I appreciate and welcome the new Guidance Paper on Gold Deposit Rates which has just been released by the World Gold Council. It is a highly interesting, comprehensive, and well documented paper that is an invaluable tool for all central bank reserves managers, an essential read indeed. The release of that Guidance also comes at the right time. Over the last years, we have seen a more and more positive perception of gold as a strategic asset by central banks which have regularly increased their gold holdings. However, central bankers continue asking how to actively manage their gold holdings because the information and understanding of the gold market has been missing. It is true that the gold lending market is an OTC market, and thus, less prone to full transparency, partly due to limitations inherent in price discovery mechanisms. However, gold lending can serve as an important active management tool which can enhance return, of course when market conditions are favourable.
The Guidance Paper provides all the clues to understanding and grasping the functioning of the market and the different factors which drive the gold lease rates. First, there is a need to properly understand the meaning of different terms used: gold deposit rates, gold lease rates (GLR), Gold Forward Offered rate (GOFO). Second, there is a need to understand the different types of gold trades: straight deposits, forwards, swaps, carry trades. And third, there is a need to understand the behaviour of the different actors in the market: miners/refiners, end-users (jewellers, industries), bullion banks, central banks.
The Guidance offers a detailed historical analysis of how the different factors driving GLR have been at play. In my view, I would like to focus primarily on two periods: before 1999, when the Central Bank Gold Agreement (CBGA) was signed, and after.
From the 80s until September 1999, the gold market was bearish. The sales of gold reserves by some central banks as well as the uncertainty about their behaviour going forward were accentuating downward expectations for the gold price. Therefore, the mining producers’ hedging demand increased, sometimes without accurate risk management considerations. To put it simply, miners were increasing selling forward their production and central banks were responding to that increase by lending their gold as GLR were high. However, selling forward implies a spot sale which depresses the spot gold price. I remember well discussions about that kind of “vicious” circle (hedging from producers/central bank lending/declining spot gold price) within the Eurosystem. For some central banks, the lending had no impact on the spot gold price, and, for others, it was contributing to the falling price. The CBGA was signed to stabilise the market and provide greater transparency in central banks’ behaviour as far as their selling and lending activity was concerned. It put a halt to that vicious circle.
In the years following 1999, gold market has profoundly changed, and became a mature market. Behaviours have changed, miners have closed their hedging books, central banks became buyers more than sellers. They are lending less and less given the low levels of GLR.
Looking ahead, I think that, unfortunately, GLR may remain low and even negative for the following two main reasons. The first is that real interest rates are extremely low and even negative in the current environment, and they will remain low. Traditional factors explaining the current low real interest rates continue to apply: low potential growth prospects, demographics, and portfolio shift towards safe assets. Furthermore, central banks’ monetary policy will remain extremely accommodative. As is very well explained in the Guidance, when real interest rates are low and decrease, gold price expectations retain a bullish trend which, in turn, will translate into low GLR.
The second reason is that producers’ hedging demand will remain low (especially if gold price keeps on increasing) while at the same time central banks’ lending supply will remain subdued. This does not mean that GLR spikes may not happen, but I see them as short-lived.
This also does not mean that central banks should not consider lending if they want to enhance the return on their gold reserves when conditions are favourable. However central banks should be operationally ready to do so when opportunities arise, meaning that they should have:
- an understanding of what allocated and unallocated risks are
- a strong legal contract with their custodians
- an assurance that their gold to be lent is Good Delivery loco London market (the reference)
- strong back-office and accounting infrastructure to cope with the gold lending trades.
