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Goldman, gold, euro zone, basis swaps [ClearOnMoney]
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Goldman, gold, euro zone, basis swaps

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Commentary

Goldman, gold, euro zone, basis swaps

13 Jan 2012 by Jim Fickett.

Goldman Sachs suggests that the force pushing gold down recently, even though real interest rates were negative, was that the dollar funding shortage in Europe caused banks to “pawn” their gold for dollars. They think the dollar funding shortage will ease this year, and the gold price will rise again.

In a recent report, summarized by FT Alphaville, Goldman Sachs reiterates the widely noted fact that gold prices tend to go up when real interest rates are negative, and suggests that the recent drop in the gold price requires an explanation. They find an explanation in the recent dollar funding shortage in Europe.

I have pointed out before that, in bouts of panic over the euro zone, dollars were seen as more desirable than gold (Flight to safety chooses dollar over gold). GS quantifies this relationship, using euro dollar basis swap rates and gold lease rates.

First, here is a little background on euro dollar basis swaps, one particular method that European banks use to obtain dollars. The Bank for International Settlements explains:

A cross-currency basis swap agreement is a contract in which one party borrows one currency from another party and simultaneously lends the same value, at current spot rates, of a second currency to that party. The parties involved in basis swaps tend to be financial institutions, either acting on their own or as agents for non-financial corporations. The chart below illustrates the flow of funds involved in a euro/US dollar swap. At the start of the contract, A borrows X·S USD from, and lends X EUR to, B. During the contract term, A receives EUR 3M Libor+ α from, and pays USD 3M Libor to, B every three months, where α is the price of the basis swap, agreed upon by the counterparties at the start of the contract. When the contract expires, A returns X·S USD to B, and B returns X EUR to A, where S is the same FX spot rate as of the start of the contract.

A gets dollars and pays the current interest rate on dollars, and both parties take symmetrical exchange rate risks. The only asymmetry in the arrangement is α, the additional rate that B pays, in addition to the current interest rate on euros. So α, termed the euro dollar basis swap rate, or the euro basis swap for short, measures the degree to which euros are currently more desirable than dollars. The euro basis swap has, unsurprisingly, been negative for at least a year, indicating that dollars are more desirable than euros.

The key observation of Goldman Sachs is that the gold lease rate has, during the euro crisis, been very highly correlated with the euro basis swap. That is, when dollars are seen as more desirable than euros, demand for gold goes down, and in a very quantifiable way. They suggest that this is the explanation for the drop in the gold price, and that, as dollar funding pressure eases this year, the gold price will rise again:

In gold, the relationship between real interest rates and gold prices has opened up to the widest levels in the current cycle. This wedge between gold prices and real interest rates as measured by 10-year TIPS was driven by a substantial surge in the demand for US dollars during December. This demand for US dollars drove the gold lease rates to unprecedented negative levels as US dollars became increasingly more valuable than gold. This new demand for dollars was mostly from European banks using the gold market to source US dollar liquidity when their funding from the US money markets dried up, which created a significant amount of gold selling.

In turn, the re-convergence of gold and real interest rates is dependent upon how long this dollar-funding liquidity squeeze lasts, forcing European banks to source US dollars from the gold market. We believe that many European banks will likely exit or sell many of their US dollar based businesses in 2012, which will likely substantially reduce this US dollar demand from the gold market, taking the pressure off gold lease rates, and pushing gold prices back up in line with real interest rates. Further, following ECB’s aggressive action on funding through the Long-Term Refinancing Operation (LTRO), the near-term pressure on European bank funding has eased significantly. Accordingly, we are maintaining our 12-month target of $1,940/toz.

There is always much more going on in the market than any one person is aware of, and I don't take arguments like this, with so many moving parts, too seriously. But it is interesting, and there is probably something to it.