People ignores the mechanics of gold markets and can easily be misled into mistakes. Central banks are sitting on huge supplies of gold that earn them no interest and cost them money just to store securely. To earn a little revenue on these static assets, they loan their gold to banks, called bullion banks, at a low interest rate on the order of 1%.
The banks turn around and sell the gold in the market, typically in the London bullion market, and invest the proceeds in a higher-paying asset, such as long-term Treasury bonds. If bonds pay 4.6% then the banks earn an easy 3.6%.
The problem is that if the gold price starts to rise, profits can be wiped out or turned to losses. And in today's market, a falling dollar not only boosts gold prices but it also makes Treasury bonds less attractive to foreign investors. That reduces demand and weakens prices to create a potential double-edged sword for carry traders.
The banks, of course, realize this and hedge their gold sales by buying gold futures. The hedge is not perfect. If central banks call in their gold loans, the banks cannot wait for contract expiration to take delivery on the gold they purchased via their futures contracts. They have to pay back their loans right away and if gold prices are stable, there is no problem for the banks going into the physical market to buy back their gold.
However, if gold starts to rise quickly, the added demand from the banks to buy gold can exacerbate the rally causing what amounts to a mad dash for the metal. The market will respond with steeply higher prices - up to 2000 dollars by end of 2010. But should Central Banks loan out more gold, the price can also crash. One large unknown is how much gold the banks have to loan out. Maybe there is none? Gold cannot be manufactured. If a bad number starts to circulate and people starts to suspect that there is no gold in Fort Knox or wherever it is supposed to be, things may get out of control. The monetary system functions only because people has confidence in it.
2 comments:
In order for this plan to work over the long run, the long term appreciation of gold has to be less than the interest rate. I think this is a fool's bet. Then again so were the billions of "mortgage backed" securities but banks bought those too.
K
If gold started to rise even more steeply, then wouldn't the banks start selling their gold instead of loaning it out?
Also, everyone in the world would start selling their gold jewelry, adding supply to the market. That's the big flaw with gold as a "scarce" commodity: it's indestructible. So there's always plenty of it around if the price gets high enough.
Post a Comment