Morgan Stanley Deconstructs The Funding Crisis At The Heart Of The Recent Gold Sell Off, And Why The Gold Surge Can Resume
A week ago, we touched upon the likelihood that the recent gold sell-off was driven primarily due to a quirk in liquidity provisioning in which gold plays a key role via its "forward lease rates", or the Libor-GOFO differential. Specifically, in "As Negative Gold Lease Rates Collapse, The Gold Sell Off Is Likely Coming To An End" we said, "In a nutshell, negative lease rates mean one has to pay for the "privilege" of lending out one's gold as collateral - a prima facie collateral crunch. The lower the lease rate, the greater the use of gold as a source of liquidity - and since the indicator is public - it is all too easy for entities that do have liquidity to game the spread and force sell offs by those who are telegraphing they are in dire straits and will sell their gold at any price if forced, to prevent a liquidity collapse." Said otherwise, the lower lease rates drop, and they recently hit a record low for the 3M varietal, the likelier it is that gold may see substantial moves lower. Today, Morgan Stanley's Peter Richardson recaps precisely what was said here, in a note titled "Recent fall in gold prices points to bank funding costs." Granted, MS only looks at the first part of the equation - the dropping lease rates, and ignores the re-normalization in gold, aka the tightening in lease rates. Well, with the 3M forward lease rate now almost back to unchanged, it appears our speculation that the gold sell off, with spot at $1575 on the 15th, is over were correct, and gold is now $40 higher, and just below the critical 200 DMA that everyone saw as the catalyst of gold going to $0. So what does MS have to add to our analysis? Well, much more optimism for one, because not only does the bank think we are right that the collapse in negative lease rates (i,e., the flattening to practically unchanged) mean the sell off is over, but such a normalization of the gold lease market has "the makings of a renewed upward assault on the recent all-time high.... Our current gold price forecast for 2012 of US$2,200/oz remains in place under these circumstances." Qed.
The key highlight of Morgan Stanley's hypothesis of what negative gold lease rates imply for gold:
Firstly, we think negative lease rates are highlighting a sharp increase in the demand for gold as collateral for US dollar loans at a time of reduced liquidity in the traditional US dollar interbank funding market. The more negative the lease rates the higher the cost of funding using gold as security.
Secondly, access to this collateral on a scale indicated by the rise in GOFO can only emerge if the providers of liquidity to the leasing market are prepared to increase the stock of lent gold in circulation. This development points to the central banks, the largest custodians of above-ground stocks and the traditional providers of liquidity to the gold-leasing market. Aware of acute funding pressures in the traditional interbank market, it seems increasingly likely to us that central banks have increased the quantum of gold available for use in a non-traditional funding market, at least until the measures to alleviate bank-funding stress in the US dollar swaps market have been successful. The recent easing in the scale of negative gold lease rates, suggests that demand for this source of short-term funding might be easing, but has not disappeared, even after the raft of measures announced by the ECB and the earlier coordinated intervention by the six central banks.
Said otherwise: we likely have smooth sailing for now, as banks will not proceed to cannibalize each other for a bit. But keep a very close eye on on that LIBOR-GOFO spread: the second it collapses, it may be time to step away from the market.
Full Morgan Stanley note:
Recent fall in gold prices points to bank funding stress
Spot gold prices fell 6.6% to $1,602/oz in the week ending 16 December 2011, their biggest losing week since early October. We attribute some of the impetus in the selling pressure to year-end portfolio adjustments, a flight to cash as concerns over the European sovereign debt crisis mounted in the face of further ratings downgrades and a related strong safe haven rally in the US dollar (USD). However, this sharp fall continued downside price pressure evident in Q4 2011 that has resulted in a decline in prices on a quarter-to-date basisof 1.5%.
This quarterly decline has reinforced the impact of the sharp falls in gold prices registered in September 2011 after prices reached a new all-time high of US$1,951/oz on September 6. This has raised market fears that the September high and rally in early November 2011 to US$1,798/oz mark the twin peaks in the ten-year bull market for gold, and effectively mark its conclusion.
Our view is different. While recognizing the technical damage sustained in recent weeks, we do not see the bull market as having reached its ultimate peak at this time. While seasonal and non-gold market factors have undoubtedly played an important role in the two corrective waves of selling since September 2011, the unusual phenomenon of negative gold lease rates and falling gold prices points to other factors at work in the gold market. We conclude in this report that these probably relate to bank funding stress. While this is expected to continue into 2012, recent coordinated actions by six central banks, and separate actions by the ECB, suggest that non-gold-related measures to ease access to US dollar swaps will gradually ease the downside pressure on the gold price. We expect this corrective phase will conclude when the Federal Reserve adopts a new round of quantitative easing in H1 2012, weakening the US dollar and reigniting the safe haven trade for gold that is likely to see a renewed and successful challenge to the September 2011 high.
Spot gold prices fell 6.6% to $1,602/oz in the week ending December 16, 2011, their biggest losing week since early October. We attribute some of the impetus in the selling pressure to year-end portfolio adjustments, a flight to cash as concerns over the European sovereign debt crisis mounted in the face of further ratings downgrades and a related strong safe haven rally in the USD. However, this sharp fall continued downside price pressure evident since the initial correction in early September 2011 and has resulted in a decline in prices on a quarter-to-date basis of 1.5%.
This quarterly decline has reinforced the impact of the sharp falls in gold prices registered in September 2011 after prices reached a new all-time intraday high of US$1,925.10/oz on September 6, and a closing price high of US$1,889.70/oz on August 22. As a result, this latest fall has raised market fears that the late August-early September high and recovery in early November to US$1,798/oz delineate the twin peaks in the tenyear bull market for gold, and effectively mark its conclusion.
The timing of this sell-off, in our view, is instructive. In part, this is due to the pressure of book-squaring and portfolio adjustments going into year-end. While this adjustment is likely to have affected a wide range of commodities, given gold’s strong relative and absolute performance throughout 2011, notwithstanding the falls in price since September, the ability to realise profits on the gold trade to offset losses in other commodities or asset classes would have increased the intensity of recent selling pressures, in our view. Spot gold returns for 2011 based on the differences between opening and closing prices will, at today’s price of around US$1,600/oz, be 12.5%, a return that is only bettered by Brent oil within the commodity universe that we monitor. Within the traded precious metals, gold has been the standout performer, with silver registering a negative return of -4%, platinum -20%, and palladium -22%.
The correction in gold also coincided with a commodity-wide sell-off linked to a sharp rally in the USD. On a TWI basis, the USD strengthened 2% in the week ending December 16, while Brent crude oil fell 6%, the MG Base Metals Index fell 5%, and US dollar gold prices fell 8%. This mirrors a similar picture since the peak of the gold market in late August when the TWI of the USD has rallied by 7% but gold has fallen by 15% up to the week ending December 16. Over this same period, the MG Base Metals Index has fallen 16%, but Brent crude has declined by only 5%.
Why is gold behaving as a risk asset?
The marked similarity between the wider components of the commodity complex has inevitably raised questions as to why gold has behaved in such a similar way to other commodities and other risk assets since early September. This question is even more pertinent when seen in longer-term perspective since the collapse of the Lehman Brothers investment bank in September 2008, as gold prices rose by 147.8% between September 10, 2008, and August 22, 2011, a compound annual return of 35.3%. In short, has the safe haven commodity asset of the first three years of the financial crisis lost this status, or is this a short-term correction and consolidation in a continuing bull trend?
Technical indicators are not encouraging in this context. The sharp fall in US dollar prices in the week ending December 16 rang many alarm bells. According to Kitco Metals:
“Ever since the February gold contract spiked to a new all-time high on September 6 at $1,925.10/oz, the bearish forces have been clawing at the marketplace. That session – [on] September 6 – etched a bearish key reversal day on the daily chart, which simply means the market rallied to a new high, but then reversed intraday to close lower, near the bottom of the daily range. The market remains under the influence of that bearish key reversal. While the September 26 spike low [sic] at $1,543/oz has held in gold market price action throughout [subsequent] months, last week's break below the widely watched 200-day moving average flashed a big red warning signal to longer-term bulls. That longer-term moving average is widely considered a proxy for the longer-term trend. The entire rally throughout 2011 has held above that key moving average, until last week. It represents an important technical breakdown and leaves the September low at $1,543/oz vulnerable to a strong test in the days ahead. If the market were to break under $1,543/oz, the next key chart support zone lies first at psychological support at $1,500/oz, but then a strong band of congestive support from the $1,475/1,482 area is seen from May through July.”
Bank funding stress might hold the key
While we recognize the force of this technical argument, we note in passing that since the fall to a closing day low of US$1,575/oz on 15 December, the market has managed to hold above the key downside support level of US$1,543/oz. Whether this recent consolidation holds long enough to become the basis for a renewed rally will, in our view, depend strongly on whether the recent acceleration in selling pressures abates because of recent monetary policy initiatives by central banks designed to alleviate bank-funding pressures.
Why are bank funding pressures and the gold price linked? Why are they now linked in a manner that has proven negative for gold prices, rather than positive, as was the case in the post-Lehman era? In our view, the answer to this question can be found in the gold leasing market and what London’s Financial Times has designated the “recollateralising of credit with gold.”
To appreciate how this recollateralising of credit with gold has developed, it is necessary to look again at the roots of European bank funding stress. Essentially, as the sovereign debt crisis has worsened, many small to medium-sized banks in Europe have experienced a rising need for cash, and particularly cash in US dollars. This was because many of these banks have borrowed US dollars in the overnight interbank market but have invested in longer-term US assets, accelerating the dangers of funding mismatches, as traditional counterparties to these loans have been withdrawing liquidity and refusing to extend loan facilities. This development has been reflected in the private market for short-term US dollar loans between banks in the London Interbank Offered Rate (LIBOR), which has risen consistently since July 25 (Exhibit 3).
As LIBOR rates kept rising, it is clear that by late November, the need for US dollar funding via the euro/USD swap market also markedly increased. In the week before the central bank intervention on November 30, the euro/USD basis swap, an instrument of the interbank market that marks the rate differential between short-term US dollar and euro loans, reached levels last seen in November 2008, indicating a severe need for dollar funding.
This persistent rise in the costs in the private market for US dollar loans as reflected in LIBOR provides the link to recent developments in the gold market, in our view. For LIBOR is also a key component of the gold lease rate, a derived value calculated by subtracting the Gold Forward Offered Rate (GOFO) from LIBOR for different maturities between one and twelve months. The London Bullion Market [LBMA] defines GOFO as the “rates at which contributors [the market-making members of the LBMA] are prepared to lend gold on a swap against US dollars”.
In the context of a severe need for US dollar funding, it is the ability to access US dollars via a swap in the gold forward market that provides the link to bank funding stress and recent developments in the gold market, in our view. As Exhibit 4 shows, notwithstanding the steady rise in LIBOR rates, GOFO rates have risen faster as the demand for borrowed gold as a means of providing collateral for short-term dollar funding has risen in line with the growing pressure on banking funding.
This rise in GOFO also dates back to the same period as the rise in LIBOR, putting downward pressure on gold lease rates. Very low or even modestly negative gold lease rates have been a feature of the gold market since 2001, when the demand for gold hedging by mining companies started to decline sharply.
However, the recent sharp move into strongly negative gold lease rates that began in late August/early September identifies an important change in the tenor of the gold market. This is not only because gold lease rates have fallen to a 22-year low, but also because the emergence of strongly negative gold lease rates has also coincided with falling gold prices. This apparent reversal between a well-attested inversion between US dollar gold prices and lease rates further highlights the significance of recent developments in what the Financial Times has called “a little-watched corner of the gold market.”
So what are the sharp fall in gold lease rates and the attendant decline in gold prices indicating?
Firstly, we think negative lease rates are highlighting a sharp increase in the demand for gold as collateral for US dollar loans at a time of reduced liquidity in the traditional US dollar interbank funding market.
The more negative the lease rates the higher the cost of funding using gold as security. Secondly, access to this collateral on a scale indicated by the rise in GOFO can only emerge if the providers of liquidity to the leasing market are prepared to increase the stock of lent gold in circulation. This development points to the central banks, the largest custodians of above-ground stocks and the traditional providers of liquidity to the gold-leasing market. Aware of acute funding pressures in the traditional interbank market, it seems increasingly likely to us that central banks have increased the quantum of gold available for use in a non-traditional funding market, at least until the measures to alleviate bank-funding stress in the US dollar swaps market have been successful. The recent easing in the scale of negative gold lease rates, suggests that demand for this source of short-term funding might be easing, but has not disappeared, even after the raft of measures announced by the ECB and the earlier coordinated intervention by the six central banks (Exhibit 6).
With funding stress still evident in the European banking system, we expect gold lease rates to remain negative until the recent exceptional measures instituted by central banks start to take effect, as demand for collateral for short-term funding will remain high. We expect the provision of liquidity to this market from above-ground stockholders to also continue, providing an additional safety valve to the European banking system while providing short-term pressure to the gold market as surplus gold from these stocks is put back into circulation. While we believe this situation will persist into early 2012, in due course we expect that these pricing pressures will subside as the US dollar swap window reopens. We expect this to result in a consolidation in the gold price above the key technical downside support level of US$1,543/oz before the adoption of more stimulatory measures by central banks, and the US Federal Reserve in particular, provides the catalyst for a renewed rally. If, as we expect, the timing of this policy initiative coincides with a normalizing in the gold lease market, then the makings of a renewed upward assault on the recent all-time high will be back in place. Our current gold price forecast for 2012 of US$2,200/oz remains in place under these circumstances.