The End of the Gold Carry Trade

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...The carry trade benefits a lot of players. The banks make out, and the investors make out. The only people who didnít do so well were the gold-bugs. The carry trade resulted in added selling of gold by the investors, putting downward pressure on the yellow metal...

With yields on government debt at unprecedented lows, it is no longer profitable to borrow gold and exchange it for risk free securities.

A gold carry trade has been in effect for over 10 years. Central banks, with hoards of gold, would lease the yellow metal to investors at a paltry 3% per annum. These investors would borrow the gold from the bank and sell it on the open market.

At the same time, they would buy futures to repurchase the gold at a later date, locking in the current price. With the proceeds from the sale of gold, they would invest in anything that could yield more than 3%. If the fund manager invested in a 10yr government bond, usually yielding around at 5%, he made some money while taking on no risk. As long as the Treasuries yielded you more than the cost to lease the bankís gold, this was the easiest money you could make!

Why would the banks do this? They have thousands of tons of gold bars in their vaults. Better for those bars to collect 3% a year than lots of dust. The carry trade benefits a lot of players. The banks make out, and the investors make out.

The only people who didnít do so well were the gold-bugs. The carry trade resulted in added selling of gold by the investors, putting downward pressure on the yellow metal. Anybody long in gold got pinched.

This trend is beginning to reverse itself.The past two months have seen the biggest global coordinated interest rate cut ever. The Fed rate is at 1%, with the smart money projecting it to be half that by year end...Inflation is expected for 2008 to be around 3%. 10 year US Treasuries are yielding as low as 3.1%. that means if you borrow gold at 3% to make 3.1% on your risk free security, you are not making much. Even in a period of low inflation, the real return on your money is negative...

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