Source: By Bart Melek, Global Head of Commodity Strategy, TD Securities
After over a decade scraping the bottom, 12-month gold lease rates have moved distinctively higher to trend above 50 bps, as US monetary policy started to tighten aggressively.
With the Fed continuing to take rates higher in the face of sky-high inflation, real interest rates will continue to rise at an accelerated rate across much of the short end of the Treasury curve. With that, speculative long activity will wane amid higher carry and rising opportunity costs. This implies that gold yields should reach multi-decade highs into 2023.
The widespread view that gold does not offer a yield is a misconception. While income generation from gold is generally not available to most private investors, central banks can actively manage their holdings to deliver returns. This can happen in two major ways: (a) bullion reserves can be lent out to earn the gold deposit rate, or (b) the metal can be swapped for dollars at the gold offered forward rate (GOFO) or the swap rate.
While central banks are also likely to capitalise on the higher gold yield environment by making gold available to the market, they are unlikely to reduce holdings. Gold reserves offer the benefit of being highly liquid holdings, which possess both pro and counter cyclical properties, are a well-recognised store of value for many millennia and are considered strategic assets which are no one’s liability. Physical holdings are also impervious to sanctions.Gold Interest Rate Mechanics
Central banks can generate material yield from gold holdings via uncollateralised loans to a bullion bank. Given that the yellow metal is a monetary asset for central banks, it can be lent out on a term deposit like any other currency in their reserve portfolio. Most commonly, a central bank will place gold on deposit with a bullion bank, in return for a deposit rate. Maturities can vary, but 1-month, 3-month and 12-month tenures are the most common. At maturity, the gold is returned with the interest paid either in gold or fiat.
Deposit rates are derived and set independently by bullion banks. Due to gold’s inherently lower risk (eg. no one’s liability), the yellow metal tends to deliver lower returns than corporate or even government bonds.
Yield from their gold holdings can also be generated via a gold swap, or more specifically, a repurchase agreement that simulates a swap. In this instance, a central bank sells its gold to a bullion bank with the promise to buy back the gold at a later date. The central bank pays interest equivalent to the GOFO rate (forward swap rate).
In this context, the GOFO rate is akin to a US dollar loan using gold as collateral. Formally, it is defined as the rate at which market-making members of the London Bullion Market Association (LBMA) will lend gold on swap against US dollars. The central bank is then able to reinvest the funds at LIBOR (more recently SOFR) and earn the premium between the dollar rate and GOFO, which amounts to the gold lease rate.
The gold lease rate is typically an over-the-counter instrument, it can be best comprehended through the interaction of the demand and supply of borrowed gold, which will be the focus for the purpose of discussion.
Entering a forward sale agreement
Exiting the forward sale agreement
Source: World Gold CouncilDecades-High Gold Yields – A Potential Boon For Central Banks
While volatile, we project that the market environment is conducive to delivering consistently higher positive lease rates, which should be quite accretive for central banks willing to deposit metal with a bullion bank in good standing.