Tuesday, October 12, 2010

3rd Qtr 2010 Review and Currency Wars


Written October 7th, 2010

The 2007 scenario we envisioned a few months ago continues to play out with large trading ranges in the equity market and a Euro that is gaining speed into the end of the year, a period seasonally strong for the common currency.

The recent hint by the Fed of a possible new round of Quantitative Easing set off a rally in commodities, gold and in most currencies versus the US Dollar. Equities and bonds have also benefited equally even though based on two diametrically opposed theories: the bond market perceives QE as a desperate response to unstoppable deflationary forces and the equity market perceives the additional injection of liquidity as the fuel for future growth and inflated P/E ratios. In a global economic system, Fed actions have international ramifications and a currency war seems to be starting among most economies: last month Japan intervened to sell Yen against the Dollar (even though their primary target would be the Renmimbi) and it announced its own QE program. Brazil and most other emerging markets are finding their currencies overheating and it will not take much before a global agreement is worked out or more protectionist policies will be adopted.

This state of affairs continues to make our strategies a valid solution for asset allocation: inflation protected securities and gold would seem to continue benefiting even though a temporary correction seems rather probable. As far as equities, if the bond market is right and the economic slowdown ends up being much more significant than anticipated, this asset class is indeed a bit overvalued; however, when compared to US Treasuries, equities don’t seem so scary.

Master Limited Partnerships have done extremely well this year handily beating broad market indexes; in absolute terms they seem expensive but in relative terms – measured by the spread of their distribution versus the yield on the 10 year UST – they still represent good value. MLP are now paying about 370 basis points over Treasuries, well above the 320 average spread and much above the 250 spread which has in the past indicated sector overvaluation.

Looking at the final stretch of this 2010, we cannot forget the upcoming November elections which may affect market direction. Overall, performance anxiety may stat to dictate market posture either way; in other words, I would expect buyers above and sellers below the recent range.

Corporate bonds which have performed very well since the 2008 lows are beginning to seem a bit pricey and a trimming of the exposure is in order.

--Davide Accomazzo, Managing Director

(This article was written on October 7, 2010)

Reversing the Model’s Line of Causation

The 1970s was a crucial turning point in the history of 20th century gold markets. The costs of the Vietnam War and increased domestic spending had the effect of accelerating inflation. Meanwhile, US gold stock declined to $10 billion versus outstanding foreign dollar holdings estimated at about $80 billion.[1] Prior to that, the London Gold Pool made up of seven European central banks and the US Federal Reserve, a group which cooperated in maintaining the Bretton Woods System, found itself increasingly unable to balance the outflow of gold reserves and defend the fixed gold price of US$35.[2]

On August 15, 1971, President Nixon, a self-proclaimed Republican “conservative,”[3] imposed a 90-day wage and price control program and other various expansionary fiscal policies in what became known as the “Nixon Shock”[4]. Most importantly, Nixon closed the gold window to prevent foreign governments that had been holding dollar-denominated financial assets from demanding gold in exchange for their dollars. By March 1973, all of the major world currencies were floating and in November 1975, the G-7 (i.e, Group of Seven) formed to hammer out the final details on a framework for a new monetary system. That agreement, which was finalized in January 1976, called for an end to the role of gold, the establishment of SDRs as the principal reserve asset, and legitimized the de facto system of fiat currencies and floating exchange rates.

The reason for retelling this story is because these events, along with a collapse in gold prices after peaking on January 21, 1980 at the high price of $850, led directly to formation of the gold leasing market during the mid-1980s. Gold loans evolved as a means for central banks to earn a return on their bullion inventories to cover the cost of warehousing bullion[5][6] by either leasing or swapping[7] gold in exchange for a lease rate. This rate is derived from the difference between the LIBOR and Gold Forward Offered (GOFO) rate.

A leasing transaction involves a central bank transferring ownership to a leasing institution (i.e., borrower), who could then sell the gold on the spot market and invest the proceeds. At a later date, the borrower would buy back the gold and return it to the central bank while paying the lease rate. Because gold could be leased at a relatively low rate from the central bank and then sold quickly on the spot market, participants in this market included gold producers who thereby gained cash to finance gold production at a comparatively low rate of interest, while simultaneously hedging against falling gold prices.[8]

The market for gold loans developed quickly after the October 1987 stock market crash left many mining companies with reduced access to capital. Prior to 1990, GOFO rates for gold normally were below 2 percent on an annualized basis and never exceeded 3 percent, providing an inexpensive source of finance for mining companies.[9] The Financial Times reported that some 30 central banks were estimated to have engaged in gold loans around this time.[10] Then in 1990 Drexel Burnham Lambert collapsed with large outstanding gold liabilities to many central banks, resulting in increased wariness and reduced supply of gold loans from central banks.[11] As a result, lease rates rose reflecting an increased tightness in the market after the loss of central bank suppliers, as well as a substantial risk premium over the implicit cost of providing such loans.

Nevertheless, the market for gold loans grew throughout the 1990s, and an informal global interbank system developed permitting dealers to borrow gold on a short-term basis in order to fulfill delivery requirements. When bullion subsequently dropped below $300 an ounce in late 1997, and drifted in that range through 2002 in what is now referred to as the “Brown Bottom,”[12] the gold carry trade came to dominate the derivatives markets. Gold’s steady appreciation since 2002, however, has rendered this trade obsolete. As a result, there has been a wholesale transformation in the gold market since the millennium began.

In a research paper published by the Swiss Finance Institute (SFI) titled, On the Lease Rate the Convenience Yield and Speculative Effects in the Gold Futures Market, the authors examine this aspect of the gold market in detail. They too note that, “…since late 2001, the profitability of the carry trade has diminished. Rising gold prices have increased risk and diminished the trade’s profitability as a result of increasing repayment costs. Consequently, the prevalence of the gold carry trade is predicated on two factors: the rate at which the central bank is willing to swap or lease gold, and whether or not the gold price is increasing.” Further, the authors Barone-Adesi, Geman and Theal (2009) observe that the COMEX “is witnessing historically low derived lease rates, decreasing hedging activity and steadily rising non-commercial open interest.”

The reason why is because the gold carry trade is risky on two dimensions. First, if the borrower invests in long-term bonds, rising interest rates could cause downward pressure on bond prices exposing the leasing institution to principal risk. Second, since the borrower is effectively short gold, if the loan is called by the central bank and gold has risen in value, they may have to purchase gold at a higher price in the spot market. Hence, there always exists the potential of driving up gold prices even higher due to short covering. This unwinding of the carry trade, as with other similar trades (e.g., yen carry trade), can result in volatile markets.

The question then is to what extent is speculation having a “tangible effect” on gold valuations, and “if so, by what mechanism does speculation influence prices?” The SFI paper points out other academics, such as Kocagil (1997), who defined “speculative intensity” as the “spread between the futures and expected spot price,” and concluded that “speculation increases spot price volatility and thus has a destabilizing effect on price.” Another researcher, Abken (1980), based his analysis on the intuition that the only return that gold yields is based on the anticipated appreciation of gold above “any marginal costs associated with the storage of gold.” Abken further argues that, “during times of uncertainty, excess demand for gold as a store of value [drives] up the spot price causing stored gold to be brought to market.”

The authors of the SFI paper, on the other hand, base part of their methodology on the work of Houthakker (1957), one of the first researchers to use trader commitment data to study speculation. To understand how speculative agents can affect the gold futures market, Barone-Adesi et al. (2009) examine the open interest data from the CFTC Commitment of Traders (CoT) report, thereby identifying commercial open interest with hedging activity, and conversely, non-commercial positions with speculative activity. The authors also study the relationship between gold leasing and the level of COMEX discretionary inventory.

Not surprisingly, Barone-Adesi et al. (2009) arrive at obvious conclusions: First, they note an ever-increasing percentage of non-commercial open interest reflects increased speculation in the gold market. Second, “the lease rate and the speculative pressure appear to work in opposition to one another; the former acts to decrease short-term bullion inventories via lease repayments, while the latter result suggests speculators dominate leasing activity in the long term… Finally, the presence of speculation in gold futures contracts can be associated with increased futures contract returns and that this effect increases with increased futures contract maturity.” What these observations suggest in their entirety is that “speculation plays a significant role in the COMEX gold futures market” as opposed to hedging activities.

Uh, okay… but isn’t this a foregone conclusion? Albeit, On the Lease Rate the Convenience Yield and Speculative Effects in the Gold Futures Market derives its determinations from some interesting theoretical ideas between the relationship of gold loans, bullion inventories, convenience yield and speculation; but in the final analysis the SFI paper raises the specter of Muth’s (1961) Rational Expectations and the Theory of Price Movements: “In order to explain fairly simply how expectations are formed, we advance the hypothesis that they are essentially the same as the predictions of the relevant economic theory.”

In other words, models unfortunately have the bad habit of assuming a predetermined conclusion around which expectations are formed, which in effect reverses the model’s line of causation. Our conclusion: research bias, the process where the scientists performing the research influence the results in order to portray a certain outcome, seems to be at work here—even though we happen to agree with such paper’s conclusions.

- Mack Frankfurter, Managing Director

On the Lease Rate and Convenience Yield of Gold Futures

[1] Spero, Joan Edelman, and Hart, Jeffrey A. (2010). The Politics of International Economic Relations. 7th ed. (originally published 1977). Boston, MA: Wadsworth Cengage Learning.

[2] Bordo, Michael D., and Barry J. Eichengreen (1993). A Retrospective on the Bretton Woods System: Lessons for International Monetary Reform. University of Chicago Press. pp. 461–494 “Chapter 9, Collapse of the Bretton Woods Fixed Rate Exchange System” by Peter M. Garber.

[3] Nixon tape conversation No. 607-11.

[4] “The Economy: Changing the World's Money” Time Magazine, Oct. 4, 1971 [First reference by Time of “Nixon Shock”]; http://www.time.com/time/magazine/article/0,9171,905418,00.html

[5] “Bullish on Bullion” by Peter Madigan, Risk Magazine, Feb. 1, 2008, Incisive Media Ltd.

[6] According to O’Callaghan, Gary (1991), two key disadvantages in holding gold as opposed to a financial instrument are storage costs and the fact that holding gold does not bear interest.

[7] A gold swap is essentially a transaction whereby gold is exchanged for currency.

[8] O’Callaghan, Gary (1991). The Structure and Operation of the World Gold Market. International Monetary Fund, IMF Working Paper WP/91/120, Master Files Room C-525, p 33.

[9] Ibid. pp 33-34.

[10] Gooding, Kenneth, “Gold Lending Rate at Record Level,” Financial Times (London), Dec. 4, 1990, p 34.

[11] “Fool’s Gold,” The Economist, Mar. 17, 1990, p 79.

[12] Term used to describe the period between 1999 and 2002, named from the decision of Gordon Brown, then the UK's Chancellor of the Exchequer to sell half of the UK's gold reserves in a series of auctions.

Barone-Adesi, Giovanni, Geman, Hélyette and Theal, John (2009). “On the Lease Rate, the Convenience Yield and Speculative Effects in the Gold Futures Market” (March 12, 2009). Swiss Finance Institute Research Paper No. 09-07.

Bordo, Michael D., and Barry J. Eichengreen (1993). A Retrospective on the Bretton Woods System: Lessons for International Monetary Reform. University of Chicago Press. pp. 461–494 “Chapter 9, Collapse of the Bretton Woods Fixed Rate Exchange System” by Peter M. Garber.

O’Callaghan, Gary (1991). “The Structure and Operation of the World Gold Market” International Monetary Fund, IMF Working Paper WP/91/120, Master Files Room C-525

Spero, Joan Edelman, and Hart, Jeffrey A. (2010). The Politics of International Economic Relations. 7th ed. (originally published 1977). Boston, MA: Wadsworth Cengage Learning.