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Gold, Time, and Interest

What would you sooner have: £100 today or £115 next month? There’s no obvious answer. It all depends on your present and expected needs. If you lend something, you expect that something back, plus a little extra. So someone who lends his gold expects to receive it back, plus an extra amount – the interest. But what happens when we live through an era of very low-to-negative interest rates, like today? Lending anything becomes much less attractive; the best you can hope for is that you get your original loan back. Not much incentive there.

Gold has always a medium of exchange. It’s widely held by central banks and other institutions as a store of wealth. In the 1980s, gold was used as collateral for a carry trade, which worked like this. A central bank loaned a bank some gold, at a very low rate of interest. The bullion bank then sold the gold and invested in securities with a higher rate of return, such as government long-term bonds. The bullion bank effectively sold the gold short.

Now suppose the loan was called in by the central bank. If gold has risen in value, the bullion bank will have to go into the market and purchase higher priced gold. Indeed, if many banks are short, the unwinding of the gold carry trade could drive the gold price even higher.

The depressed price for gold and the gloomy noises about the future price of gold meant that central banks happily lent their gold; bullion banks happily borrowed it and invested in US treasury bills; and there was an explosion in the bullion business. Everyone was (more or less) happy – except for holders of physical gold, who blamed gold miners for helping to depress the gold price.

Time moves on. Today, the gold lending market has become so developed that for every ounce of physical bullion in the possession of banks there may be hundreds of paper liabilities. No one has a real idea of the true level of paper gold leverage that we have now reached. One thing is certain: a low and positive gold leasing rate has led to a substantial uncovered position. From a central bank’s perspective, if a lease is coming due then there is no incentive to renew it – would they really want to, given the unknown counterparty and systemic risks that may occur in today’s unstable economic climate?

It is clear that there is no real incentive today to lend gold. The appetite for doing so has vastly diminished. The gold price has recently moved rapidly from $1,200 to $1,550/ounce. With yields converging towards zero and even going negative, the likelihood that gold will be lent by anyone is illogical – and that ought to mean that as the supply dries up, the price can only go higher.

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