The Thermometer Is Way Above Normal

October 20, 1997 – Many aspects of Gold are misunderstood by many people, and this lack of knowledge leads to numerous misconceptions about Gold, its usefulness, and in particular, its ongoing role as money. However, there is one aspect of Gold that is nearly totally misunderstood – interest rates.

If you ask 99 out of 100 people, they will say that ‘Gold earns no interest’. They of course are stating that they are unable to earn any interest on the Gold they own, but they are totally wrong. Gold does pay interest, just as the Dollar, Franc, Pound or any other currency pays interest, namely, if you lend it to someone else.

If you lend your Dollars to a bank by putting them into a time deposit, you earn some interest on your deposit. Similarly, if you lend your Gold to a bullion bank, you also earn a rate of interest. There is, however, a catch. The minimum deposit in this game is generally 10,000 ounces, the present Dollar equivalent of which is about $3¼ million.

Thus, few people recognize that Gold ‘does pay interest’ because this game is clearly for the big players. It is also pretty much a closed club – there are less than one hundred bullion banks around the world that accept Gold deposits. However, it is amazing to see how many people perpetuate the false notion that Gold does not pay interest, even within the Gold industry where people should know better.

In an industry sponsored forum, I recently heard the Chairman of a large and well known Gold mining company, which had a forward sale that hedged future production, make to a room full of analysts, portfolio managers, and executives from other mining companies, the pernicious statement that Gold pays no interest. I was incredulous both that the statement was made, and that it was not challenged. If Gold did not pay interest, did he mean that his company borrowed interest-free from a bullion bank the Gold required to complete its forward sale? No, of course not. His company is paying interest on that borrowed Gold, just like it is paying interest on the Dollars being borrowed.

I would like to explore this concept of interest rates more fully. The reason is that interest rates act much like a thermometer. The level of a currency’s interest rate can tell you much about the patient.

There is a normal rate of interest. Moreover, a lot can be learned by examining a currency’s interest rate. Have you ever stopped to consider why interest rates in Italy are higher than interest rates in the United States, which are higher than interest rates in Switzerland? Or why are the various European central banks so concerned about the convergence of interest rates as one condition precedent to the establishment of the European Monetary Union?

Basically, interest rates reflect risk. Increase the risk, and the interest rate rises. For example, in answer to the above question, interest rates on the Lira are higher than those of the Dollar because the risk of the Lira is greater. We all know the propensity of the Italians to inflate their currency, and the higher interest rate reflects that risk. Similarly, the market believes (as I do) that the Federal Reserve is more likely to inflate the Dollar than the Swiss National Bank would inflate the Swiss Franc.

Therefore, the risk of holding Dollars is greater, so Dollar interest rates are higher than Swiss Franc interest rates.

So what money has the lowest rate of interest? It is Gold because it has the least amount of risk. Gold cannot be inflated away by some central bank, so the varying inflation premium in the interest rate of national currencies is absent from Gold. However, all is not well with Gold’s interest rate at the moment. Gold interest rates are abnormally high.

Throughout history Gold’s interest rate is well documented. Normally it is less than 1%, meaning that a triple-A credit risk could borrow Gold at less than 1% per annum (in fact, it is often less than ½%). In recent weeks, however, Gold’s rate has been holding steadily above 3%, and for most of this year it has been above 2%. Something is out of kilter here.

The nature of Gold has not changed – central banks cannot inflate it. So why is Gold’s interest rate so high? Given the basic premise that interest rates reflect risk, what risk has increased for Gold to cause these higher rates? Why is the thermometer way above normal?

Gold has another kind of risk now generally forgotten because it is not a risk normally seen in national currencies – it is delivery risk. From time to time Gold traders may be required to deliver Gold to extinguish a short position. In contrast to national currencies which can be created by the stroke of a pen in order to fulfill a commitment to meet a short position in a national currency, Gold cannot be considered ‘delivered’ by making a bookkeeping entry if the counterparty to that outstanding contract requests physical Gold. Delivery of Gold – and not just a promise to pay it – is required.

What does it all mean? Here is the conclusion by one veteran and very astute participant in the Gold market, Murray Pollitt of Pollitt & Co., a Toronto brokerage firm: “In our view a crisis is developing. Derivative traders, commodity and hedge funds, many mining companies and God knows who else are short hundreds of millions of ounces of gold and silver on technical, ideological and emotional grounds. Contrary to popular myth there is no lender (or supplier) of last resort.”

The point is very simple. In contrast to currencies, Gold cannot be created out of thin air. Any person who is short Gold (and Silver too) may be called on to deliver the metal. Mining companies can deliver from production, but commodity and hedge funds do not have that option.

Gold’s interest rate is running at a very high 3¼% because there is a shortage of physical metal, so Gold borrowers may not be able to deliver Gold when the time comes for them to meet their commitment to return the Gold being borrowed. Anyone lending Gold today must understand that the abnormally high interest rate they are earning is a direct consequence of the higher risk of delivery/repayment they are accepting.

To avoid defaulting on their commitment to deliver, the speculative players must buy back their shorts in the market. A higher Gold price, perhaps with a crisis, will be the natural result of any rush to acquire the metal needed to deliver to cover shorts. A crisis will occur if the rush for metal gains momentum.

The reason is that rapidly rising Gold prices will threaten the solvency of many commodity pools and hedge funds that are short Gold.

As the Gold price rises, the shorts will be required to post more margin to prove their financial resources (i.e., their capacity to deliver) and/or may actually be forced to deliver Gold against their short position. This action means the shorts will be buying Gold, which further drives up the Gold price, which in turn creates a vicious circle of more margin calls and more buying. There is a recent example of this frenzy.

Consider what happened last year to the price of copper when the attempted corner amassed by Sumitomo’s rogue trader began to unravel. The price of copper plummeted in a matter of days. A similarly violent move in Gold is likely, but in the reverse – Gold will soar.

The reason for this different result is that there was a surplus of copper that was being masked by Sumitomo to make it appear as a shortage. With Gold, the opposite is occurring.

There is a shortage of Gold being made to appear as if it were a surplus. We know there is a shortage because Gold’s interest rate is way above normal.

Though market prices and market conditions can stay out-of-whack for a time, in the end normal conditions will always prevail. Therefore, we know that Gold’s interest rates will once again fall back to historically normal levels below 1%.

But we also know that for interest rates to return to normal, the other side of the equation must also return to normal – the Gold price must rise.

No one knows whether it will take $380 or $500 or some higher price in order to prod holders of the metal to put sufficient Gold back into the market (i.e., enticing them to hold Dollars instead of Gold) which will reduce the current shortage of metal But we do know that the current low Gold price is every bit as much an anomaly and extraordinary occurrence as Gold’s exceptionally high rate of interest.