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Hedging The Carry Trade GATA and the Gold Conspiracy The Washington Agreement
Miners are involved in a long term business venture. They spend large sums of money building gold mines, digging out the ore and processing it. Their big risk is that cash flows from the sale of gold will not meet their expectations. This can arise either because they are bad miners, and fail to extract the necessary tonnage out of their mine, or because the price of gold has fallen below the level at which they budgeted when deciding to build the mine.
Miners are generally more confident of their mining capabilities - which they can manage - than the spot price of gold, which they know will be unpredictable. But they can mitigate the risk of falls in the spot gold price by selling gold which they expect to be able to produce before they actually produce it. This is producer hedging.
It can be done in three main ways. In the first gold is borrowed from someone who has a surplus (e.g. a bullion bank), sold at today's price to someone who wants it (a jeweller), and then the gold loan is paid back with new gold from the mine some time later. In the second a straightforward future sale is done - for delivery months or even years ahead. In the third strategy the miner buys a put option which confers the right but not the obligation to sell at a known price sometime in the future.
Buying a put option on gold protects the miner from a falling gold price but still allows him to benefit from the up-side of a booming gold market if one occurs, because the right to sell - as per the option - is abandoned, and the gold produced is sold at a higher price in the spot market. In a rising market Ďputí options have that considerable advantage over futures, but they are a much more expensive hedge than a future if it turns out that the gold price doesnít move much during the period.
Hedging future production against a falling gold price is good sensible business if you fancy mining, rather than speculating on the gold price. Just about any miner who in 1990 took a ten year view on gold mining without hedging would have underperformed because of the disappointing gold price in that period. Those who did would have been obvious corporate victims of the hedgers, who would have sold gold earlier and higher, and in general have the stronger finances now for takeover activity. Two of the biggest miners - Barrick and Anglo - have grown bigger in part because they were smart hedgers.
However, one of the features of the market is that the equity in gold mines is held by people who like gold more than they like miners. Investors tend to buy gold shares because they give leverage and outperform bullion in a gold bull market. So miners who hedge face a barrage of abuse from their investors when the gold price starts to perform. Why? Because if the gold miners have sold their future production they donít benefit as much from the increasing gold price, and so their share prices under-perform the non-hedgers. Barrick and Anglo are currently experiencing this.
These things go in cycles. Hedging was the smart thing to do in 1990. It has been smarter more recently to be a non-hedger. This allowed Newmont (a non-hedger) to emerge with the higher rated shares to steal Normandy (a hedger) out from under the nose of Anglo (a hedger) and become the biggest gold mining company in the world.
This has an effect on the bullion price. Hedgers are out of fashion and are consequently unwinding their hedge books in the market to make sure they donít under-perform non-hedgers in a booming gold share market. Anglo and Barrickís full hedge books are the equivalent of pent-up demand for gold, because these miners are now stopping forward selling or even buying some hedges back. By contrast empty hedge books are the equivalent of overhanging supply, because smart miners are going to start selling forward their future production when they fear prices could fall. Right now we are in the middle of a period when the price is moving favourably, and the minersí hedge books are being cut back. This is good for the gold price temporarily as there is less supply. But eventually it will be followed by excessive supply and a cycle of producer hedging.
If bankers can borrow something cheaply they start to look around for ways of dealing it to make money.
Bullion banks and central banks which sit on large piles of their own bullion in their own vaults make no money out of it. Neither to custodians of unallocated gold [see Keep it Safe FAQs]. Provided they can find someone trustworthy to lend it to they can have both the security of gold and a small income.
Largely because of hedging there is a market for borrowed gold - with borrowing demand coming from miners. Their sales in the spot market can be delivered to jewellers from bullion bank stocks allowing them to repay the loan from production.
The carry trade involves a simple trading strategy which seems to have become widespread in investment banks during the depreciation of the Japanese Yen in the early 1990s. Because Japan stagnated when its property and shares bubble burst in 1990 yen interest rates fell to almost zero under the hand of a government trying (unsuccessfully this time) to stimulate demand. Meanwhile in the USA dollar interest rates were quite high, and were being maintained there also for political reasons - namely trying to prevent inflation. The investment bankers enjoyed a bonanza. Using their good credit ratings they borrowed Yen for virtually nothing and sold them for dollars. The dollars they received were lent in the US at artificially high rates, and to make things even better the Yen fell under growing selling pressure from the investment banks.
It was very profitable. Eventually it fell to bits when the bankers taking their profits exceeded the inflow of bankers opening up the new trade. The yen climbed sharply, and any gains on the lending were wiped out in the FX loss. LTCM took a fair share of the pain.
What the investment bankers needed then was another currency which cost little to borrow, and could be relied upon to fall in value. Enter gold.
The central banks had been busily publishing papers discussing what to do with the dead stock of their gold reserves, and concluding that holding it as a reserve was old-fashioned. The bullion banks could sniff a reasonably reliable supply of borrowed gold for the foreseeable future, and the investment banks rubbed their hands. The smart money borrowed gold, sold it, deposited the dollars received in the US on high rates, and (depending on who you believe) regularly talked down the price of gold. A very great deal of money has been made by banks - not miners - who have borrowed gold.
GATA is the Gold Anti-Trust Action committee. GATA alleges that the gold market is subject to systematic rigging by a series of US and global institutions, in contravention of the USAís Anti-Trust laws and the Constitution of the USA. The goal of GATA is to bring a case to trial.
It is said that if you owe a million dollars you have a big problem, but if you owe 100 million dollars the bank has a big problem. Add on a couple of zeros and you have the basis of the gold conspiracy which if you start investigating gold you will quickly come across.
The basis of the conspiracy theory is that huge amounts of gold have been sold and borrowed on the carry trade, and that the central banks have realised a little late that their economists might be wrong. As, like the Yen before, the gold price rises, a whole raft of LTCM types will fall out of the derivatives markets, unable to return the gold they have borrowed because they can't afford to buy it back at these rising prices. The resulting default could bring down the international financial system, so the world's financial institutions have conspired to hold down the price of gold.
The conspiracy theorists are gold 'bugs'. Their core belief is that gold is the king of monetary assets. Their additional belief is that institutions like the Fed, the IMF, the BIS, the Exchange Stabilisation Fund, the Bundesbank, the European Central Bank, the National Bank of Switzerland, and the Bank of England are conspiring to hold down the price of gold in order to prevent the circumstances where constituents of the international financial scene - particularly the customers of JP Morgan Chase, Goldman Sachs, Deutsche Bank and Credit Suisse - implode under losses arising from 8,000 to 20,000 tonnes of gold carry trades. Were such an implosion to start it is clear the gold price would go into the stratosphere.
The evidence is disturbingly persuasive in some senses. There seems to have been collusion in the manipulation of some German and US gold reserve accounts. There is hearsay 'evidence' which suggests a private confession by the Governor of the Bank of England, and there are extraordinarily well timed interventions by bearish comment which suggests an official desire that gold does not shoot upwards.
But in the end the full blown conspiracy theory seems to fall over because, like all good conspiracies, it requires too much collusion between many parties unlikely to sustain the necessary secrecy. It is difficult to believe that those who would have to be involved are really prepared to conduct a deception on the scale alleged by the GATA committee, and still keep it quiet. If the conspiracy theorists are right it is impossible to reconcile it with the US Treasury's flat statement of its gold position which seems to state quite unequivocally that the US bullion reserve is still US owned and is still in the Treasury's vaults.
Another key weakness of the gold bug case is that the full blown financial catastrophe has not already occurred. The significant $ price rise in gold through 2002/3 should have initiated the crisis expected if - indeed - the scale of the short positions were as anticipated by GATA.
In the cold light of day the apparently persuasive strength of GATAís case needs to be measured against the enormous amount written daily about gold and financial markets. Given the tens of thousands of official sentences coming out of quasi-governmental institutions there are going to be ambiguous passages and inferences available to support any conspiracy theorist who looks for them for long enough. On this basis what looks like a clear case of fiddling the accounts can possibly be explained by wishful thinking and selective use of official statements, numbers and gossip.
On the other hand GATA is probably right that the outside world does not know the whole truth - which is to be expected. If the BIS and the Fed believed that they could save a major banking player by a measured intervention in the gold market, conducted secretly, cleverly and legally - just - through the Exchange Stabilisation Fund, then they would do it, and possibly rightly so. They certainly ought to keep it quiet if they want it to work.
The truth is almost certainly somewhere in the middle. It is likely that some modern economists believed gold was in long term oversupply, and was fundamentally useless in productive terms, and would therefore decline in price. It is likely they persuaded some central bankers - and/or unallocated custodians - to sell or lend their gold. It is likely they persuaded some willing investment bankers to believe in a gold carry trade, and it is likely that some money managers were prepared to believe their investment bankers. It is certain that some investment banks made a lot of money through the gold carry trade - either as principals or facilitators. It is even possible that some of their customers have too. Equally it is possible that the Washington Agreement (explained below) was a nasty shock to the carry traders and that the central banks intervened with urgency. It may even be the case that gold swaps have left large stores of gold in the custody of countries who don't own it.
But surely there cannot be 8,000 tonnes of exposed gold shorts out there, can there? That's the entire US gold reserve.
Well maybe there could, it's only 100 billion dollars worth. LTCM could have shorted that before lunch, and come back for more in the afternoon - on leveraged capital of only $5 billion! There were banks then which were dumb enough to let them do it on the derivatives markets, so who knows?
The Washington Agreement - mentioned above - is an interesting bit of state sponsored market manipulation. The following is a quote from the website of USA Gold
[The Washington Agreement] began with a statement released jointly by European central banks from Washington, D.C. on Sunday, 26 September 1999 under support of the following signatories---
The European Central Bank and the central banks of Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Sweden, Switzerland, and England.
Mr. Wim Duisenberg, President of the European Central Bank, announced the joint Statement on Gold:
"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 sellers, 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 tons and total sales over this period will not exceed 2,000 tons.
4. The signatories to this agreement have agreed not to expand their gold leasings and their use of gold futures and options over this period.
5. This agreement will be reviewed after five years."
The gold bulls were ecstatic and chased the price dramatically upwards from $260 to $325. They were later devastated when the temporary rally ran out of steam and the price fell back to $278 within a couple of months. The conspiracy theorists thought something was afoot. The following extract comes from http://www.gata.org/bofi.html
"According to reliable reports received by the plaintiff, this effort was later described by Edward A. J. George, Governor of the Bank of England and a director of the BIS, to Nicholas J. Morrell, Chief Executive of Lonmin Plc:
'We looked into the abyss if the gold price rose further. A further rise would have taken down one or several trading houses, which might have taken down all the rest in their wake. Therefore at any price, at any cost, the central banks had to quell the gold price, manage it. It was very difficult to get the gold price under control but we have now succeeded. The U.S. Fed was very active in getting the gold price down. So was the U.K.'"
Lonmin, incidentally, had lost a huge amount of money in Ashanti - a hedging miner - which had been whiplashed by the price spike. But even if it's true that Mr George sunk the rally with his US allies it could reasonably be argued that it was the least they could do. After all it was the central banks which were behind the intervention which caused the rally in the first place, and this could easily be seen as the immediate cause of financial instability.
Everything can easily be turned completely upside down. The Washington Agreement to which the market reacted in such a bullish way now hangs over the gold market with its implication of future oversupply. Had there really been a mutual European central bank desire to defend the value of their gold reserves they would have done immeasurably better by stating that all the parties intended to treat gold as a long term monetary reserve for the foreseeable future, but retained their strict independence of action. The attaching to the agreement of a firm commitment for a 5 year period laced the whole arrangement with bearish possibilities. For all the market now knows there are four or five willing central bank sellers of gold within the signatories, and their bullion will flood onto the market in 2004. It's hard to envisage a more effective mechanism for capping enthusiasm for gold, especially when you realise that points 2, 3, 4 and 5 of the statement were busily reminding the market how actively bearish the signatories had recently been.
Sometimes it looks almost as if it was a package designed by an investment bank which had sold five year call options (and, if it was clever enough, had bought one month call options as a hedge for the announcement). An equally amusing conspiracy theory is that the Washington Agreement was designed by central banks themselves to depress the gold price to ensure they didnít look too stupid as they continued to dump. After all, unlike all other gold investors, governments are far more concerned about possible electoral damage than the financial damage of being shown to have got it wrong. Perhaps they were simply temporarily embarrassed when the price went bananas.
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