Watch Gold’s Interest Rate

March 9, 2001 – It is natural for us humans to search for rules we hope will prove to be unchanging. We want these rules to be unchanging because we hope that they can be used to help explain, or perhaps even predict, an uncertain and unknowable future.

For example, waves always break upon rocks in a way consistent to some basic principles of force and matter. But while unchanging rules are possible within the realm of the physical sciences, no such unchanging rule is possible in the social sciences because human will is ever changing and always unpredictable. Therefore, regarding markets, what worked last year may not work this year. This observation explains an old Wall Street adage – As soon as you open the lock, Wall Street throws away the key.

I am making this point because there has been much talk about the dramatic rise in Gold interest rates over the past couple of weeks. Much of this talk focuses upon interest rate jumps in the past in an attempt to explain the present or predict the future. But because markets are always changing, the relationship between Gold’s interest rate and its price is always changing too, so it has to be analyzed in view of prevailing circumstances.

For example, in an environment when Gold liquidity is readily available, a spike in interest rates may reflect new Gold borrowing for hedging by a mining company or perhaps a forward sale by a central bank, either of which would have a bearish impact on the Gold price, at least in the short-term. But those are not the prevailing circumstances at the moment, as other factors are driving the Gold interest-rate-to-price relationship.

Foremost among these is the collapse of the Turkish Lira, which makes uncertain the prompt repayment of many of the Gold loans extended to borrowers in that country. In other words, there are going to be some losses on these Gold loans, and the process is already causing lenders to re-think their willingness to lend as loosely as they have in the recent past. It’s a credit crunch, with Gold loans hard to come by.

Those borrowers who owe Gold are therefore presently feeling the squeeze. They must keep rolling over their loans at any interest rate offered to them, unless these borrowers can both find some metal as well as muster the financial resources to purchase it in order to repay their loan.

Few firms have the financial resources to respond so quickly to the rapid change in conditions arising from an unforeseen event, this case being the collapse in Turkey. So, as one would expect, panic conditions are now setting in, as evidenced by the backwardation in Gold’s short-term interest rates. Its short-term rates soared to as high as 7% earlier today, a level even above the US Dollar’s short-term rates.

These are truly abnormal conditions, and as a consequence, they can’t last. Something has to happen for normality to return to the market, and there are only four alternatives.

1) The borrowers of Gold have to start repaying some of their Gold loans. This alternative is unlikely because most they have neither the metal on hand nor the financial resources to buy the necessary metal in the market.

2) The Gold lenders have to start easing up on their tight lending conditions. The skittishness arising from the Turkish problem is unlikely to diminish, so credit conditions will remain tight. There is another factor supporting this view. It is unlikely that they have much metal to lend. The lenders just do not have the Gold available to them they did a few years ago, or even six months ago. The Gold that provided the liquidity in the past has already been loaned out. The central banks do not have an infinite supply of Gold that they can keep feeding into the market to prevent the panic which is inevitable because Gold has been loaned-out at a rate much faster than it can be mined. It’s a classic recipe for a banking disaster – the bullion banks have borrowed Gold in short-term maturities and made long-term loans.

3) The price of Gold must rise. A rising price will ease market conditions and bring liquidity with it. Interest rates are high because the market is starved for metal. The metal the market needs is owned by the strong hands who have been accumulating it in the $250’s and $260’s. They will only be induced to part with that metal at higher prices. How high will that be? We don’t know. We do know only a higher price will move metal out of the strong hands. But it will only happen if we get prices high enough to induce the strong hands to part with their metal in exchange for some national currency.

4) The central banks now attempt to repeat their manipulation of the Gold price in the Oct-Nov 1999 post-Washington Agreement environment. But this time their effort will even be more difficult. Just as the shorts panicked after the announcement of the Washington Agreement, they are panicking again, this time because of the Turkish problem. But the shorts today are even bigger than they were back then, and because of all the lending that has taken place since the end of 1999, there is even less metal available today than there was in the Fall of 1999 (Gold’s interest rates back then were lower too). So any attempt to stop the Gold price from rallying now will take an even greater amount of new derivative related exposure than the massive amounts seen in the last few months of 1999. But maybe that is happening.

Open interest on Comex calls in the last few days has risen by 16,000 contracts. That’s 1.6 million ounces, or nearly 50 tonnes. Who would be willing to take the risk of selling these calls with Gold so cheap? Probably the same central banks who have been manipulating the price. They are still trying to keep the Gold price under their thumb. Will they succeed yet again? There’s the rub. No one knows. The markets may be getting ready to ‘throw away the key’, but maybe not. While we know that Gold is unbelievably cheap and eventually going higher, we just don’t when.

Watch the $272 level. Gold probed that level today, but backed off, though still closed up over $5 on the day. If $272 is hurdled, the long awaited rally may be finally underway. And it also may be the rally in which those who have been manipulating the Gold price are finally forced to throw in the towel, just as they were forced to do so the last time the price of Gold was being manipulated, which was in 1971.