Red Alert Update
(27 February 2012)
In Backwardation in the Case of a Monetary Metal, we have explained how to interpret backwardation in the case of gold or silver. The major difference between gold and silver on the one hand and industrial or agricultural commodities on the other hand is the large stock to flow ratio, i.e. the fact that there are large stocks of gold and silver held for investment purposes which can immediately be on the market for sale should the price rise high enough. Therefore, the gold and silver markets do not exhibit the occasional shortages such as, for example, the markets for wheat or corn. Backwardation therefore has a different cause which we have identified as counterparty risk in gold or silver swaps.
This update adds one further possible cause of backwardation: significant carrying charges for holding US$ deposits or outright negative nominal interest rates.
The title Red Alert Update alludes to Antal Fekete’s article Red Alert (also see his The Last Contango in Washington). In these articles, he explains that persistent backwardation causes gold to leave the public exchanges and trading venues and to disappear into private hands. One way of understanding this is to view the market makers in the same fashion as the warehouse managers of industrial commodities or the operators of grain elevators in the case of wheat or corn. In a backwardation environment, they can no longer afford to maintain their inventory, and so the liquidity of the market dries up. We have touched on this aspect in Section 4 of The Many Values Of Gold.
We are grateful to One Bad Adder at FOFOA’s blog (formerly Topaz) for insisting on the danger of negative (nominal) interest rates and refer to his article The Last Rubicon. Three ideas now fit together:
- FOFOA’s insistence that the London gold market is in danger not from rising prices and buying pressure of unallocated or even allocated gold, but rather from a sudden extreme risk aversion and deleveraging. We refer to his Todays (quote-unquote) ‘Gold’.
- One Bad Adder’s insistence that the danger is negative (nominal) interest rates which can indeed be expected in an environment of extreme risk aversion when all investors crowd at the very short end of the yield curve and in demand deposits.
- A quick review of our Backwardation … article shows that indeed negative nominal interest rates or, alternatively, carrying charges for US$ deposits, can cause backwardation.
Therefore, Antal Fekete’s Red Alert may be triggered when short term nominal interest rates turn consistently negative. What matters is not so much demand deposits for retail customers, but rather the question of whether money in size, say US$ 50 million or more, may have to accept what is effectively a negative nominal interest rate, just for the privilege of a very liquid short-term investment.
There is in fact a recent precedent for carrying charges on large demand deposits (which, at that time, they did not enact, if I remember correctly). On 5 August 2011, the Wall Street Journal reported:
Bank of New York Mellon Corp. on Thursday took the extraordinary step of telling large clients it will charge them to hold cash.
The shift is also emblematic of the strains plaguing the U.S. economy. Fearful corporations and investors have been socking away cash in their bank accounts rather than put it into even the safest investments.
The giant bank, which specializes in handling funds for financial institutions and corporations, will begin assessing a fee next week on customers that have been flooding the bank with dollars, Bank of New York told clients in a note reviewed by The Wall Street Journal.
Bank of New York finds its deposits “suddenly and substantially increasing” as investors are in a mass “de-risk” mode. The bank said the decision was driven by the fact that it cannot invest much of the new deposits because clients have the ability to move the funds out at any moment.
The ultra-low interest rates set by the Federal Reserve in an effort to stimulate the anemic recovery have also neutered banks’ ability to reap profits from investing their deposits.
Bank of New York said that customers that have deposited more than $50 million into their accounts since the end of July will face an annual fee of at least 0.13% of the excess deposits. The fee would rise if the one-month Treasury yield dips below zero, according to the letter sent to customers.
A second indication of difficulties in managing large sums of short-term money is the 13 Week T-Bill Yield which has remained very close to zero during most of the second half of 2011. Investors who have large sums to invest and therefore cannot use demand deposits at a bank, typically choose short term Treasury Bills instead.
Since 13 week T-bills do not carry a coupon, they are auctioned at a price of 100% minus a discount, the 13 Week T-Bill Discount, and at maturity are repaid for 100%. So far, the auctions have been done only at a true discount, and it has not been possible to auction T-bills at a premium which would correspond to a negative nominal interest rate. Several Primary Dealers have apparently asked to make negative nominal interest rates possible in the future. According to the minutes of the Treasury Borrowing Advisory Committee of January 31, 2012:
[…] The question was asked if it made sense for Treasury to permit bids and awards at negative interest rates in marketable Treasury bill auctions. DAS Rutherford noted that there were operational issues associated with such a rule change, but that the hurdles were not insurmountable. It was the unanimous view of the committee that Treasury should modify auction regulations to permit negative rate bidding and awards in Treasury bill auctions as soon as feasible. Rutherford noted that any decision on this policy change would likely be made at the May refunding. […]
Let us now review our article on Backwardation … and reconsider the formula for the interest rate on swaps of gold for US$, i.e. the interest rate paid if one lends gold and borrows US$ for a fixed period. This rate corresponds to the Gold Forward Offered Rate (GOFO) in the case of the LBMA or to the gold base rate in the case of the COMEX:
swap rate paid =
+ nominal risk-free yield of US$
+ risk-premium because you might not return the borrowed US$
+ storage expenses for the gold
– risk-premium because your counterparty might not return the gold
– carrying charges for US$
The last term, the carrying charges for the US$ deposits, was assumed to be zero in our previous article, and we had not anticipated that the nominal risk-free yield of US$ might become negative. If we now take a possible environment of negative nominal interest rates into account, we would have a negative nominal risk-free yield of US$ or, alternatively, zero nominal risk-free yield of US$, but non-zero carrying charges for US$. So even if the two risk premiums cancel or can be ignored, it may happen that the carrying charges of US$ or the negative nominal yield of US$ exceed the storage expenses for the gold. In this case, an efficient market discovers a negative swap rate paid which means backwardation.
Gold! It is the only medium that currencies do not “move thru”. It is the only Money that cannot be valued by currencies. It is gold that denominates currency. It is to say “gold moves thru paper currencies”.
Dollars bidding on MSFT stock set the value of that stock. If dollars are frantically bidding on MSFT (high velocity), the stock skyrockets. If dollars stop bidding for MSFT all at once (low velocity), the price falls to zero. This is true for everything in the world **except gold**.
Gold bids for dollars. If gold stops bidding for dollars (low gold velocity), the price (in gold) of a dollar falls to zero.
The critical situation to watch for is therefore the flight of capital down along Exter’s Pyramid,
from any riskier and longer term investments into T-bills and demand deposits and perhaps even into tangible cash, into gold, or if gold it not available, then into hoarding any of the necessities of life (also see FOFOA’s All Paper Is Still A Short Position On Gold).
We like to summarize the outcome of the ultimate flight of capital as follows:
- If physical gold is available at a fixed currency price, the gold will be hoarded while credit collapses. In the absence of bailouts, we get 1929-1933.
- With bailouts as follows:
- If physical gold is not available, capital flight will be into the necessities of life instead (hyperinflation).
- If physical gold is available at a fixed currency price, there will not be enough of it.
- If physical gold is available at a floating price in terms of credit money, its price may skyrocket, but gold can continue to flow and help avert hyperinflation.