April 12, 1999 – If you could borrow Dollars at 1% and invest them in another asset (e.g. T-Bills) yielding 4%, would you do it? Of course you would because there is very close to no risk in this transaction. As long as the federal government continues to pay you the 4% interest you are earning on the T-Bill, you can pay the 1% interest you owe on the Dollars you borrowed to fund the T-Bill purchase and still walk away with a 3% profit. Sound too good to be true?
Well, it is too good to be true because who would be stupid enough to lend you the Dollars at 1%? Anyone with the Dollars to lend could invest them in T-Bills directly, earning the 4% T-Bill yield rather than the 1% interest income from the loan to you. But let’s change this equation slightly.
If you could borrow Gold at 1%, which would then be sold into the market in exchange for Dollars, and these Dollars were then invested in T-Bills earning 4%, would you do it? This transaction is not as easy to decide as the previous one because a major element of risk has been introduced. If the rate of exchange between Gold and Dollars were to change, your loss could be considerable from what otherwise may appear to be a simple financial transaction.
For example, assume you borrowed 10,000 ounces of Gold at 1%, and you converted those ounces into Dollars at $280 per ounce. You could then purchase $2.8 million of T-Bills yielding 4%. If in one year, Gold is still at $280, you reverse the transaction, buying Gold from the proceeds of the T-Bill to repay both the Gold loan and the 1% interest due on that loan. You would then walk away with $84,000 profit ($112,000 interest earned on the T-Bill less the $28,000 needed to purchase an additional 100 ounces of Gold to repay interest on the Gold loan). But what if Gold is not at $280 in one year time?
If Gold were to fall $30 in one year to $250, your profit increases. To purchase the 10,100 ounces needed to repay principal and interest on the Gold loan, only $2.525 million is required. Your profit soars to $387,000, more than 4-times the profit if the Gold price had remained unchanged at $280. However, this opportunity also has a risk.
If the Gold price were to rise $30 in one year to $310, you end up with a big loss. To purchase the 10,100 ounces needed to repay principal and interest on the Gold loan, $3.131 million is required, which is $219,000 more than the $2.912 million proceeds from T-Bill principal plus the interest earned thereon for one year.
These examples clearly present the incentive to keep the Gold price low, IF, and I repeat IF, you are borrowing Gold at its low interest rate to fund the purchase of relatively high interest rate assets, hoping to earn the difference in yield without any adverse exchange rate movement. But is anyone borrowing Gold to fund these types of transactions?
I contend that many banks, hedge funds and trading firms are indeed borrowing Gold, which is then sold into the market in exchange for national currencies (principally Dollars, but other national currencies are also used). They then use these national currencies to purchase a variety of non-Gold assets to earn this interest rate differential. What’s my proof they are doing this?
There are several interrelated bits of evidence showing that Gold is being actively borrowed. These include:
1) A number of central banks in recent years have indicated that they are lending Gold to earn the interest that it offers, thereby turning this ‘reserve’ asset into a ‘revenue’ asset. Most recent of these is the Swiss National Bank, which reported that it had loaned 187 tonnes as of December 31, 1998, up from 99 tonnes a year earlier. Prior to 1997 it had no loans outstanding.
2) Gold mining firms have increased their forward sales from near zero twelve years ago to about 4,000 tonnes today (1200 tonnes in Australia, 1100 in North America, 1000 in South Africa, and 700 tonnes everywhere else). This Gold has been loaned almost exclusively from central bank hoards.
3) The Federal Reserve is one of the world’s largest Gold storage sites. The Gold stored there is central bank Gold (the Federal Reserve is not allowed to accept privately owned Gold for storage). The weight of Gold in the Federal Reserve has dropped from 9800 tonnes in December 1991 to 7900 tonnes in December 1998. While some of this Gold may have been withdrawn so that it could be sold, the balance has been withdrawn so that it could be loaned.
I have shown that banks and others willing to borrow Gold have the incentive to act, namely, the opportunity to earn the interest rate differential if the Gold price remains flat, as well as the exchange rate profit if the Gold price falls. Also, I have shown that the central banks are willing to loan Gold, thereby accommodating those who want to borrow the metal. While heretofore Gold has remained primarily within the vaults of the central banks, in recent years Gold has been mobilized.
There is no doubt in my mind therefore, that a huge weight of Gold is being borrowed, and by implication, it is this huge weight of Gold that has pushed the Gold price to an abnormally low level. Never before has Gold’s purchasing power been so low. In other words, Gold at $280 is better value than Gold at $35 in the 1960’s, adjusted for the loss in purchasing power of the Dollar. But can this anomaly of a low Gold price continue?
This game has already gone on longer than I had expected, so I’m probably the last person to rely upon for any predictions. But the valuations of Gold compared to national currencies, but particularly the Dollar, are so absurdly out-of-line (see the Page 3 chart of the Fear Index and the related discussion), that one can only conclude that the end of this game is upon us. If so, Gold is about to reverse course and head higher.