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The Bullion Banks

by James Turk


Though Gold interest rates have fallen somewhat from their exceptionally lofty levels of a few weeks ago, the rates remain inverted. This continuing inversion with the one month rate above the three and six month rates is noteworthy.

The conventional wisdom is that Gold interest rates are high because the demand to borrow metal remains high. I doubt this interpretation. It seems to me that this explanation about the demand to borrow metal is just the shorts, led by the bullion banks, trying to talk down the price of Gold. Further, I suspect that the real answer to this inversion in rates comes from the supply side of the equation, i.e., there is less metal being loaned into the market.

The wire services have been reporting the inversion in Gold interest rates, but they are using the conventional wisdom to explain this phenomena. Their articles regularly state that lease rates are rising because of new producer selling, quoting as usual the omnipresent but unnamed "traders" who offer this supposed insight into the market. I believe this observation from traders to be somewhat questionable. It is also probably self-serving because I believe these traders are 'talking up' their position, which is short the market.

The traders want the market to believe that the reason for the rate inversion is increased demand. It serves their purpose to say so because traders are overwhelmingly short Gold at the moment, so the traders want a lower Gold price and are giving everyone a bearish view - increased demand for borrowing in order to sell this borrowed metal, which will result in a lower Gold price. But I continue to believe that the answer to this exceptional rate inversion, and the high interest rates in general for all maturities, is decreased supply. These high rates provide a very rare opportunity for the central banks to lend at exceptionally high rates - so why aren't they lending?

I've have quoted below a written summary I receive every morning from a London trader at one of the world's top bullion houses. His comments are usually reliable and balanced compared to other traders, many of whom only provide commentary favorable to their current trading position. Note what I have underlined. Like me, this trader is also asking whether Gold interest rates are going up because of increased demand or decreased supply?

"The need for short term metal continues with borrowers paying up massively to get their hands on short term metal. The real question to ask is this borrowing related to new spec shorts coming into the market or more worrying from the real sector (producers and CBs) who feel this is it and that the price outlook is not going to get much better and so are covering their bets. Many players expected CBs to lend into this relative tightness. Either they haven't or the appetite for metal to fund shorts or producer hedging is too great."

By way of comparison, here's another commentary received the same day from a different London trader. Note that this trader's "two reasons" do not even consider the supply side of the equation, and his commentary is palpably biased.

"Gold has suffered badly, especially in Tokyo time, and with lease rates going through the roof in the very short term, rumours abound as to the reasons why. There are two obvious reasons for the tightening, firstly central bank selling, and secondly producer forward selling. The most likely scenario at the moment is that both are occurring."

Bouts of producer selling, even when done in large volumes, historically has never resulted in such a dramatic inversion in Gold interest rates. And with Gold prices so low at the moment, and producer forward selling already substantial, the volume of new producer selling here is small, a conclusion I have reached both from logic and my observation of the market. Therefore, it seems to me that some other forces must be at work here.

I think the answer to the abnormal inversion in Gold interest rates is not in the DEMAND side of the equation (i.e., the need to borrow Gold), but rather in the SUPPLY side of the equation. which reflects the willingness or lack thereof by owners of Gold to deposit their metal with bullion banks - like Goldman, HSBC and the others - in order to earn interest on that metal.

My sense of what is happening is that the central banks, which together are by far the major source of Gold deposits in the bullion banks, are slowly but surely pulling out their deposits. The bullion banks have no lender of last resort to lend them metal to fund their Gold loans - many of which now have 5, 10 or 15 year maturity - so the bullion banks must keep bidding up Gold deposit rates to keep these long-term loans funded. It is a classic bank liquidity squeeze, arising because banks borrow short (take 3 to 6 month deposits) and lend long (Barrick and Ashanti have 15 year Gold loans for example). Commercial banks have a central bank to bail them out of this type of liquidity squeeze, but there is no lender of last resort to bullion banks, so Gold interest rates rise as a result. The bullion banks must borrow to fund their Gold loans, no matter the cost.

There is a good reason why the central banks may be withdrawing deposits from the bullion banks. Perhaps the central banks see the increased risk in the bullion banks, and are therefore pulling out their Gold from the bullion banks for safety reasons. I'm sure the central banks remember how the central bank of Portugal lost 17 tonnes of Gold that it had on loan to Drexel Burnham when that firm went under. The risk of the bullion banks is clear because as the Gold price falls, the mine cash-flow drops and the mines that the bullion banks had financed become vulnerable.

For example, another mine filed for bankruptcy recently, Dakota Mining, with $20 million of debt owed to the bullion banks. Former president of Dakota, Alan R Bell, made a very significant statement. He said that the company couldn't make a profit even with a cost of production of $220 per ounce. Even though those banks that had loaned $20 million of Gold are secured by the mining assets, i.e., the mine and related equipment, those assets are worth little at current Gold prices. If Dakota cannot make any money with those assets at current prices, then what value are those assets to the bullion banks? It is therefore logical that the central banks are probably wondering about the quality of bullion bank assets and asking themselves how they are going to be repaid the Gold they have placed on deposit.

A couple of weeks ago, Peter Fava the head of the bullion banking operation of HSBC and also the Chairman of the LBMA, said that some central banks were withdrawing Gold deposits from bullion banks because of Y2K concerns. Maybe there are also other concerns that he didn't mention.

by James Turk / Freemarket Gold & Money Report--A Commentary on Precious Metals and Monetary Matters
August 1, 1999

Copyright © 1999 by Freemarket Gold & Money Report. All Rights Reserved.

First published on July 26, 1999 in Letter No. 248
Please e-mail any questions or comments to: jamesturk@fgmr.com


Reprinted by USAGOLD with permission of FGMR. No further reproduction without permission of FGMR.

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