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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

Taking a look at recent ECB term deposit rates (the 7-day term deposits used to sterilize SMP liquidity) one will observe that rates have expanded somewhat from 1bp to 4-5bp (the latest auction settled around 5bp):

ECB SMP Term Deposit Rate

Total amount of bids has also fallen below €300bn (with SMP liquidity around €206bn). This indicates that overall excess liquidity has fallen considerably (based on the term deposits auctions to lower than €100bn) and is pushing short-term rates higher. This is reflected on overnight repo rates with the Eurex GC Pooling EUR Funding Rate climbing to 4-5bp. LTRO repayments and lower Target2 balances have started having an impact on money market rates. The latest auction only had €254bn in bids and is a good indicator of available funds in the Euro money market.

Falling excess liquidity will start pushing money market rates closer to the cost of funds (currently 75bp). Unless the latter is lowered by the ECB it is possible that money market lenders will start avoiding long repo maturities and focus on short-term deals (overnight/weekly). It also points to a higher probability of an ECB rate cut in the immediate future.

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):


Ever since the Draghi (‘we ‘ll do whatever it takes’) speech in the summer of 2012, the Euro has had a strong rally versus the dollar, rising from 1.22 to over than 1.36. This rally has recently caught the eye of the ECB who seems to be worried that the strong euro will become a drag on the Eurozone exports growth. Looking at the fundamentals one can make certain observations about the future path of the Euro currency.

The rally is mostly due to the OMT effect with euro breakup risks lowering significantly and inter-euro imbalances, especially in Target2, taking a strong downward path since September. The German Target2 surplus for January is €134.5bn lower than August with the drop reflected on corresponding Spanish and Italian figures as well as on government securities yields. These developments have driven outside investors (for instance MMMFs) to increase their investments in the Euro area, after a long period of reducing their exposure. Flight-to-quality (which is usually bullish for the dollar) has reversed with ‘risk on’ being the main market signal during the last few months.

In terms of interest rate parity, the euro has definitely diverged since the summer. Although the premium of euro interest rates compared to dollar rates (proxied by 3 and 12-month libor rates) is negative (-0.2% and -0.4%, an inverted curve), the euro has strengthened significantly. The chart below seems to suggest a ‘fair rate’ close to 1.25 given the current interest rate differentials:


One of the major positive Euro factors has been the growing Eurozone Extra-Euro trade surplus which has allowed the current account to reach a 1% of GDP surplus in the current 12-month period. Most recent Eurostat data suggest that the strong currency is now hurting exports. Since exports have been the only source of growth for the Eurozone (with internal demand being highly negative), this developments lowers potential growth for 2013 even further (most recent projections suggest zero 2013 GDP growth).

Real economic activity which was -0.6% for the last 2012 quarter, as well as private credit growth and other indicators, seem to be out of sync with bullish sentiments in the financial markets which will have to catch up sooner or later. Moreover, since Euro money market rates arbitrage with the ECB deposit facility rates (due to excess liquidity despite 3Y-LTRO repayments), any further rate cuts by the ECB will only have marginal effects (EONIA rates are already at 0.066% and swap rates lower than 0.15% up to maturities of 1 year).

Overall it seems that the Euro is overvalued based on interest rates differentials, driven by OMT effects but its strength is now hurting the real economy and especially exports. ECB monetary policy cannot have any strong effects (since short-term rates are already close to the ZLB) unless it engages into serious quantitative easing with a view of lowering long-term rates and enhancing the monetary transmission mechanism. It is hard to see how the OMT effect alone can maintain the current Euro strength which will probably have to correct sooner or later.

One should keep in mind that the bulk of the German trade surplus is now with Extra-Euro countries, making the Euro effective exchange rate a key determinant of its external position for the near term future. The fact is that this rate has appreciated substantialy (+5.3%)  since mid-2012 after falling 10.4% during 2011 – early 2012 (and 13.6% since 2010):

Euro effective exchange rate

During the second half of 2012 GGGBs had a vey nice rally, more than doubling in prices with the 10Y bond closing at 53.20 on Friday. The reasons had to do with the reduction of the Grexit risk,  commitment by official lenders on long-term financing (at very low rates) and a possible official haircut after the German elections. What I ‘d like to note is that, in my opinion, there isn’t much upside left on this trade unless there are serious rating upgrades of the Greek economy.

Looking at the ECB elidgible assets database, one can observe that the (ISIN:GR0128010676) 2023 bond carries a 57% valuation haircut.

ECB GGGB valuation haircut

That means that a bank can only finance 43% of a bond purchase through the ECB and will have to commit another 57% as capital or unsecured lending in order to settle the purchase, making it a very low leverage trade. Although the bond does pay higher coupons than current low-risk core bonds, the major source of income for a buyer is the capital gain from the difference between the current market value and the nominal amount payable at maturity which can be amortized during the remaining life of the instrument. As a result, one can make a very crude and simple calculation that investors will be willing to buy the bond as long as the future capital gain is more than the capital they ‘ll have to commit because of the high haircut (assuming that capital is expensive). In other words the higher price accepted would be:

PV(100) – market value = 57% * market value. If 100 is discounted with the current 10-year AAA yield of 2%, the actual PV is 82 and current market value 52.20.  Obviously, the above formula implies a 100% return on capital. Given the fact that the current 10Y bond YtM is 10.68%, this return is quite sensible. As a result, GGGBs are trading at a fair value for leveraged plays and do not provide an opportunity for further ‘easy profits’. Higher prices will be possible by the push-to-par effect for short maturities and future rating upgrades which will lower ECB haircuts.

Assuming a 2% annual return on capital (22% total), the highest price possible under current conditions would be close to 72.9.

The Greek PDMA released the final results for the Greek bonds buyback. The total principal offered was €31.9bn for which €11.29bn in EFSF 6-month Bills will be needed (compared to the originally anticipated €10bn amount) while the weighted average purchase price was 33.8%.  The Annex contains a breakdown per bond series:

Greek bond buyback results


My initial comments:

  1. The purchase price achieved for every bond series is equal to the maximum price allowed in the auction. So it seems that the size of the auction allowed bondholders (which were at least 40% foreign) to achieve the best price offered.
  2. In the case of short-term series (2023-2025) only 40% of the principal held was offered. This percentage increased to 50% for 2026/2027 and to 55% for the longer dated series. Bondholders decided to mainly exchange long-term bonds (which would probably become illiquid anyway after the buyback) and hold on to shorter term ones which provide for push-to-par mechanics.
  3. Total principal write-off will be close to €20.6bn. Since each series pays €987mn till 2023 and EFSF interest will be deferred for the next 10 years, Greece will manage to avoid paying interest for €20.6bn principal completely and another €11.3bn till 2023. That’s around€ 6.5bn (for €20.6bn) and €3.5bn (for €11.3bn) for a total close to €30bn. As a result, outright debt reduction will be close to €27bn till 2023 plus another €3.5bn in deferred interest payments.
  4. Since domestic institutions seem to have offered almost 100% of their holdings and pension funds hold €7.9bn it will be almost impossible to enable the bond CAC’s in the future, especially since they can only be enabled for all series simultaneously and they require a 66% majority. In other words, remaining holders are now much more secure.
  5. Greek banks seem to be the main losers. Although they ‘ve probably calculated fair value around 21-25 (which means they ‘re making a small profit right now), they will lose on future interest payments and amortized principal. Their future outlook is much worse since they don’t have GGB profits to look into. How the Cypriot banks participated remains to be seen.

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Kostas Kalevras

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