A Secret Time Bomb Made of Gold
September 12, 2007

THE VOLATILITY SEEN THIS QUARTER IN the stock and credit markets may be new to younger investors. But there is something lurking out there that can make things really dicey.

A little-known fountain of free money called the "gold carry trade" is in danger of drying up. And if it does, then markets from gold to bonds and even stocks can be in for a wild ride.

Before even explaining what the gold carry trade entails, let me first say that its demise has been forecast for nearly a decade. In researching this topic, I found articles as far back as 1998 looking for an explosion in gold prices and commensurate damage to other markets, if not the economy. In other words, this is a story that is as old as Methuselah.

But with a sinking dollar, soaring commodities, and several diverse technical conditions on the charts, the dynamics are coming together to make the end of the gold carry trade a lot closer to reality than ever before.

The gold carry trade is similar to the yen carry trade, which has been a hot topic in the markets this year. Basically, money is borrowed from one source at a low interest rate and invested elsewhere at a higher rate. As long as relevant exchange rates and asset prices remain stable, a profit is made with little effort.

Central banks are sitting on huge supplies of gold that earn them no interest and cost them money just to store securely. To earn a little revenue on these static assets, they loan their gold to banks, called buillon banks, at a ridiculously low interest rate on the order of 1%.

The banks turn around and sell the gold in the market, typically in the London bullion market, and invest the proceeds in a higher-paying asset, such as long-term Treasury bonds. If bonds pay 4.6% then the banks earn an easy 3.6%.

The problem is that if the gold price starts to rise, profits can be wiped out or turned to losses. And in today's market, a falling dollar not only boosts gold prices but it also makes Treasury bonds less attractive to foreign investors. That reduces demand and weakens prices to create a potential double-edged sword for carry traders.

The banks, of course, realize this and hedge their gold sales by buying gold futures. According to Kevin Schweitzer, senior vice president with Hudson Securities, a firm that makes markets in gold stocks, the hedge is not perfect. If central banks call in their gold loans, the banks cannot wait for contract expiration to take delivery on the gold they purchased via their futures contracts. They have to pay back their loans right away and if gold prices are stable, there is no problem for the banks going into the physical market to buy back their gold.

However, if gold starts to rise quickly, the added demand from the banks to buy gold can exacerbate the rally causing what amounts to a mad dash for the metal. The market will respond with steeply higher prices, and Schweitzer sees this pushing gold to $850 by the end of the year.

All of this is fundamental in nature so let's examine the technicals a bit more. As the chart shows, gold peaked in May 2006 in what some labeled a speculative bubble. However, rather than falling quickly as burst bubbles portend, the market moved sideways for the next 15 months (see Chart 1).