Evidence grows that squeeze is only starting


11:30p EDT Friday, October 1, 1999

Dear Friend of GATA and Gold:

The gold carry trade and the short squeeze are finally
news for the mainstream press. Here's a fine article
from the Sydney Morning Herald for Saturday, October 2.
Those of us on the other side of the planet get to read
it a day before publication!

Gold Anti-Trust Action Committee Inc.

* * *


By Steve Burrell
Sydney Morning Herald

Saturday, October 2, 1999

Paul Lee, the head of gold trading at Dresdner
Kleinwort Benson in Sydney, could be forgiven for
forgetting where he lived this week.

He didn't go to bed for three nights straight as he and
his fellow traders stayed at their screens around the
clock, riding the biggest and fastest rise in the gold
price in almost 20 years.

Lee's sleepless-in-the-saddle week began last Sunday
with unexpected news from the other side of the world.

With his unruly shock of hair and unfashionable black-
framed glasses, European Central Bank president Wim
Duisenberg looks more like a slightly owlish university
don than a white knight.

But when he and 15 of his fellow European central
bankers announced at the IMF-World Bank meeting in
Washington that they were capping sales and lending of
gold out of their official reserves, they became a
battalion of white knights and the Seventh Cavalry
rolled into one for the beleaguered gold sector.

The unprecedented announcement took the market
completely by surprise and sparked one of the most
dramatic surges in the gold price in a generation.

The gold price soared almost 25 percent in a few days
to as high as $US329 an ounce 30 percent above its
late August low of $US252.90 before consolidating
around $US300 by the end of the week.

On Tuesday alone, the London price rose $US20.40 an
ounce, the largest increase in dollar or percentage
terms in more than 17 years.

The agreement, master-minded by the central banks of
the world's 10 biggest economies, was a co-ordinated
attempt to reverse the long slump in the gold price
which had recently seen it crash to 20-year lows of
around $US250 an ounce, putting gold producers around
the word under extreme pressure.

Secret discussions on the deal began in earnest in
August, after an announcement on May 7 by the UK that
it was planning to sell gold reserves sparked a $US30
per ounce crash in the gold price and left the market
vulnerable to further falls.

Last weekend's announcement lifted a black cloud which
had hung over the gold market for more than three

"The enormity of the announcement by European central
banks cannot be underestimated," says Colonial State
Bank chief economist Craig James. "The threat of
central bank sales was the prime factor driving the
gold price lower.

"The expectation of lower prices led to short selling
by speculators, inducing further downside.

"The removal of the spectre of substantial central bank
sales means mine supply and demand will again be the
main determinants of the gold price."

But while the sudden, spectacular surge in the gold
price has produced some happy miners and gold company
shareholders, for others the revival of the precious
metal has come as an expensive surprise.

For a lot of speculators, including some of the world's
biggest hedge funds, it was a case of the free lunch
biting back.

They were up to their eyeballs in the financial
markets' latest version of a licence to print money,
the "gold carry trade."

The near-vertical trajectory of the once-languishing
gold price in the wake of the central bank announcement
has all the hallmarks of a rush of speculators to the

The hedge funds and other financial market heavyweights
including, market rumour has it , big investment banks
such as Goldman Sachs were forced to unwind plays which
could involve around $US25 billion ($38.4 billion) in
borrowed gold, frantically buying to cover their
"short" positions and driving the price up even

On Tuesday, as gold prices spiked higher to $US326 from
$US304 in matter of minutes, rumours swirled about
massive buying by a New York dealer on behalf of a
client unwinding a $4 billion bet on the gold price
falling, according to the Wall Street Journal.

Gold's amazing resurgence may also have dramatically
changed the rules of the game for many producers, who,
like the funds, had borrowed central bank gold and sold
forward to hedge their production.

The higher interest cost of carrying these positions
means it is no longer profitable for them to sell
forward and may even prompt a major buyback by
producers to cover these short positions, according to
some analysts.

As Paul Lee notes: "Structurally, the entire industry
has changed."

The "gold carry" is a close cousin of the "yen carry
trade," which got the hedge funds into so much trouble
last year.

Speculators borrowed yen at ultra-low interest rates
and reinvested the proceeds in higher yielding
securities a guaranteed money-making proposition until
the yen started to rise against the US dollar and made
paying back the borrowings more expensive. With the
gold carry, hedge funds and other speculators borrow
gold from a central bank, leveraging up their position
by using bank credit to increase the size of the

They then sell this borrowed gold and invest the
proceeds in other securities, such as US Treasury

The trick in this case was that, until recently, the
cost of borrowing gold was only around 1.5 percent to
2 percent because central banks, keen to earn some
interest on their large gold holdings, were prepared
lend it out at a low rate.

With rates on US Treasuries at more than 5.5 percent,
it was money for jam.

What's more, with gold prices falling, they could also
expect to make money when they eventually returned the
gold to the central bank because they could buy it at a
lower price than when they borrowed it a standard
speculative play called shorting the market .

With leverage, these speculative positions could
deliver the hedge funds and their investors returns of
40 percent or more.

Unlike the yen carry trade, there is no currency risk
involved, though, as they were to discover, they were
exposed to interest rate risk and, of course, the
chance that the gold price might actually rise.

With central banks selling their gold reserves, so-
called "fabrication" demand for gold in the previously
strong Asian market still recovering from the economic
crisis and inflation low, there seemed little risk of

If anything, with the spectre of central bank sales
hanging over the market, further falls were expected.

It was little wonder that the hedge funds arrived in
droves to take advantage of this free lunch during the
past year or two.

Just as no-one really knows how exposed the hedge funds
were to the yen last year, it is hard to be sure how
big their short position in gold was going into last
week and at what price those positions started going
under water.

Some analysts have put their collective short positions
as high as 8,000 tonnes. More reliable estimates of
central bank lending of around 5,000 to 6,000 tonnes to
both forward selling gold producers and speculators
suggests it would be closer to 2,000 to 2,500 tonnes.
Still, that's up to $US25 billion worth of gold at
current prices.

One of the first signs that the magic pudding of the
gold carry was about to turn sour came the previous
week when gold rallied almost $US6 an ounce in the wake
of the Bank of England's second auction of its gold

The 25-tonne auction, part of a gradual unloading of
half of Britain's total reserves, was eight times
oversubscribed, with some of the world's biggest
producers among those buying up big to cover short
hedging positions.

The subsequent price rise to more than $US260 an ounce
was only the beginning.

The rally was supercharged over the weekend with the
surprise announcement by the European central banks
that they were capping annual gold sales from their
official reserves at 400 tonnes for the next five
years. With sales of around 1,715 tonnes by the UK and
Switzerland already decided, this was close to a
moratorium on selling until late 2004.

It also dramatically reduced the amount of central bank
gold likely to be sold worldwide in the next few years.

Together the European central banks, the US and the
International Monetary Fund hold 80 percent of
official sector gold. With the IMF changing its mind
about on-market sales to fund its recent debt relief
initiative and the US not having sold gold since the
late 1970s, the European decision was pivotal.

The announcement largely removed the threat of massive
central bank sales which had hung over the market since
the Belgian central bank announced it was unloading
gold reserves in March 1996 a fear which was
intensified greatly when Australia's own Reserve Bank
revealed in early July 1997 it had already begun
selling gold.

The European banks' weekend announcement fuelled an
immediate $US16-an-ounce jump in the gold price, taking
it above $US280 an ounce for the first time since early

Although the average price at which the funds were
carrying their gold positions is unclear, this would
have started to take them close to the danger zone
where it would cost them more to repay the gold they
had borrowed from the central banks than when they
borrowed it.

They were already facing a squeeze from another
direction the interest rates charged by the central
banks for borrowing their gold. In recent months this
so-called lease rate had jumped from 1.5 percent to
around 4 percent, amid rumours the central banks were
withdrawing gold from the market. This sharply reduced
gains on the gold carry.

At one stage during the turmoil of the past week the
lease rate climbed above 10 percent.

For those borrowing on a "floating lease" basis akin to
a floating rate mortgage this means the gold carry was
costing them a lot of money.

Significantly, the European banks said last weekend
that, in addition to limiting their gold sales, they
would also curb their gold lending, agreeing "not to
expand their gold leasings and their use of gold
futures and options over this period".

With the European central banks holding around a third
of the estimated 5,000 to 6,000 tonne pool of bullion
reserves available to be lent out, this could have a
significant impact on the level of gold borrowings and
will help keep lease rates high.

Combined with the rising gold price, the rise in the
lease rates appears to have been the signal for the
speculators to get out by buying gold to cover their
short positions.

This bail-out made the climb in the gold price even
more spectacular, driving it as high as $US329 an ounce
in London trading on Wednedsay and leaving it at $US302
an ounce, a rise of 14 percent over the week,

The short squeeze was tightened even further by the
fact there were few sellers in the market. This was
partly because producers and other holders of gold were
waiting to see if the price rose further and partly
because producers were themselves short because of
previous forward selling at prices much lower than
prevailing now.

In effect their position was not much better than the
hedge fund themselves.

To put this week's rise in perspective, however, the
gold price is still well below the $US340 to $US350 an
ounce range that prevailed before the RBA's sale
announcement in mid-1997.

And it's still miles away from the $US400-an-ounce
levels of early 1996, before the Belgian sales
announcement not to mention its all-time high of $835
an ounce in 1980.

Although there is a big question mark over whether gold
will approach the levels of two years ago, the price
outlook is definitely brighter and current levels could
well be maintained or bettered, according to analysts.

While the recent spikes were driven by the bail-out of
the speculators, the rise in the gold price is also
reflecting shifting fundamentals in the industry and
the world economy.

The unexpectedly rapid recovery from financial crisis
of many of the East Asian economies among the biggest
buyers of gold for jewellery and other manufacturing
uses means fabrication demand is stronger and likely to
improve, as will the generally stronger outlook for the
world economy as whole.

The World Gold Council put gold demand at record levels
in the June quarter, with supply down by 5 percent on
six months earlier.

The annual gap between fabrication demand and mine
production has been around 500 tonnes for the past few
years and, according to a respected analyst of the
market, NM Rothschild & Sons chief economist Ric Simes,
it will rise to 1,000 tonnes a year for each of the
next few years as mine production growth slows.

The prospect of higher global inflation and signs that
the recent era of US dollar strength is coming to an
end also makes gold a more attractive proposition,
though the inflation hedge factor is far less important
than it has been in the past.

And on the supply side of the market, the European
central banks' decision to limit sales and lending,
along with the rethink on sales by the IMF, will also
lend price support.

After the present bout of volatility and short-covering
passes, Dresdner's Paul Lee sees the gold price
establishing a new firm foundation around $US275 to
$US280, although he doesn't rule out the price spiking
even higher than $US329 in the short term if hedging
positions continue to be unwound.

With demand firm, Colonial State Bank's Craig James
sees the price returning to around the $US325 to $US350
level which prevailed before the threat of central bank
sales slammed the market.

Rothschild's Ric Simes sees the price settling above
$US300 an ounce. "The reasons why gold might trend
higher were already accumulating (before the recent
price jump)," he said.

"They included US dollar weakness, strong physical
demand, the current short-term liquidity issues,
strength in other commodity prices, especially oil,
strong coin demand in the US and marked slowdown in
mine production growth.

"Y2K and weaknesses, or a sharp fall, in US equities
were other candidates that could lend strength to any

Simes says the likelihood of producers selling forward
could cap further price rallies in coming months,
though they may be deterred from this if the market
stays in a state of "backwardation", where spot prices
are higher than prices for future sales.

"Longer term, the market deficits will absorb sizable
amounts of above-ground stocks," he said. "Given where
costs of production are, a price settling above $US300
an ounce and noticeably above this level if the US
dollar is weak would appear warranted."