry trade. But more people in the market are talking about it, and London-based Gold Fields Mineral Services Ltd. this year made its first reference to the carry trade in its closely watched annual survey of the gold market.
"For many years a significant quantity of gold has been borrowed as a source of cheap finance," Gold Fields said in its report. "The arbitrage has in fact been remarkably similar to ( though far smaller than ) the famous 'yen carry trade.' "
Gold Fields managing director Philip Klapwijk later told analysts he estimated the size of those positions to be 400 metric tons -- worth about $3 billion at current rates. At this stage, there isn't a lot of knowledge about the gold carry trade outside the gold market. That could suggest Wall Street's risk-hungry clients aren't as enamored with the idea as they once were with the equivalent yen strategy.
In that sense, it presents less of a systemic risk. Conservative policies adopted by hedge funds and other institutions after the fall crisis may have had a constraining effect.
There is no question, however, that the gold carry trade has been an attractive deal for some market participants. From the time gold peaked at around $417.50 a troy ounce in February 1996 until just recently, gold leasing rates rarely rose above 1%, while long-term Treasury yields have been either side of 6%. That is a healthy spread. However, lease rates, which reflect the cost of borrowing gold, shot above 4% last week, with some market observers speculating that year-2000 fears and liquidity concerns were behind the jump in rates. Traders said those factors also helped drive the price of front-month gold futures down $1.80 to $260.30 per ounce on the Comex division of the New York Mercantile Exchange Wednesday.
"The locals and the speculators are selling, essentially saying, 'Gee, let's try this market again another time,' " said George Gero, first vice president of Prudential Securities in New York. "The market is essentially down to the funds and trade houses now."
For those investors, who reportedly are also among the heaviest gold borrowers, a continued increase in lease rates could portend a sudden and damaging short-covering rally in the metal. Such a scramble would be of huge benefit to the price of gold, although it would be unlikely to move other markets significantly, said Frank Veneroso, a gold expert at Veneroso Associates and author of the Gold Book Annual.
"I don't think [the gold carry trade] is a big deal," he said. "I think that sometime down the road, it will get unwound. But I've never believed it's been large enough to create any systemic risk." |
