The War Against Gold is Meant to Rescue Japan

July 15, 1999

Several years ago in an essay on gold ("The Golden Sextant"), I pointed out that gold is arbitraged like currencies, which is to say on the basis of interest rate differentials. Currencies with higher interest rates are always in backwardation against those with lower rates. As of that time, gold had never been in backwardation against any currency because gold LIBOR (or the gold "lease" rate, as it is usually termed) had never been above the interest rates on any currency. And for good reason: Gold had always been considered the soundest money and therefore had always carried the lowest interest rate structure.

Today yen interest rates are lower than gold lease rates. Accordingly, gold is in backwardation against the yen. This backwardation may be seen indirectly by multiplying forward gold prices on the Comex times like maturity forward yen prices against the dollar. It may be seen directly on the Tokyo Commodities Exchange (TOCOM) (www.tocom.or.jp), where at July 7 spot gold was quoted at Y1009/gram, and June 2000 gold at Y992.

This situation invites the following trade. Sell gold in New York for dollars; put the proceeds in U.S. Treasury notes at 5 percent; and buy the same amount of gold forward in Yen at a lower effective dollar price. Even if the yen exposure is hedged (probably unnecessary), the cost of the hedge is unlikely to exceed 3 percent, which is the amount by which the Treasury rate (approximately 5 percent) exceeds the gold lease rate (approximately 2 percent).

In other words, a holder of gold today can maintain his long gold position (on paper at least) while earning more than twice the gold lease rate. Under these conditions, it is not surprising to find most of the open interest on the COMEX in the nearby months (the sellers?) and most of the open interest on the TOCOM in the further out months (the buyers?). For those interested in short positions, it appears that total open interest on the TOCOM is some 470,000 1-kilo contracts against warehouse stocks of less than 10,000 kilos.

While nothing is certain, in the event of a dollar decline, the odds of a loss on the forward yen exceeding a gain on the forward gold appears slight.

Why do I say this? Because I believe that the underlying manipulation affecting gold today is the yen interest rate.

The notion that the yen is actually a sounder money than gold, and thus deserving of a lower interest rate structure, strikes me as ludicrous given the state of Japan's economy, banking system, and government finances. Rather, I am of the view that today's yen interest rates are an artifice of the current international monetary system and represent a desperate attempt by the world's central bankers to bail out the Japanese economy before its problems engulf us all.

Otherwise, it is to me unfathomable why any central banker would hold his country's reserves in yen at current yields rather than in gold.

Again, I offer these comments in the spirit of true cafe conversation, and should you deem them worthy of posting, would be quite pleased to receive intelligent reaction or rebuttal. Bonne chance.

* * * * * * * *

Another way to view gold's backwardation in yen on the TOCOM is as payment or incentive to Japanese citizens (and others) to defer the urge to convert yen to gold.

Suppose I am Japanese. I earn my living in yen, keep my savings in yen, and think in yen. With yen interest rates at only half a percent and viewing the banking and economic problems in my country, I begin to think of converting some yen savings to gold. But when I check the prices on the TOCOM, I discover that I will pay less for gold to be delivered to me next summer than today, and can keep earning my measly half a percent in the interim. As of July 9 gold for July 1999 delivery was Y1015/gram, and for June 2000 delivery Y997. Looks like a pretty good deal, at least as long as I can trust the TOCOM to make good on delivery next June.

Judging by the TOCOM's historical volume figures, a lot of people are beginning to think along these lines. Volume for June exceeded 1.8 million gold contracts, almost twice any preceding month. Volume for the first half of 1999 exceeded 7 million contracts, putting this year on track to break the 1994 annual volume record of almost 12.5 million contracts.

No historical figures for open interest or warehouse stocks are available, but warehouse receipts at the end of May covered less than 9,000 gold contracts. As of July 8 open interest was more than 480,000 contracts, and the net short position of TOCOM members was 87,500 contracts -- that is 87.5 tons, of which almost 52 tons were represented by Mitsui and more than 14 tons by Sumitomo.

At $260/oz., 87.5 metric tons of gold equates to well over $700 million.

The TOCOM's blurb on "market credibility" claims it has over $400 million for customer insurance against defaults by its members. So if you can trust Mitsui and Sumitomo to deliver the gold next June, hold on to your yen and go for the half-percent interest and the 1.8 percent discount, which, not coincidentally, total approximately the gold lease rate. After all, what you are effectively doing is loaning to the market the gold that you otherwise would have bought today. Indeed, the TOCOM is really doing nothing more than running a huge gold loan by its customers.

What many used to trading commodities often don't appreciate is that in the currency and gold markets, exchange rates (the dollar gold price being an exchange rate) are set at spot. Future exchange rates are simply the product of interest rates (the gold lease rate being an interest rate) and arbitrage.

Suppose I have $100. It earns interest at 5 percent, and a year from now I have $105.

Suppose I have Y100. It earns interest at half a percent, and a year from now I have Y100.5. So if today $1 buys Y120, I can choose now between having $105 next year or Y12060, if I convert my $100 to yen and invest the Y12000 at half a percent.

This calculation suggests that one year from now, if $105 equals Y12060, the exchange rate should be about $1 to Y114.85. Accordingly, if I wanted today to buy a one year forward contract for yen against the dollar, I would expect to get a rate around this level, which is in fact quite close to that currently quoted.

On the other hand, if I want to buy oil or copper or orange juice one year forward, I have no interest rate to use, and without looking up the prices, I do not even know if they will be in contango or backwardation.

Put another way, all the judgments that go into setting futures prices in commodities are distilled in the interest rates for currencies and gold.

The difference between currencies and gold is not that gold is a commodity but that gold is a money whose supply -- though large -- is not infinite.

The Fed will never run out of dollars; the Bank of Japan will never run out of yen. But both, and all the central banks together, CAN run out of gold.

All the talk today about gold being "demonetized" is as off the mark as the notion that governments "gave gold its value" under the gold standard. Gold gave the currencies that were linked to it their value depending upon the credibility of the link. And today gold is slowly revealing the bankruptcy of Japan.

My guess is that if we had figures for the private or invisible gold market such as we have for the TOCOM, we would see a similar picture writ much larger.

Much of what GATA alleges, if true, supports this view. My only disagreement with GATA goes not to the likelihood that governments and central banks are taking actions designed to support the shorts in the gold market, but to the underlying reasons for their action.

In my view, they are not engaged in some petty corruption for the benefit of favored bankers or even in an effort to somehow demonetize or tarnish gold. They are being forced to mobilize their gold to support a yen interest rate that is below the gold lease rate.

They are, as I have tried to point out, effectively bribing people to hold yen today by offering discounted gold in the future. And they are doing this, I believe, because they have run out of options to stave off financial collapse in Japan.

Finally, I should add a word about the gold mining companies.

Larry Parks (www.fame.org) has done a good job pointing out that these companies do not appear to understand their product. They think that they are selling the raw material for jewelry, not money.

To my way of thinking, rather than writing letters to British Prime Minister Tony Blair, the gold mining companies should be promoting currency exchange boards, except the money to which the link should be made is not the currency of some big power but gold.

Any country willing to accept the discipline of a true currency board, like that in Argentina, can just as easily accept the discipline of a gold standard. They are effectively the same system except for one very important difference: Under a currency board you take the interest rates of the reference currency, but under the gold standard you get the interest rates historically associated with gold -- that is, the gold lease rate.

And if you really want to bust the shorts, you get China, Taiwan, and Hong Kong to begin considering a common currency based on gold. What better way to further the integration of Hong Kong's economy with mainland China's, to draw investment capital to China, and to begin in a peaceful manner the reunification of China and Taiwan?

Why these three central banks with their huge hoards of U.S. Treasuries want to keep financing a consumption boom in the United States is beyond me. But if I were a G-7 central banker, je pourrais te dire mon pire cauchemar. C'est pas Japon. Bonne fin de semaine (oops, une expression Quebecoise, pas un intello, moi). A bientot.

Today yen interest rates are lower than gold lease rates. Accordingly, gold is in backwardation against the yen. This backwardation may be seen indirectly by multiplying forward gold prices on the Comex times like maturity forward yen prices against the dollar. It may be seen directly on the Tokyo Commodities Exchange (TOCOM) (www.tocom.or.jp), where at July 7 spot gold was quoted at Y1009/gram, and June 2000 gold at Y992.

This situation invites the following trade. Sell gold in New York for dollars; put the proceeds in U.S. Treasury notes at 5 percent; and buy the same amount of gold forward in Yen at a lower effective dollar price. Even if the yen exposure is hedged (probably unnecessary), the cost of the hedge is unlikely to exceed 3 percent, which is the amount by which the Treasury rate (approximately 5 percent) exceeds the gold lease rate (approximately 2 percent).

In other words, a holder of gold today can maintain his long gold position (on paper at least) while earning more than twice the gold lease rate. Under these conditions, it is not surprising to find most of the open interest on the Comex in the nearby months (the sellers?) and most of the open interest on the TOCOM in the further out months (the buyers?). For those interested in short positions, it appears that total open interest on the TOCOM is some 470,000 1-kilo contracts against warehouse stocks of less than 10,000 kilos.

While nothing is certain, in the event of a dollar decline, the odds of a loss on the forward yen exceeding a gain on the forward gold appears slight.

Why do I say this? Because I believe that the underlying manipulation affecting gold today is the yen interest rate.

The notion that the yen is actually a sounder money than gold, and thus deserving of a lower interest rate structure, strikes me as ludicrous given the state of Japan's economy, banking system, and government finances. Rather, I am of the view that today's yen interest rates are an artifice of the current international monetary system and represent a desperate attempt by the world's central bankers to bail out the Japanese economy before its problems engulf us all.

Otherwise, it is to me unfathomable why any central banker would hold his country's reserves in yen at current yields rather than in gold.

Again, I offer these comments in the spirit of true cafe conversation, and should you deem them worthy of posting, would be quite pleased to receive intelligent reaction or rebuttal. Bonne chance.

Goldschläger and Goldwasser are liqueurs containing pure gold flakes.

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