Echoes Of Yen Carry Trade Risks Reverberate In Gold Market

Looking for another market risk factor to worry about? Try the gold market.

There, certain investors have taken advantage of the precious metal's relentless slide in the past three years to put on what's known as the gold "carry trade."

The trade involves borrowing gold from banks at prevailing low interest rates, selling it and converting it into cash, then using the proceeds to buy higher yielding assets such as Treasuries.

If and when investors are forced to cover those positions, some say the effect could resemble the turmoil caused by the reversal in the popular yen carry trade last fall, when the dollar nose dived and investors were forced to flee high-risk assets. Treasuries, already under pressure from concerns over U.S. inflation risks, could be among those markets to suffer in the fallout.

Limited disclosure means no one can ever really know the full extent of the "carry trade" in gold, but talk is certainly starting to grow on the issue.

Significantly, London-based Gold Fields Mineral Services Ltd. this year made its first ever reference to the carry trade in its closely watched annual survey of the gold market.

"For many years a significant quantity of gold has been borrowed as a source of cheap finance," Gold Fields said in its report. "The arbitrage has in fact been remarkably similar to (though far smaller than) the famous 'yen carry trade.'"

Gold Fields managing director Philip Klapwijk later told analysts he estimated the size of those positions to be 400 metric tons -- worth about $3 billion at current rates.

The potential impact of a sudden reversal in gold, both in terms of the "short squeeze" boost it would give to the price of gold and its effect on other markets, would depend on the circumstances surrounding the short-covering activity, said Gold Fields director Paul Walker.

"If there were to be a major economic shock, those who had been shorting the gold market would have to do some quick covering. And, of course, 400 tons is not a trivial amount," Walker said.

Gold Remains The Cheapest Currency

At this stage, market analysts outside the gold market don't seem focused on the gold carry trade at all. Many told Dow Jones Newswires they were unaware of it.

This could suggest Wall Street's risk-hungry clients aren't as enamored with the gold carry trade as they once were with the equivalent yen strategy, and in that sense that it presents less of a systemic risk. The conservative policies adopted by hedge funds and other such institutions after they suffered heavy losses during the crisis in the fall may have had a constraining effect.

There's no question, however, that the gold carry trade has been an attractive deal, one that many hedge funds and other speculative short sellers would have found irresistible.

"Gold is the cheapest currency around," said Hunt Taylor, senior vice president of Rye, N.Y.-based Tremont Partners, which tracks hedge fund performance. "Hedge funds do occasionally find creative ways to finance transactions in gold."

Indeed, some market observers and participants allege that, at the time of its near collapse, Long Term Capital Management was exposed to the tune of 300 tons of gold. An LTCM spokesman told Dow Jones Newswires earlier this year that the fund had never invested in metals, including gold.

Jump In Gold Lease Rates May Sour Carry Trade

From the time gold peaked at around $417.50 a troy ounce in February 1996 to until just recently, gold leasing rates rarely rose above 1 percent, while long-term Treasury yields have been either side of 6 percent. That's a healthy spread.

However, lease rates, which reflect the cost of borrowing gold, shot above 4% last week, with some market observers speculating that Y2K fears and liquidity concerns were behind the jump in rates.

"Lease rates have come down a bit, but they're triple normal," said Bill Murphy, chairman of the Gold Anti-Trust Action Committee, or Gata, a group alleging that a cabal of unnamed Wall Street investment houses and bullion banks have been manipulating the gold market in a collusive fashion. Industry and market participants have responded with deep skepticism to Gata's claims.

Conspiratorial or not, Murphy's analysis highlights some inherent risks in higher gold lease rates.

"It has to do with the general liquidity situation out there," said Murphy. "If the credit rates are rising, why should there be any less scrutiny in the gold market? Banks are going to start withdrawing their gold liability in addition to the credit problems surrounding Y2K. So you've got a double whammy."

While gold prices skidded in a narrow range along 20-year lows for much of July, the market began to stage a bit of a recovery since last week, in part bolstered by the jump in lease rates.

Some believe the higher rates could portend a sudden and damaging short-covering rally in gold.

Still, it's difficult to to say how much gold is currently being used as a true "naked short" in the carry trade and how much is simply part of producer hedges or gold that is borrowed by fabricators to produce gold-based products.

"There are some who argue that because of the huge losses in yen carry trade that banks have been refinancing their yen-dollar carry trades with gold," said Frank Veneroso, a gold expert at Veneroso Associates and author of the Gold Book Annual. "I'm very skeptical of that. And in any case, if lease rates stay around 4 percent, the carry trades would be reduced."

While a rush to cover short positions would be of huge benefit to the price of gold, it's unlikely to have significant ramifications on other markets, he said.

"I don't think (the gold carry trade) is a big deal," he said. "I think that sometime down the road, it will get unwound. But I've never believed it's been large enough to create any systemic risk whatsoever," he said. "A couple of tens of billions of dollars ain't going to get you anywhere in terms of systemic risk."

Michael Casey and Janet Whitman

Dow Jones News Service

21 August 1999

-- andy (2000EOD@prodigy.net), August 22, 1999