R.I.P. Gold Carry Trade

Adam Hamilton    June 15, 2001    4357 Words


Of all the culprits responsible for the bombing of the gold price over the last seven years, the gold carry trade maintains its prominence as one of the primary gold-suppressive developments.  The gold carry trade has had the effect of creating a ready outlet for central bankers desiring to lease their gold which enabled the flooding of the physical gold market with marginal gold supply, driving down gold prices. 


The gold carry trade proved extremely valuable for both the gold creditors and the gold debtors.  The gold creditors were able to artificially protect their fragile and ever-inflating fiat currencies by moving thousands of tonnes of gold into the market to meet demand and keep gold prices locked in their earth-bound trajectory.  The gold debtors were able to borrow gold at trivial interest rates hovering around 1% for many years, sell the gold in the open market, and use the proceeds to invest in virtually risk-free assets returning 500%+ of their cost of capital. 


The gold carry trade was the ultimate insiders’ deal, providing legendary profits to those elite banks well-connected enough to finagle a piece of the action.  Unfortunately for the legions of gold bears, the gold carry trade seems to be unraveling due to recent market developments.  In this essay we will briefly examine the gold carry trade, describe its allure to participants, and detail two macro-strategic market developments that may be hammering the nails in the gold carry coffin for the foreseeable future.


Although the gold carry trade can be complex, it is easy to understand if simplified to distill its flavor and understand the rational behind it. 


The words “carry trade” describe a specific type of speculative play that is not uncommon in our highly interconnected global markets.  Speculators engage in a carry trade to attempt to arbitrage differences in rates of return created by vagaries of international trade and finance.  In order to engage in this type of activity, arbitrageurs look for large differentials in the costs of capital in one area versus the returns they can reap by deploying capital in another area.  By borrowing cheap money and investing it in higher-yielding speculations, the “spread”, or the differential between the cost of capital and the rate of return realized by deploying capital, can be realized as profits.


As an example, imagine you had the opportunity to borrow US$1m.  Even better, the folks from which you can borrow the million bucks decided to offer you a sweetheart interest rate on the deal.  They told you they would only charge you 1% interest.  At the end of a year, you would have to pay the $1m principal back to your creditor plus $10,000 in interest.  Would you take the loan?  It probably depends on how you could deploy the proceeds.


One option would be to take the $1m loan at the trivial 1% cost, and invest the entire $1m in US Treasury bills.  US T-bills are considered “risk-free” investments throughout most of the international financial community.  If held to maturity, they guarantee a certain nominal rate of return and they will not be defaulted upon unless the US government fails and loses its power to print money and tax its subjects.  So, knowing this, you go take the $1m loan and immediately use the cash to buy $1m of US Treasury bills with a maturity of one year, exactly matching the loan.  Imagine this takes place a couple years ago, so the yield on your Treasuries is 6%.


Congratulations, as you have just successfully entered into a carry trade!  You borrowed $1m at 1%, and you invested the proceeds in what is widely considered the safest short-term investment in the world, that was paying 6%.  After one year, your T-bills will have earned you 6% of $1m, or $60,000 in interest, plus you would receive your $1m in principal back.  So, at the end of the year, you collect your cash from the US government, pay back your friends the $1m loan plus the 1% interest of $10,000, and you can pocket a hefty profit of 5% of $1m, $50,000.  $50k for doing absolutely nothing?!?  Not bad work if you can get it, eh?


Obviously, if it were this easy, everyone would quit their jobs, go borrow vast amounts of money, and sit at home earning huge profits in various carry trades.  The primary problem is finding a really cheap source of capital to secure the seed money to launch the carry.  For the average American, there is virtually no way to find a low enough cost of capital.  If you walked into your neighborhood bank and asked for a loan at 1%, your banker would burst out laughing at you.  Maybe you could get a loan at the prime rate plus a couple percent if you were a really creditworthy customer, but that would be much higher than the US Treasury rates.


If you maxed your credit cards as is all the rage these days, you might be able to get capital with a cost of 18%-20%, a punitive rate that would have been considered criminal usury in the not too distant past.  If you give the bankers title to your house for 30 years, you might be able to secure capital at 7% to 8% if you are lucky.  The bottom line is it is virtually impossible for a normal person to obtain capital cheap enough to engage in a carry trade.


Another critical aspect of a carry trade arises since one borrows large amounts of money to do it.  The destination for the carried capital HAS to be safe.  For instance, if you take a $100,000 dollar cash advance on your credit card at 20%, it is probably not prudent to convert it into rubles and buy Russian junk bonds and hold them for a year because they may yield 45% if the underlying Russian companies (and currency) survive.  To engage in a carry you need a target for deploying your borrowed funds that is very safe.  This is typically only original short-term debt issued by a handful of stable first-world governments around the world.  If the target for carried capital deployment is not safe, then you risk bankruptcy when the money is lost and you cannot pay back your original debt.


So, if you can find a cheap enough cost of capital, a safe enough destination, and you have the credit to borrow large amounts of money, you too could make enormous profits in carry trades.  The notorious gold carry trade is based on the exact same idea.  Elite money-center bullion banks were given sweetheart opportunities to borrow central bank physical gold at 1%, sell it in the open market, and immediately invest the proceeds in higher yielding “safe” investments and reap vast profits.


Like everything else regarding the ancient metal of kings, a substantial amount of background information is needed to understand the gold carry market.  The rational of the central banks for leasing gold at 1% is no exception.


In a superficial nutshell, central banks are private or government-sanctioned banks that create fiat currencies, totally paper backed by NOTHING except the good faith and credit of a nation.  These fiat currencies are used for trade and commerce in their respective countries.  Since central bankers are not elected, unaccountable to the people, invariably socialistic and anti-free market, and undisciplined, history teaches us they ALWAYS get into trouble by expanding money supplies at rates far faster than economic growth. 


ANY study of the history of central banks inevitably comes to this conclusion.  In human financial history, central banks always ultimately fail because they expand their paper currencies too fast (called inflation) which ends up ultimately destroying them.  Attempting to control the money supply and price of money in a smoke-filled room of central bankers is as anti-free market as the California socialist Democrats trying to set energy prices by regulatory fiat.  Whenever politicians or central bankers muck around with free markets, pain and misery are always the ultimate bitter fruit of their labors.


In the early 1990s, central banks around the world were facing serious problems.  Central bankers, as usual, had printed far more paper fiat money than their economies needed.  As more paper dollars, or pounds, or francs, or marks, etcetera chased relatively fewer goods and services, prices began to rise in the central bankers’ respective economies.  This price inflation, caused solely by central bank promiscuity with fiat currency supplies, would ultimately have devastating consequences on economies and markets as it has all throughout history.


Through six millennia of human commerce, gold has always been the undisputed ultimate store and arbiter of value.  Empires rose and fell, governments came and went, countries grew and imploded, currencies lost their values as they were debased, but the value of gold has held constant through all the miserable human experiments with currency debasement.  There is no fundamental difference between Greenspan now growing the US money supply at unbelievably aggressive rates and the ancient Romans debasing their currency by diluting coins with base metals.  The more things change, the more they stay the same.  Or, as King Solomon wisely opined, “There is nothing new under the sun.”


Gold is the ultimate barometer of currency debasement (inflation), so investors all over the world watch it like hawks for signs a currency is in trouble.  If the gold price denominated in a particular currency rises dramatically, chances are dangerous waters lie dead ahead for that currency and the economy it represents.  Because of this critical “watchman” role, gold is the mortal nemesis of central bankers rapidly inflating fiat currencies.


Back to the 1990s, central bankers realized they were in trouble if the gold price rose dramatically and signaled its ancient and unappealable veto on their undisciplined fiat currency growth.  Some among their ranks realized that they could temporarily short-circuit the gold barometer by flooding the market with physical gold, which would offset demand and drive down gold prices.  Collectively, central banks around the world had possession of 25% of all the gold ever mined in world history, over 30,000 tonnes, so they had a ready supply to draw from. 


The main problem was the international markets would likely frown on a particular central bank liquidating its gold reserves, as that would imply there was nothing of value backing its fiat currency.  The clever solution was for central bankers to sell gold into the market without selling it on their books.  Looking at their assets, investors around the world would still see gold bullion, but the gold bullion would not actually have to be in the vaults supporting these assets.  The central bankers resorted to the creative accounting fiction of gold leasing to dump their gold onto the world markets while making it look like they still owned gold, crucial for international confidence in their respective fiat currencies.


In a gold lease transaction, a central bank loans gold out to a high-quality borrower, usually called a “bullion bank”.  The central bank physically delivers real physical gold from its vaults to the bullion bank, creating a gold loan.  The central bank then gets to keep the gold on its books as an asset, because the loan is contractually supposed to be paid back in the future, and fee simple title never technically changes on the fungible gold.  The end result is the central banks can dump gold and depress the gold price while at the same time maintaining the fiction that the gold is on hand in their vaults to back their fiat currency experiments.


Of course, offering gold loans does little good if no one wants to borrow gold!  The other half of the gold carry trade fell into place because of below-market incentives the central banks offered to favored elite private banks.


History has clearly shown that central bankers usually aren’t the sharpest tools in the shed.  In order to move the gold out of their vaults to flood the world market and short-circuit the gold barometer warning of currency debasement, they resorted to the old used-car salesman tactic of deep discounts.  They offered gold loans at interest rates of 1% to elite money-center bullion banks.  A 1% cost of capital is a tremendous deal, and the central banks attracted the bullion banks to the artificially low interest rate like flies to a rotting carcass.


The bullion banks could borrow physical gold from central banks at 1%, immediately sell it in the physical gold market, and invest the cash in high yielding high quality US Treasury debt.  The gold carry trade was born.  A willing lender, the central banks, found a willing borrower, the bullion banks, and thousands and thousands of tonnes of central bank gold hemorrhaged from central bank coffers and flooded the markets worldwide in the 1990s.


The only catch was the bullion banks were expected to repay their gold debts with actual physical gold, not depreciating Federal Reserve Notes in the process of debasement.  When gold loans came due, physical gold would have to be purchased in the open market or seduced away from gold mining companies through forward sales in order to pay back the gold loans.


In a declining gold price environment, the gold carry trade worked beautifully for all involved.  Central banks were able to covertly move a very large quantity of gold onto the world markets, artificially overwhelming demand and temporarily keeping the gold price in check.  Through that action, they delayed the day of reckoning when gold announces to the world the rotten cores of their debased paper currency pyramids.  Bullion banks, on the other hand, obtained an elite sweetheart deal that gave them capital to invest at a rate far below normal market interest rates, often hovering around 1%.  They made tremendous profits with very little risk to themselves as long as the gold price was trending southward.


Estimates of the total amount of gold leased run from 5,000 tonnes from the anti-gold partisans to 16,000 tonnes from pro-gold factions.  After all of our research, we certainly believe that number is on the high end of the scale.  If, for example, 15,000 tonnes of central bank gold has been flooding the global gold market in the last decade, that would explain much of the drop in the gold price.  This is the equivalent of six YEARS worth of TOTAL world gold production being dumped on the open gold markets.  Natural economics laws dictate that when a wave of artificial marginal supply temporarily overwhelms natural demand, prices plummet.


Two incredible recent market developments have put the lucrative gold carry trade in mortal danger, however, which is music to the ears of international gold investors. 


First, Alan Greenspan chose to bail out NASDAQ speculators who were whining for a hit from the monetary needle like junkies after their feathers were singed in the tech bubble burst last year.  Greenspan launched the most aggressive easing cycle in the sordid history of the private United States Federal Reserve bank, slashing short-term interest rates by 250 basis points in less than five months while at the same time running the printing presses full throttle to flood the US economy with ever more fiat dollars. 


Why “sordid” Fed history, you wonder?  Charged with maintaining the value of the dollar, our currency has been debased so much by the Fed that it has lost over 95% of its value since the Federal Reserve Act was rammed through a lame-duck holiday-thinned session of Congress by subterfuge in late 1913.  Talk to your parents or grandparents about how much $1 USED to be worth, and realize that the reason $1 is worth practically nothing today is almost exclusively because of the Federal Reserve inflating the money supply and debasing the dollar since 1913.  With $20 today worth less in real terms than a single dollar in 1912 before the private Federal Reserve started printing money with reckless abandon, there is zero doubt the Federal Reserve has been an unmitigated disaster for the United States of America and failed its mission miserably.


In Greenspan’s current haste to prop up the drastically overvalued US equity markets and save the leveraged-to-the-hilt US banking system, his latest frantic display muscled the yield curve around like a logging chain welded to the nose ring of a bull.  As the Fed gutted its Fed Funds rate, short-term US Treasury rates of return for bond investors plummeted like a car driving off a cliff.


With short-term US Treasury rates crashing to seven year lows, and more frantic interest rate cuts likely ahead, the destination end of the gold carry trade appears to have been dealt a mortal blow.  The following graphs illustrate this point.


Both graphs show the one year gold lease rate, which is the cost of borrowing central bank gold for elite bullion banks, as the blue line.  The one year US Treasury bill yield is shown as the red line.  The spread, or the difference obtained by subtracting the gold lease rate (cost of capital in the gold carry trade) from the US T-bill yield (a typical destination of gold carry capital), is shown as a dark green line.  It represents the profit to be made by arbitraging the gold carry trade to capitalize on rate of return differentials.  The area under the dark green spread line is shaded in light green and visually shows the magnitude of gold carry profits as gold lease rates and the T-bill yields change.  Gold is graphed as a yellow line slaved to the right axis to have a point of reference for the carnage in the physical gold market while the gold carry trade thrived.


Our first graph shows over seven years beginning in 1994, when Alan Greenspan and New York Fed President William McDonough quietly took seats on the secretive Bank for International Settlements, contrary to the intentions of the United States of America when the BIS was created.  Late 1994 is also around the time where the Gold Anti-Trust Action Committee (www.gata.org) reports all kinds of strange trading activities commencing in the world gold markets defying free markets and logic.  Reg Howe, in his landmark lawsuit against the BIS and some elite bullion banks, alleges 1995 is when gold market suppression campaigns began in earnest.  For these reasons and many more, 1994 is a great place to start.


All interest rates in this graph are 20 trading day moving averages, as they smooth some of the volatility of the raw daily data and make trends easier to discern.



Other than during the important Washington Agreement gold lease rate and gold price spike of late 1999, the gold carry trade has been extremely profitable for those elite banks deemed privileged enough to partake.  The dashed white line represents the average spread over this period, which was 3.6%, very healthy.  This compares to an average gold lease rate of 1.8% over the same period.  The average one year US Treasury bill yield was almost 5.5%.  The gold carry profits were a whopping 200% of the cost of capital!  Looking at it from another perspective, for every $1 in gold interest costs, the bullion banks could hope for $2 in spread profits.  Great opportunity if you can swing it!


Also, it is important to remember that the gold carry trade could continue to grow as long as central banks had gold to dump and were willing to dump it.  Since the bullion bank borrowers were all large money-center banks with sterling credit, they could commit billions or tens of billions to the gold carry.  A 3.6% spread profit on billions and billions of dollars is a very attractive cashflow stream!


Our next graph uses the same conventions as the previous one, except the time horizon is zoomed in to only the last two and a half years and all the interest rate data in this graph is smoothed with a FIVE day moving average, in contrast to our 20 day moving average in the previous graph.



Other than the Washington Agreement of late 1999, where European central bankers had the blinding burst of insight that central bank gold sales and leasing were destroying the gold market, the gold carry has been very profitable for the last couple years.  Note the huge spike in gold lease rates after the Washington Agreement that paralleled a monster rally in the price of gold.  Soon, however, gold lease rates crashed and the gold carry once again proved to be a very lucrative elite game in 2000.


For the period in the graph, the gold lease rate averaged 1.9%, the T-bill yield weighed in at 5.4%, and the gold carry profit spread averaged 3.5%.  Over the whole period of time, the averages were very close to what we observed in our first graph above.


BUT, all “good” things must come to an end, and Commissar Greenspan and his Central Planning Committee on interest rates decided that they must try to protect the monstrous equity bubble they had spawned from the unforgiving forces of reality.  The US Fed began slashing US interest rates even before New Year’s hangovers were slept off this year, and have been dropping them in a panic ever since.  The panic is very evident and apparent as the Fed has acted multiple times this year BETWEEN scheduled FOMC meetings with emergency 50 basis point rate cuts.  Since the Fed itself claims it takes six to nine months for interest rate changes to fully hit the economy, there is no reason to do inter-meeting cuts other than to avert an equity or banking panic or to play warm and fuzzy mind games with the bleeding equity bulls.


Greenspan’s largesse is marked with the double arrow hydra above.  Note that US Treasury yields begin to plunge rapidly, first on the expectation of rate cuts and then on the actual deeds themselves.  Gold carry profits began to implode with the plummeting short-term US interest rates.


Then, to make matters even worse for the gold carry participants, gold lease rates began trending up earlier this year, indicating extreme uneasiness over physical tightness in the gold market.  Because gold market participants around the world are finding less physical gold available to meet demand, gold lease rates are trending up to reflect the higher risk of borrowing gold.  Provocatively, the last time lease rates exceeded 2% regularly was right before the huge Washington Agreement gold rally of 1999.


So, in the great tradition of the classical military “pincer” maneuver, where an army splits up and simultaneously attacks two opposing flanks of an enemy, the gold carry players are getting squeezed on both ends of their game.  Their cost to borrow gold for one year was climbing to around 2.5% in late May.  At the same time, their profit spread was being eviscerated by Greenspan mucking around with the short end of the US yield curve.  By the end of May the spread had collapsed to a mere 1.3%, slightly more than a third of its average for the last seven years.


With Greenspan totally expected to continue to slash rates later this month and the US equity markets ready to collapse in a heartbeat if any noises of raising rates in the near future are uttered, the gold carry profits are likely to shrink substantially further in 2001.


Above, we mentioned TWO reasons why the gold carry trade is in serious trouble.


Second, in addition to the Greenspan effect on short-term Treasury yields, with the physical gold market very tight and daily volatility and gold lease rates ballooning dramatically in recent months, there is an ever-rising probability that gold’s twenty plus year bear trend is embarking on or nearing a major reversal.  While the gold carry trade was profitable when gold prices were falling, it is utterly suicidal while gold prices are rising.  If bullion banks begin to detect an imminent gold rally, they will not want to borrow gold with a ten-foot pole.


For example, if a bullion bank borrows gold today at $275, but one year from now it expects gold to be $350 or higher, the loss from borrowing gold due to the rise in the gold price will DWARF any conceivable arbitrage carry spread.  It will be forced to buy expensive gold in the open market to pay back its cheap gold loan.  If expectations of a rising gold price take hold, even the anti-gold bullion banks will avoid the central banks hocking gold loans on the street corners like the plague.


Remember, unless you are an unfortunate capitalist forced by Democratic socialists to sell power below market prices in California, there are two consenting parties to every mutually beneficial free-market transaction.  Central banks can offer all the gold they have left to lend, but if no one wants to borrow the gold due to the ever-increasing potential for a major gold rally, then nothing happens.  The Japanese government has created an environment offering capital at almost zero percent interest for many years, yet it didn’t do a bit of good because no one wanted to borrow.  Credit is meaningless without a willing borrower.


With plummeting short-term US interest rates, rising gold market pressure as evidenced by the high gold lease rates and volatility, and an increasing expectation of a serious gold rally, it is looking more and more like the gold carry trade is drawing its last gasping breaths for the foreseeable future.  Although gold bears will lament its untimely demise, the gold bulls will celebrate its death with glee. 


Without the incentives for the gold carry and the actual trade itself, it will be much more difficult for central banks to dump their gold onto the market.  If they cannot lend the remaining gold, they will be forced to sell it outright if they want to keep shedding their dwindling hoards.  As that path is fraught with peril politically and has the potential for eviscerating fiat currencies on the global ForEx markets, it is a dangerous trail central banks will likely refuse to travel down.


The quiet, anti-climactic death of the gold carry trade is a tremendously bullish development for gold investors around the world.


Adam Hamilton, CPA     June 15, 2001     Subscribe