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I ‘ve already pointed out the fact that the price of gold seems to be closely correlated with negative real money rates. In this post I will try to describe a possible relationship between certain money and gold interest rates and gold price by using simple futures pricing.

Imagine a gold producer who wishes to hedge its future production through gold futures. The bank that will become its counterparty will have to provide an arbitrage free forward price for the relevant futures contract. The way to do that is the following:

  1. Borrow gold from a bullion bank. The cost will be the Gold Offered Forward Rate (GOFO). The borrower will have to provide cash as collateral which will be swapped for gold.
  2. Sell gold spot (S: price). The income will be used to cover the cash swap for the gold loan. The gold lender will invest the cash collateral in a risk-free investment such as Treasury repo which will earn the General Collateral (GC) rate.
  3. At maturity the borrower will earn the GC rate and pay GOFO while the gold provided by the producer will be used to close out the gold loan.

As a result, the fair forward price will be: F = S exp((GC – GOFO)*T). T: years

The above indicates that if the GC rate is above the GOFO rate, gold will be in contango. Furthermore, futures do not postpone physical transactions but actually bring them forward in time, by selling spot ‘future supply’ and creating a bearish situation.

Looking into the subject from an income point of view, if GOFO is higher than GC, holding gold provides a higher return than cash which is bullish for gold prices. As long as gold prices are increasing, a gold holder will enjoy both capital gains and a higher ‘repo’ return. The gold position can be closed out at any time by buying a gold future (with the same maturity as the gold loan) which will drop the return to the GC rate and ‘monetize’ any capital gains due to gold price appreciation.

Based on the above, a large spread between GOFO and GC should be matched by higher gold prices while a negative spread will lead to gold price drops. This is evident in the chart below where the GC rate is proxied by the GCF Treasury index:

Gold - GOFO - GCF

Although it is clear that there are other factors influencing gold prices, the GOFO-GCF spread appears to have substantial explanatory value with high relative co-movement.

Latest data indicate the spread dropping to zero (and even negative) territory which explains the recent gold weakness. Unless this situation reverses, it is not unreasonable to anticipate that gold will continue its downward path.

The long-term price relationship with the Libor-GOFO spread is illustrated in the next graph which includes data since 1995 till Dec-2006. The move of gold price changes to positive territory since 2001 is strongly correlated with the spread dropping to near zero. Only when gold started providing ‘cash-flows’ (in the form of GOFO payments) similar to cash did demand increase substantially.

libor gofo - gold price change

As noted already by other people, gold does not provide any cash flows. Although most people consider it a hedge for inflation and think that its current rise was a result of inflation fears due to QE by major banks, in my view the reason is much simpler: Negative real interest rates. As long as the risk-free rate of return (for instance 1-Year Treasury) is negative in real terms, gold usually starts producing capital gains, something which happened both in the 1980’s as well as in the GFC. 2003 – 2004 was also a period of negative real rates when the price of gold also appreciated significantly, although at that time other low risk investment alternatives were available in the real sector (MBS and other securities).

The result is that gold (in real terms) has only appreciated during these two periods, staying between $200 – 300 for the rest of the time:


The above chart indicates that a return to the long-term trend would mean prices 2 – 3.5 times lower than current ones, eliminating a large part of capital currently invested into gold. Monetary tighting by the Fed in the near future (which has started to be indicated by certain FOMC members) will most probably have a strong effect on gold prices. This is indicated by the large correlation between the two since 2007 (the blue line is 1-Year Treasury minus CPI inflation rate):


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Kostas Kalevras

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