A squeeze to please
Secret talks between the world's top bankers led to this week's remarkable about-face by the gold price. Steve Burrell reports.
Secret talks between the world's top bankers led to this week's remarkable about-face by the gold price. Steve Burrell reports.
Paul Lee, the head of gold trading at Dresdner Kleinwort Benson in Sydney, could be forgiven for forgetting where he lived this week.
He didn't go to bed for three nights straight as he and his fellow traders stayed at their screens around the clock, riding the biggest and fastest rise in the gold price in almost 20 years.
Lee's sleepless-in-the-saddle week began last Sunday with unexpected news from the other side of the world.
With his unruly shock of hair and unfashionable black-framed glasses, European Central Bank president Wim Duisenberg looks more like a slightly owlish university don than a white knight.
But when he and 15 of his fellow European central bankers announced at the IMF-World Bank meeting in Washington that they were capping sales and lending of gold out of their official reserves, they became a battalion of white knights and the Seventh Cavalry rolled into one for the beleaguered gold sector.
The unprecedented announcement took the market completely by surprise and sparked one of the most dramatic surges in the gold price in a generation.
The gold price soared almost 25 per cent in a few days to as high as $US329 an ounce 30 per cent above its late August low of $US252.90 before consolidating around $US300 by the end of the week.
On Tuesday alone, the London price rose $US20.40 an ounce, the largest increase in dollar or percentage terms in more than 17 years.
The agreement, master-minded by the central banks of the world's 10 biggest economies, was a co-ordinated attempt to reverse the long slump in the gold price which had recently seen it crash to 20-year lows of around $US250 an ounce, putting gold producers around the word under extreme pressure.
Secret discussions on the deal began in earnest in August, after an announcement on May 7 by the UK that it was planning to sell gold reserves sparked a $US30 per ounce crash in the gold price and left the market vulnerable to further falls.
Last weekend's announcement lifted a black cloud which had hung over the gold market for more than three years.
"The enormity of the announcement by European central banks cannot be underestimated," says Colonial State Bank chief economist Craig James. "The threat of central bank sales was the prime factor driving the gold price lower.
"The expectation of lower prices led to short selling by speculators, inducing further downside.
"The removal of the spectre of substantial central bank sales means mine supply and demand will again be the main determinants of the gold price."
But while the sudden, spectacular surge in the gold price has produced some happy miners and gold company shareholders, for others the revival of the precious metal has come as an expensive surprise.
For a lot of speculators, including some of the world's biggest hedge funds, it was a case of the free lunch biting back.
They were up to their eyeballs in the financial markets' latest version of a licence to print money, the "gold carry trade".
The near-vertical trajectory of the once-languishing gold price in the wake of the central bank announcement has all the hallmarks of a rush of speculators to the exits.
The hedge funds and other financial market heavyweights including, market rumour has it , big investment banks such as Goldman Sachs were forced to unwind plays which could involve around $US25 billion ($38.4 billion) in borrowed gold, frantically buying to cover their "short" positions and driving the price up even further .
On Tuesday, as gold prices spiked higher to $US326 from $US304 in matter of minutes, rumours swirled about massive buying by a New York dealer on behalf of a client unwinding a $4 billion bet on the gold price falling, according to the Wall Street Journal.
Gold's amazing resurgence may also have dramatically changed the rules of the game for many producers, who, like the funds, had borrowed central bank gold and sold forward to hedge their production.
The higher interest cost of carrying these positions means it is no longer profitable for them to sell forward and may even prompt a major buyback by producers to cover these short positions, according to some analysts.
As Paul Lee notes: "Structurally, the entire industry has changed."
The "gold carry" is a close cousin of the "yen carry trade", which got the hedge funds into so much trouble last year.
Speculators borrowed yen at ultra-low interest rates and reinvested the proceeds in higher yielding securities a guaranteed money-making proposition until the yen started to rise against the US dollar and made paying back the borrowings more expensive. With the gold carry, hedge funds and other speculators borrow gold from a central bank, leveraging up their position by using bank credit to increase the size of the exposure.
They then sell this borrowed gold and invest the proceeds in other securities, such as US Treasury bonds.
The trick in this case was that, until recently, the cost of borrowing gold was only around 1.5 per cent to 2 per cent because central banks, keen to earn some interest on their large gold holdings, were prepared lend it out at a low rate.
With rates on US Treasuries at more than 5.5 per cent, it was money for jam.
What's more, with gold prices falling, they could also expect to make money when they eventually returned the gold to the central bank because they could buy it at a lower price than when they borrowed it a standard speculative play called shorting the market .
With leverage, these speculative positions could deliver the hedge funds and their investors returns of 40 per cent or more.
Unlike the yen carry trade, there is no currency risk involved, though, as they were to discover, they were exposed to interest rate risk and, of course, the chance that the gold price might actually rise.
With central banks selling their gold reserves, so-called "fabrication" demand for gold in the previously strong Asian market still recovering from the economic crisis and inflation low, there seemed little risk of that.
If anything, with the spectre of central bank sales hanging over the market, further falls were expected.
It was little wonder that the hedge funds arrived in droves to take advantage of this free lunch during the past year or two.
Just as no-one really knows how exposed the hedge funds were to the yen last year, it is hard to be sure how big their short position in gold was going into last week and at what price those positions started going under water.
Some analysts have put their collective short positions as high as 8,000 tonnes. More reliable estimates of central bank lending of around 5,000 to 6,000 tonnes to both forward selling gold producers and speculators suggests it would be closer to 2,000 to 2,500 tonnes. Still, that's up to $US25 billion worth of gold at current prices.
One of the first signs that the magic pudding of the gold carry was about to turn sour came the previous week when gold rallied almost $US6 an ounce in the wake of the Bank of England's second auction of its gold reserves.
The 25-tonne auction, part of a gradual unloading of half of Britain's total reserves, was eight times oversubscribed, with some of the world's biggest producers among those buying up big to cover short hedging positions.
The subsequent price rise to more than $US260 an ounce was only the beginning.
The rally was supercharged over the weekend with the surprise announcement by the European central banks that they were capping annual gold sales from their official reserves at 400 tonnes for the next five years. With sales of around 1,715 tonnes by the UK and Switzerland already decided, this was close to a moratorium on selling until late 2004.
It also dramatically reduced the amount of central bank gold likely to be sold worldwide in the next few years.
Together the European central banks, the US and the International Monetary Fund hold 80 per cent of official sector gold. With the IMF changing its mind about on-market sales to fund its recent debt relief initiative and the US not having sold gold since the late 1970s, the European decision was pivotal.
The announcement largely removed the threat of massive central bank sales which had hung over the market since the Belgian central bank announced it was unloading gold reserves in March 1996 a fear which was intensified greatly when Australia's own Reserve Bank revealed in early July 1997 it had already begun selling gold.
The European banks' weekend announcement fuelled an immediate $US16-an-ounce jump in the gold price, taking it above $US280 an ounce for the first time since early May.
Although the average price at which the funds were carrying their gold positions is unclear, this would have started to take them close to the danger zone where it would cost them more to repay the gold they had borrowed from the central banks than when they borrowed it.
They were already facing a squeeze from another direction the interest rates charged by the central banks for borrowing their gold. In recent months this so-called lease rate had jumped from 1.5 per cent to around 4 per cent, amid rumours the central banks were withdrawing gold from the market. This sharply reduced gains on the gold carry.
At one stage during the turmoil of the past week the lease rate climbed above 10 per cent.
For those borrowing on a "floating lease" basis akin to a floating rate mortgage this means the gold carry was costing them a lot of money.
Significantly, the European banks said last weekend that, in addition to limiting their gold sales, they would also curb their gold lending, agreeing "not to expand their gold leasings and their use of gold futures and options over this period".
With the European central banks holding around a third of the estimated 5,000 to 6,000 tonne pool of bullion reserves available to be lent out, this could have a significant impact on the level of gold borrowings and will help keep lease rates high.
Combined with the rising gold price, the rise in the lease rates appears to have been the signal for the speculators to get out by buying gold to cover their short positions.
This bail-out made the climb in the gold price even more spectacular, driving it as high as $US329 an ounce in London trading on Wednedsay and leaving it at $US302 an ounce, a rise of 14 per cent over the week, yesterday.
The short squeeze was tightened even further by the fact there were few sellers in the market. This was partly because producers and other holders of gold were waiting to see if the price rose further and partly because producers were themselves short because of previous forward selling at prices much lower than prevailing now.
In effect their position was not much better than the hedge fund themselves.
To put this week's rise in perspective, however, the gold price is still well below the $US340 to $US350 an ounce range that prevailed before the RBA's sale announcement in mid-1997.
And it's still miles away from the $US400-an-ounce levels of early 1996, before the Belgian sales announcement not to mention its all-time high of $835 an ounce in 1980.
Although there is a big question mark over whether gold will approach the levels of two years ago, the price outlook is definitely brighter and current levels could well be maintained or bettered, according to analysts.
While the recent spikes were driven by the bail-out of the speculators, the rise in the gold price is also reflecting shifting fundamentals in the industry and the world economy.
The unexpectedly rapid recovery from financial crisis of many of the East Asian economies among the biggest buyers of gold for jewellery and other manufacturing uses means fabrication demand is stronger and likely to improve, as will the generally stronger outlook for the world economy as whole.
The World Gold Council put gold demand at record levels in the June quarter, with supply down by 5 per cent on six months earlier.
The annual gap between fabrication demand and mine production has been around 500 tonnes for the past few years and, according to a respected analyst of the market, NM Rothschild & Sons chief economist Ric Simes, it will rise to 1,000 tonnes a year for each of the next few years as mine production growth slows.
The prospect of higher global inflation and signs that the recent era of US dollar strength is coming to an end also makes gold a more attractive proposition, though the inflation hedge factor is far less important than it has been in the past.
And on the supply side of the market, the European central banks' decision to limit sales and lending, along with the rethink on sales by the IMF, will also lend price support.
After the present bout of volatility and short-covering passes, Dresdner's Paul Lee sees the gold price establishing a new firm foundation around $US275 to $US280, although he doesn't rule out the price spiking even higher than $US329 in the short term if hedging positions continue to be unwound.
With demand firm, Colonial State Bank's Craig James sees the price returning to around the $US325 to $US350 level which prevailed before the threat of central bank sales slammed the market.
Rothschild's Ric Simes sees the price settling above $US300 an ounce. "The reasons why gold might trend higher were already accumulating (before the recent price jump)," he said.
"They included US dollar weakness, strong physical demand, the current short-term liquidity issues, strength in other commodity prices, especially oil, strong coin demand in the US and marked slowdown in mine production growth.
"Y2K and weaknesses, or a sharp fall, in US equities were other candidates that could lend strength to any rally."
Simes says the likelihood of producers selling forward could cap further price rallies in coming months, though they may be deterred from this if the market stays in a state of "backwardation", where spot prices are higher than prices for future sales.
"Longer term, the market deficits will absorb sizable amounts of above-ground stocks," he said. "Given where costs of production are, a price settling above $US300 an ounce and noticeably above this level if the US dollar is weak would appear warranted."
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