[A-List] Re: What Is Making Gold Move Up? And How Far?

[Henry C.K. Liu]

The historical high for gold is around $850 per ounce on January 21, 1980.  We
are a long way from that since 1974, when President Ford restored Americans'
right to hold gold bullion. Those who bought gold or went long on gold in 1980
have all gone down the drain. I personally knew a few of them.

Gold Forward Rate Agreement (GOFRA) is a hedging instrument used by producers
who, having drawn down gold loans , can lock in forward gold interest rate
exposure. The GOFRA hedges against the combined effect of moves in both US
dollar and gold interest rates with settlement in dollars.

The GOLFRA (Gold Lease Forward Rate Agreement) restricts itself to gold interest
rates with settlement in gold. The increased activity of the central banks in
lending gold to the market means that they, too, have exposure to gold rate
volatility and the GODFRA (Gold Deposit Forward Rate Agreement) is tailored to
their particular activities.

Since July 1989, twelve market-makers have contributed to the GOFO page on
Reuters their rates for lending gold (against US dollars) and at 10 am a mean is
calculated automatically giving the market, in effect, a gold LIBOR (London
Interbank Offered Rate).

In 1997 a second page GOFO was added providing logical data, which allows the
user to apply the rates to other applications, such as spreadsheets and charts.
Reuters LBMA07 gives a full list of contributor codes.

Reuter Monitor Dealing Service (RDS) is a communications system established by
Reuters and available to users on subscription. RDS is used increasingly by
professional traders in gold, especially by banks who also trade foreign
exchange through this medium.

Central banks choose to lend gold when they could have sold it for dollars
because they would have gotten more dollars for their gold, and earned the
dollar interest rate -- Gold lease rate differential.  Central Banks chose to
lease out their gold in preference to selling it for the following reasons:  1.
CBs believe that they should continue to back their currency with a significant
quantity of gold. They know that gold is the ultimate store of value, in case
dollar hegeminy collapses.  2.The duty of the CBs is to regulate the financial
markets - and not to make profit in sale-purchase of gold and/or other precious
metals.  3.CBs leased out their Gold not because they wanted to earn the lease
money, but to provide liquidity to the markets.

The purpose of lending was to prevent a squeeze due to short-term increase in
demand and/or cornering of the market by big speculators.

The continuity with which CBs lent Gold to the market at low lease rates capped
the price of gold, which is the policy goal of all CBs, to keep the value of
their respective currencies.  When gold price rises in dollars terms, all
currencies depreciates against commodity prices regardless of their exchange
rate to dollars.  Lower prices resulted in higher physical demand and lower
mining output. Demand-supply gap continued to widen and the CBs continued to
fill this gap with easy lending. The bullion banks, gold producers and others
borrowed gold from the CBs and sold it in the cash market for dollars. Though
the CBs continue to hold the title to their gold, the physical gold will not
come back to them because of continuing leasing.

In addition to the already booked interest rate -- lease rate differential, the
borrowers of gold are sitting over huge mark to market profits as the price of
gold was at 20 year lows. There is only one problem, a very big problem -- if
the Central banks want their Gold back, then where will this gold come from? For
these Gold loans to be settled, either the future mining should exceed future
demand and/or the CBs  must sell their Gold holdings. If the CBs were to sell
their Gold now, then what explanation do they have for leasing out their Gold -
when  they could have sold it and realized a much higher price?

For mining production to exceed demand, the price of Gold must go up
significantly. If the price of gold does go up significantly, then some big
bullion banks may go bankrupt. One big failure would result in chain of
defaults. It appears that some CBs now realize this and, therefore, are planning
to sell their Gold reserves just to bail out some market players who are short.
It is possible that the Bank of England made the controversial decision to sell
their Gold reserves in order to protect some bullion banks. It is also possible
that for the same reason some other CBs may be ready to sell their gold
reserves, whenever the price of Gold starts shooting upwards.

It is the policy duty of CBs to correct any imbalances in the economy. Their
actions in the gold market during the last several years have created an
explosive imbalance. Demand - supply gap was widening as the price was falling.
It is possible that at some point in the not too distant future, or now, all the
metal available for lease and/or sale will be gobbled up by consumers. At that
point will begin the mother of all squeezes - and then not even the G-7 would be
able to bail out any bank and/or trader short. The Fed has recently reminded us
that it  can print currency and/or manipulate interest rates, but to bail out
somebody short in gold they will need gold, which the Fed cannot print.

The biggest proof that the CBs have got it all wrong is that they are being
forced to sell Gold at 20 year lows and that too, at a time when the physical
demand is far in excess of the current mining.  Chinese demand for gold between
now and February 2003 is stagerring.

A lot of analysts feel that gold has lost its value as a reserve asset. They
know that the sentiment among the gold investors has been bearish. They believe
that sooner or later the masses are going to stop buying gold and gold jewelry.
They are increasing looking wrong headed.

In one fell swoop fifteen European central banks have effectively transformed
the fortunes of
gold and, potentially, the way the gold market functions.  On September 26, the
European Central Bank (ECB) and the central banks of Austria, Belgium, Finland,
France,
Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Sweden,
Switzerland
and England announced the following: "In the interest of clarifying their
intentions with respect
to their gold holdings, the above institutions make the following statement:

"1. Gold will remain an important element of global monetary reserves.

"2. The above institutions will not enter the market as seller, with the
exception of already decided
sales.

"3. The gold sales already decided will be achieved through a concerted
programme of sales over the
next five years. Annual sales will not exceed approximately 400 t and total
sales over this period
will not exceed 2,000 tonnes.

"4. The signatories to this agreement have agreed not to expand their gold
leasing and their use of
gold futures and options over this period.

This agreement will be reviewed after five years."

After issuing the statement the president of the ECB, Wim Duisenberg, indicated
that apart from
the 15 signatories to the agreement, the US Federal Reserve had indicated that
it will not
change its oft- stated stance on gold sales.

The impact of this statement was immediate. As traders returned to their desks
the Monday after, the
gold price exploded, breaching resistance level after resistance level. After
closing on Friday at
US$268.50/oz, the price raced upwards to touch an intra-day high of US$327.30/oz
in New York
on Tuesday, its highest level for almost two years. Profit taking forced the
price back somewhat,
but it has since regained its upward momentum aided by a statement from the Bank
of Japan
that it too had no plans to sell gold from its monetary reserves.

Although the removal of uncertainty over outright sales has undoubtedly provided
the
launch-pad for gold's rally, it has been sustained by the impact of point four
of the joint
statement. By agreeing not to expand their activities in gold leasing, and gold
futures and
options over the next five years, the signatories to the agreement have removed
the obstacle
that has capped many of gold's previous rallies- producer forward selling. By
reducing central
bank lending, miners and speculators can no longer rely on forward prices being
in contango,
and in the short term at least this will have a dramatic impact on the way these
three parts of
the gold market operate.

The effect of this reduced liquidity can already be seen in gold lease rates.
According to Mining
Journal's Precious Metals Monthly Monitor, the one month lease rate averaged
0.68% in
January. Since then, the rate has steadily risen and in September averaged
3.92%. Since the central bank's announcement, lease rates have reached almost
10% which, with the London Inter-Bank Lending Rate at a little over 5%, means
that gold is more expensive to borrow than cash and is effectively in
backwardation.

The implications of this new environment are serious. Producers that have
protected themselves
with hedges based on rolling lease-rate contracts are now in a dangerous
situation. If they
cannot borrow gold to roll contracts forward, they will have to deliver gold
that they have
produced at the contract price or purchase gold on the spot market at the
prevailing price to
meet their obligations.

Investment funds are also in a different environment. In the past, they have
taken advantage of
the negative sentiment in the gold market through gold-carry trades - borrowing
gold at what
until recently had been low lease rates, selling it on the spot market,
investing the proceeds
then buying back gold on the spot marking or rolling the contract forward. The
inability to roll
forward such positions has fuelled much of the recent price rise.

How long this situation lasts will depend on central banks that are not involved
in the
agreement. According to Andy Smith, metals analysist with Mitsui in London, such
banks already
account for up to 75% of all lending. In the medium to long term, they are
likely to take
advantage of the new environment and increase their lending which, says Mr
Smith, will
eventually reduce borrowing costs of gold. But he warns that this will take a
while and lease
rates will be less predictable.

At its peak, the Fed held over 12,700 tonnes (around 409 million oz), more than
one-third of global official stocks, on behalf of 73 nations or international
organisations, such as the IMF.

The Fed's famous 'gold window' closed in 1971 when the United States no longer
sold gold for dollars at a fixed price, so the stockpile ceased to grow. The
bank's reputation as an impartial safe haven was also shaken in1979 when the US
government froze 50 tonnes (1.6 million oz) of Iran's gold at the Fed during the
Tehran embassy hostage crisis.  The fate of Saudi gold is not solid.

During the 1990s, almost 2,600 tonnes (83 million oz) of gold was moved out of
the Fed as many other central banks mobilized their reserves for leasing, swaps
or sale. In 2000 and 2001 there was a further outflow of 355 tonnes (11.4
million oz) and 259 tonnes (8.3 million oz) respectively, reducing stocks of
"earmarked gold" at the Fed to 6,703 tonnes (215.5 million oz) at the end of
December 2001. Much of the decline in stocks over the past dozen years has
represented gold being moved to London for leasing; indeed, gold flows out of
the Fed have in the past often followed hard on rises in the gold leasing rate,
as central banks shifted more gold to benefit from higher rates. (Conversely,
when leasing rates have been very low - the situation during much of the second
half of 2001 - it has not paid foreign central banks to move stocks out of New
York.) The improvement in security following the collapse of the Soviet Union
has also encouraged some European countries to repatriate their gold
holdings. The ongoing decline in Fed stocks means it may eventually lose the
cachet of having the world's largest stock in its vaults, because US reserves in
Fort Knox alone are around 4,600 tonnes.
The Bank of England has always maintained an active, if modest, trading role in
gold, both for the management of UK reserves and to match its sales of
Sovereigns, of which it remains the official distributor. Between July 1999 and
March 2002 the Bank of England acted as an agent for the UK Treasury, which
initially planned to dispose of 415 tonnes (13.34 million oz) or 58% of the
country's gold reserves (the sales target was subsequently revised downwards).
The Bank of England held seventeen auctions, initially for 25 tonne (0.80
million oz) lots, the sales quantity per auction later being lowered to the 20
tonne (0.64 million oz) level. The final auction took place on 5th March 2002
and brought the total amount of metal sold on behalf of the UK Treasury to a
little over 400 tonnes (12.86 million oz). Following the conclusion of the sales
programme the UK was left with a stock of 315 tonnes (10.13 million oz),
slightly more than originally forecast.

The sale of UK gold reserves generated a fair amount of controversy. The
National Audit Office (NAO) was instructed to prepare a report into the method
and execution of the gold sales. This report came to the broad conclusion in
January 2001 that, in the designing and implementing of the sales programme, the
objective of selling 'in a transparent and fair manner while achieving value for
money' had been successful. However, the NAO report suggested that the Treasury
review the possibility of adapting the auction design or even using the London
gold fixing as an alternative or additional means of selling gold. This
conclusion may well explain the subsequent decision (referred to above) to
reduce the amount of gold offered at each auction.

The Bank of England has played an additional role in the gold market as a
recognised International Monetary Fund (IMF) depository. It holds gold on behalf
of many nations and often acts on their behalf in gold transactions. Because of
its unique experience with gold among central banks, it has done much to develop
the leasing and swap market, which is centred primarily on London. The Bank of
England also lends out to the market a small percentage of the UK's own gold
reserves.

Many central banks have come to rely on the Bank of England in introducing them
to these gold market activities, which has resulted in even more foreign gold
reserves moved to the bank's vaults. And from the first steps of the lending
market, they have often entrusted the bank to execute other operations, whether
in derivatives or outright sales. Thus the Bank of  England has been at the core
of widening central bank involvement in gold.

The leasing of gold became an integral and increasingly important part of the
more sophisticated gold market of the 1990s, especially in the provision of
liquidity to facilitate forward and derivative transactions.

Central banks are the predominant source of leased gold. According to GFMS, by
the end of 2001 over 80 of them were providing through their deposits and swaps
more than 4,650 tonnes (150 million oz) to the market, earning a return on an
otherwise sterile asset. By comparison, under 500 tonnes (16 million oz) of
leased gold is available from non-official sources. Central banks, in short,
provide the market's liquidity.

Moreover, the mobilizing of their gold for leasing has brought many central
banks back into the market for the first time in three decades, and given them
an insight into what else it can offer in terms of writing options on their
reserves or outright sales. Central banks have got a taste for earning a return
on gold through their leasing, making them eager to see how else they can
profit.

Central bank gold has provided liquidity for many gold market operations,
whether gold loans or forward and option books by mining companies, masking gold
sales by central banks until the moment of delivery, underwriting speculators'
short positions, underpinning bullion dealers' consignment stocks, or simply
providing jewellery manufacturers with working metal. However, producer hedging
has provided up to two-thirds of the liquidity requirements much of the time,
except when a large central bank sale was underway calling for borrowed metal to
conceal sales in published gold stocks until it was all over.

Initially, leasing often came from central banks in developing countries, eager
for some return on gold but, increasingly, major European central banks,
including the Austrian, Belgian, Netherlands, German and UK central banks, came
to participate. Even the Swiss National Bank joined in. GFMS estimate that
between 1995 and 1999 over 60% of new leasing came from European central banks.

Thus the Washington Agreement of September 1999 in which 15 European central
banks announced, among other things, that they would not increase their leasing,
had an immense impact on the gold lease rate, which momentarily went to 10%
Clear evidence of how the gold market has come to live on leased central bank
gold. Although less than 15% of all world official gold holdings are currently
leased, the Washington Agreement, combined with the reluctance of other large
holders such as the United States to enter the leasing market has put a question
mark against the assumption that liquidity from the central banks will always be
readily available to the market. On the other hand, many central banks have
shown a reluctance to close out swaps and reduce their existing deposits. This
has been the case in spite of a slump in the level of gold leasing rates, itself
mainly caused by a reduction in outstanding producer hedge positions in 2001,
which has continued in the first half of 2002.
An open position resulting from a sale is known as a short position. It is
created because the trader or speculator believes the price will fall and he/she
can cover later at a lower price and make a profit. For
example, he/she may sell gold at $300 an ounce, hoping the price will fall to
$280 at which level he/she can buy to cover the position.

The establishing of short positions can depress the price because it implies
steady selling. But going short can also cause problems both for the individual
and the market if, instead, the price rises. If
substantial short positions have been built up (and there are examples of
speculators being short between 1 and 10 million oz) a sudden increase in price
may force them to cover. Such a run for cover, known as a "short squeeze" or
"short covering" only accelerates the rise.

In options the grantor or writer of a call is also potentially short because
he/she may be called upon to deliver gold and therefore will normally delta
hedge the position.

The London Bullion Market Association (LBMA) was established in 1987 to
represent the interests of the participants in the wholesale bullion market.

The LBMA comprises:  10 market making members who quote prices for buying and
selling gold (and silver) throughout each working day from 8.00 am until 5.00 pm
(See also: LBMA Market Makers) 44 ordinary members, covering a wide range of
banks, trading companies, assayers and refiners, mints and security companies 24
international associates; a category of membership that was introduced during
2000.

The LBMA works with: The Financial Services Authority (FSA), which supervises
the major market participants, who operate under the London Code of Conduct HM
Customs & Excise on tax policy, such as Value Added Tax

The LBMA maintains: The London Good Delivery List for gold and silver through
its Physical Committee

The LBMA organises: An annual Precious Metals conference. The inaugural event
took place in Dubai in February 2000, a second LBMA conference was held in
Istanbul in May 2001, with a third one following in June 2002 in San Francisco.
A fourth Precious Metals conference is planned to take place in Shanghai in
2003.

London bullion market clearing turnover:
Annual daily averages
Ounces transferred (millions)       Number of transfers
 1997             36.8                        1,285
 1998             31.2                        1,188
 1999             31.0                        1,007
 2000             23.2                           793
 2001             21.5                           802

Monthly daily averages
Ounces transferred (millions)    Number of transfers
2002
January         16.3                       662
February       20.1                       822
March           17.4                       714
April              19.2                       739
May               19.3                       744
June               21.0                        842
July                17.3                        744
August           17.1                        718
September      16.4                       728
October          17.5                        659

It is very unlikely we will see $500 gold in the foreseeable future, let alone
another all time high.

Henry C.K. Liu


Jas Jain wrote:

> The move up in the price of gold, for the past year or so, has been
> primarily driven by fundamentals. In order of decreasing importance they
> are:
>
> 1. Very low short-term rates
>
> When the risk-free returns on short-term instruments were 5-6%, the cost of
> carrying gold was relatively high. With rates now close to 1% there is
> little reason to risk paper money.
>
> 2. Falling Dollar
>
> The price of gold has been lot more stable in terms of Swiss franc and the
> Euro. As dollar has been falling, it automatically has given boost to gold.
>
> 3. Risk Inherent in Paper Currencies
>
> This would become far more important as the world economies slide into
> depression. Currently, a small risk premium has come into play in people
> wanting to put their savings in gold.
>
> These fundamental forces alone should take the gold price to $500 an ounce
> over the next two years. However, once speculators get the whiff there is no
> telling how far the price of gold could go.
>
> To gauge how far speculation could take the price of an ounce of gold, we
> resort to numerology, or relative prices of assets under speculative fervor.
> And what better guide than NASTYQ!, aka NASDAQ, market. We surmise that an
> ounce of gold is worth at least as much as a share of NASTYQ! Since NASTYQ!
> peaked at 5,148, we project that $5,148 for an ounce of gold is not only not
> farfetched but a realistic target. Conversely, the low price of gold in
> recent years, around $260, is a good target for NASTYQ!
>
> Gold is real money. Paper money is based on faith only. Who do you have
> faith in? How many governments have fallen and how many paper currencies
> have disappeared for good?? You need to have a very long time horizon to
> answer these questions properly.
>
> Jas
>
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