Sunday, November 25, 2012

What gold's negative lease rate teaches us about the zero-lower bound

When people talk about gold, they usually talk about the gold price. But there are a few other key gold market metrics that often go unmentioned. The chart below stacks the gold price on top of the gold forward rate (GOFO), LIBOR, and the lease rate. The gold lease rate is an interest rate. Just as you can lend your cash to a bank at the bank's deposit rate, you can lend your physical gold to a bank at the lease rate.

Understanding GOFO and the lease rate is important not only for gold bugs, but for anyone who wants to get a good grasp of the phenomenon of interest rates. GOFO and the gold lease rate demonstrate that interest rates are not phenomena solely confined to paper assets. The ability for an investor to lease their gold and earn an interest return makes up part of gold's peculiar "own-rate". All commodities have own-rates. From our perspective as consumers, we rarely get to see these markets, but they do exist. I've illustrated them in the following chart:

Go to this scribd link for a high res version if you want to understand how GOFO, LIBOR, and the lease rate interact.

One thing you may have noticed from the chart is that gold's three month lease rate (at bottom) is negative. Back in November 2011 the one month lease rate fell to a record low of -0.5%. Now anyone familiar with the idea of the zero-lower bound may find this surprising. Interest rates aren't supposed to be able to fall below 0%. If they do, people will simply redeem the underlying 0% yielding asset and store it themselves. Why keep gold on loan to a bank only to pay a -0.5% penalty when you can withdraw it and keep it under the mattress for free? Yet the market was willing to bear negative lease rates.

The reason for this oddity is that as the yellow metal's price rises, it becomes ever more attractive to robbers. One ounce to a robber at $300 is tempting, but not as tempting as that same ounce at $1750. So it costs more to insure gold. Secondly, storing gold is somewhat costly. Do you hide it under granny's bed, or do you buy a home safe for it? At which point do you rent a vault at a bank? Anecdotal evidence suggests that banks specializing in gold storage have been running out of space over the last few years, implying rising storage costs.

In a nutshell, that's why people haven't withdrawn their gold as lease rates have turned negative. In keeping their gold on loan to the bank rather than bringing it at home, they avoid all the headaches of storage costs, insurance, and the fear of theft, yet still get exposure to gold price appreciation. The negative lease rate is the fee they pay in order to have someone else incur all these headaches.

Like the gold market, the currency market also has the capacity to bear a negative interest rate. If the rate on bank deposits falls to say -0.25%, depositors would likely keep their cash on loan to the bank since storing it at home or in a vault is costly. How low can deposit rates fall before people start to withdraw cash? -1%? -2%? Cash, after all, is thin and light, surely easier to store than gold. One way to prevent cash redemption at negative deposit rates is to make cash storage costly. If someone wants to withdraw $100,000 in cash, make them take it all in $5 bills. The high cost of storing low denomination bills will get anyone to reconsider withdrawal. I've discussed the idea of varying redemption denominations here.

So as the gold market shows, the zero-lower bound is a soft bound, not a hard one. As for all you gold bugs out there, I'll write more about negative lease rates sometime soon.


  1. you could potentially charge a negative interest rate as a fee for banking services, but would this encourage people to spend or borrow more?

    1. You need to think in terms of the spread. If other assets are expected to yield -2%, then charging a -1% interest rate on deposits won't necessarily encourage people to spend or borrow. The fee on deposits needs to fall more for that to occur.

    2. I have a question on the lease rate. In most places I have looked it is interpreted as an offer rate at which the dealer/bank lends gold. This makes sense if you think it's derived from 2 other offer rates (LIBOR and GOFO). Also typically people think of a Central Bank lending or leasing the gold.

      Here you think of the lease rate as a deposit rate which helps out with thinking about the storage costs. I guess the storage costs have gone up and if the gross lease rate is small then the lease rate net of this cost might be negative. Lending the gold out at a negative rate may be then cheaper than storing it.

      The only issue I have is that storage costs (including insurance etc.) that I have read about talk about .25-.40% while the lease rate went bellow -.50%. It is true that I am thinking about the average cost of storing gold as reported by various ETFs and not the marginal cost at a given point in time.

      Are you aware of any estimates that would back up this story? Also am I correct when thinking about the lease rate as an offered rate and of Central Banks as the main player in lending gold out?

    3. Hi Alex, you'd need to determine what term the 0.25-.40% storage cost that you read about applied to. For instance, if that was a 1-year rate, you'd want to compare it to the 1 year lease rate, but not the 3-month lease rate. If the 0.25-0.4% storage cost is indeed a 1 year rate, the 3-month storage cost could very well be higher than that, although I don't know enough about these costs to be sure.

  2. A few comments.

    Appropriate storage cost for retail would be Gold Money or Bullion Vault at 0.12% pa. As they are not doing it for no profit, the wholesale rate for storage would be say half of that. Also, for a bullion bank itself the cost of storing physical would effectively be zero as the vaulting cost is paid for by its clients.

    I'd be very careful reading derived lease rates from GOFO and LIBOR it is a very approximate figure and likely not zero, or a lot less than the derived figure says. During the period in the chart no bullion bank was offering to pay the Perth Mint to lend gold.