The hand of GOFO strikes again The gold market is abuzz with the news that gold forwards (GOFO), otherwise known as the gold lending rate, have returned to negativity this week. It's significant because the last time this happened was in 2008 (click to enlarge): Gold enthusiasts love negative GOFO because they associate it with backwardation, and the fact that spot gold is fetching a premium over forward gold. They believe this defines the moment that gold becomes superior to "paper money" - even in a down market: In fact, more objective gold watchers usually note that backwardation and negative GOFO are much more likely to be a factor of a change in money market interest rates or inflation. Last time GOFO went negative, Evy Hambro, the manager of BlackRock's $5bn World Mining Fund, told us the following: The backwardation is a function of interest rates falling rather than gold leasing rates spiking. What's happened is that interest rates have come down, with the borrowing costs of gold remaining roughly the same, so the relative contango over the very near term has shrunk. He added that this was the reason why in yen terms backwardation in gold was an entirely normal phenomenon. We think Hambro's point stands to this day. Of course, it may be more confusing this time around given that gold is backwardating in the context of monetary tightening rather than easing talk. But the clue is possibly in the fact that this time it's lease rates that are spiking. We propose this suggests that it's the ascent of long-term yields (and real yields) that is causing the ruckus. It is as if the gold market is telling us that unless greater easing comes the market's way, especially in the face of higher yields, we will undoubtedly face disinflation, if not deflation, some time soon. Self-inflicted private market interest rates are now possibly far too high to prevent the market from wanting to liquidate assets or from pricing in a negative time value of money in collateral markets, which had previously entrapped liquidity in them. For it is only in a deflationary context, without sufficient money printing (as in Japan), that gold forwards have a tendency to go negative. We should also note that GOFO, as well as gold prices, only recovered in earnest when it became clear that central banks would begin to ease on an unprecedented level to keep the market supported. In fact, recent history tells us that gold is much more likely to under perform during deflationary episodes than outperform: For example, gold declined for most of 2008, reaching a market bottom on November 12, two days after FT Alphaville's Tracy Alloway pointed out that the inevitable had happened, and that to all intents and purposes the Fed was now purposefully expanding its balance sheet in a manner that evoked Japanese quantitative easing. GOFO rates went negative between November 20 and November 24, and were associated with a short-lived move higher in the gold price, which lasted until November 25, but also very importantly with a period in which the threat of negative repo rates was being dodged by a dramatic increase in the rate of US Treasury fails-to-deliver. Yes, gold recovered thereafter but the run-up very importantly followed Ben Bernanke explicitly stating on December 1 that the central bank would purposefully seek to expand its balance sheet by means of strategic asset purchases and unprecedented liquidity operations, which included the extension of the Term Securities Lending Facility, which swapped out Treasury collateral in exchange for inferior and less liquid forms. In that sense, negative GOFO prefigured greater central bank policy experimentation. If not for the QE experiment, it's hard to say if gold would at that point have started its epic run higher at all, and if negative GOFO would have been eliminated so quickly. One thing's for sure. At the time, falling GOFO may have signified that those who had cash were prepared to lend it to the gold market for less than they hoped to get in return, possibly because they could count on an alternative form of carry associated with shorting the commodity, especially if they happened to be depository institutions. The below shows the recent history of the GOFO lending rate: It's important to note that during the negative GOFO period those who had gold were much more likely to benefit from borrowing with negative rates than those with other repo-able securities like Treasuries, whose rates were synthetically being bound at zero by the option to fail-on-delivery. It's worth noting that the fall in gold lending rates also coincided roughly with the Fed's announcement on October 6 that it would start paying interest on excess reserves. This was the day the Fed effectively set a floor on interest rates. Zirp, of course, only became a reality on December 16, after the IOER floor was already firmly established and after talk of quantitative easing had already begun. In paying 0.25 per cent on excess reserves, the Fed had set a floor on interest rates but also inadvertently created a much bigger settlement problem on the side lines. For as long as the option to fail-to-deliver kept repo rates synthetically supported, it meant dealers could fail-to-deliver scarce securities without fear of penalty, and continue to be paid 0.25 per cent in the process for keeping cash raised against those securities as excess reserves at the Fed. The effects of this, however, may have bled into the gold lending market, where failing-to-deliver is never an option because of the much greater stigma attached to the act. In commodity markets, generally, a delivery failure is always to be avoided for reputational reasons, and in that sense represents a consistent penalty regime. Without the option to fail, and in an environment of scarce quality collateral, the gold lending market arguably began to reflect the real negative collateralised borrowing rate which the repo market could not. Since failing to deliver was not an option in the gold market, the only way cash lenders could be enticed to lend cash against gold - when the alternative was keeping cash on reserve at 0.25 per cent - would be if the forward markets compensated for the delivery failure risk by pricing-in a so-called positive time spread (backwardation). This meant that after absorbing the gold they could sell it and hedge it in the forward market at a better rate than 0.25 per cent. When news of a fails charge was first widely publicised, unsurprisingly negative GOFO abated. This makes sense if you consider that those who were borrowing cash against quality collateral, may have turned to the gold collateral market to avoid being exposed to the fails loophole, which was keeping rates artificially supported. Another notable point to burst the gold enthusiasts" GOFO chant, is the gold carry story as told by gold lease rates: Lease rates can be said to represent the gold repo rate. When they are positive they are indicative of the cost of borrowing gold. When they are negative, however, they are indicative of the cost of borrowing cash against gold. In 2008 gold lease rates went up sharply in line with soaring Libor. This is because anyone who saw fit to lend cash against gold, was by definition giving up the opportunity to earn a much higher rate in the unsecured markets with the lease rate accounting for the opportunity cost. But as we mentioned, this was in many ways a dud measure, because chances were no-one was prepared to lend cash at those high rates unless it was securitised by the safest collateral. The super high lease rates were a bit of a fallacy. What we had in reality was an environment in which the traditional carry associated with the market was impossible to achieve, meaning there was arguably a lot less gold available for lending than normal. Only the most distressed - those who needed cash for liquidity reasons rather than to generate Libor carry - came to represent the bulk of the gold lending market. Since it was unlikely that these distressed parties could fetch the high rate implied by Libor, the high lease rate was no longer reflective of the opportunity cost for absorbing gold in exchange for cash. The real opportunity cost was now much lower. But, of course, for as long as fails-to-deliver were a possibility in the conventional repo market no-one would overpay to lend cash against gold at a punitive rate. To entice cash lending against gold, either lease rates had to go negative or the GOFO lending rate had to take the slack by turning negative. So as Hambro implied, this may have had less to do with a gold forward discount, and much more to do with the fact that the gold forward market, which is almost always a function of money market interest rates, had started to account for a time discount of money due to there not being enough alternative risk-free earning options in the market. In short, it was indicative not so much of a cash crunch, but the need to compensate the borrow market for the negative rate of cash associated with hedging their investments. As soon as a fails charge became associated with conventional repo, negative rates could no longer be dodged in repo, and there was no longer a need to compensate cash lenders in the gold market for what was a de facto punitive rate relative to conventional repo. Furthermore, once Libor was smashed to a pulp by extraordinary central banking operations, and QE revived the time value of money in forward markets, lease rates soon visibly adapted to the new negative repo reality, which represented the fact that some players had ample access to the liquidity priced at the new low levels of Libor and that others did not. The cash-for-gold carry was born. From now, positive gold lease-rate episodes arguably reflected episodes when the cash-for-gold window was closed (at least for as long as GOFO remained positive). At these times, there were more parties seeking safe investments than distressed borrowers seeking cash against gold, and there was no incentive to lend against gold. At least not unless gold forward rates went negative. Negative gold lease-rate episodes, conversely, indicated periods of demand for cash against gold collateral. At these times, there were more parties seeking cash against gold than there were parties seeking safe investments. For those who had cheap liquidity, it became cost-effective to absorb gold for the purpose of earning a better-than-market rate. So what does today's negative GOFO and positive gold lease rate signify? This is obviously speculative, but we dare say it could mean any of the following: 1) The opportunity cost associated with lending cash against gold is rising because rates are rising. For as long as Libor is stuck down this can only be expressed in a higher lease rate, which itself can only be pushed higher by means of a negative GOFO rate, because lease rates = Libor minus GOFO. 2) The cash-for-gold window is firmly closed since cash lenders would theoretically have to pay a punitive negative rate if they wanted to invest their cash in gold collateral. If you need cash and have gold, chances are you will be forced to liquidate instead, unless you can negotiate off market terms. 3) High lease rates are forcing an unwind in previously established cash-for-gold positions, as cash lenders pull money out of the gold market and take it elsewhere. To unwind the position, they're needing to buyback their shorts and sell their forward hedges, which is backwardating the curve. 4) Despite higher yields, a scarcity of USTs is once again encouraging fails-to-deliver despite the existence of a penalty rate. This is creating a new floor on rates in repo markets (the penalty rate): The gold forward market is consequently once again being forced to price in a negative cost of money on the forward curve, to compensate for artificially supported rates elsewhere, a function of rising real yields. 5) It's Libor that should be much lower, if not negative. Holding gold (or any commodity) rather than cash is now an opportunity cost. Related links: Gold borrowing cost hits post-Lehman high - FT Jim Rogers Correctly Predicted Gold Would Fall To $1200, And Now He Thinks It Could Go As Low As $900 - Business Insider Golden Slumbers - Project Syndicate