Text size

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).

Chart 1

Last month, gold broke out from that range to resume its bull market, moving quickly from 670 to 721 in just eight trading days. A 7.6% move in such a short period is a wake-up call for the carry traders.

Schweitzer also points out that open interest in gold futures, which measures the current size of bets made by futures traders, is 34% lower than it was last year at the presumed speculative price peak. In other words, the speculation present today is lower than it was the last time prices went up like they are now, and Schweitzer thinks that this gives the market a lot of room to the upside. Traders who buy momentum markets -- think Nasdaq in 1999 -- have not yet piled on.

Seasonally, gold is also entering one of the stronger parts of the year. Commercial players in the gold industry, the so-called smart money, are still buying and otherwise acting as if they expect prices to continue to rise (see Getting Technical, "Gold Stocks Are Precious Again," Sept. 10). Put it all together and the technicals support higher prices, short-term corrections excepted, and that will continue to pressure the gold carry trade.

What is the price that breaks the bank, so to speak? It is hard to say. But with so many factors conspiring to keep the rally going, it does look as if the carry trade is finally about to unwind. Banks that hold big short positions in gold are going to be very vulnerable. Investors sitting on a stash of Krugerrands or Maple Leafs will be a lot happier.

Also read Getting Technical, Sector Alert:

"Gold Stocks Are Precious Again," Sept. 10, 2007.