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The GOFO and the Gold Market
Although the London bullion market predominantly trades paper gold, it needs some physical to give the appearance that the market is a solid one.
In times of market stress, there are two conflicting forces pulling on the gold market. When liquidity tightens (as it is now) financial assets fall in price. Because the gold market is dominated by paper gold trading, including many highly leveraged players, selling prevails and the gold price falls.
But in reality, physical gold becomes even more valuable in times of crisis. How can this be, you ask?
To explain, we need to look at what is called the Gold Forward Offered Rate - the GOFO. GOFO is the rate of interest you pay if you swap your gold (short term) for US dollars. Alternatively, it is the rate of interest you receive for lending US dollars against gold.
Lately, the GOFO rate has been falling. This indicates a few things. Firstly, it tells us that gold's value as security for a US dollar loan has increased. If a bank needs to get US dollars in a hurry (as often happens in a liquidity crisis) then using gold as collateral (security) is the cheapest way to do this. Currently, the GOFO rate is 0.3% for a term of one month, the lowest level since February 2011.
Just as a government bond rises in price as its yield falls, so should the price of gold rise as its implied yield (via GOFO) falls. But this doesn't happen in the gold market.
In fact, it's the opposite. That's because in times of a liquidity crisis or deflationary scare you have leveraged paper gold holders selling, while at the same time increasing fear leads unallocated gold 'owners' to request taking ownership of their gold...and moving it out of the 'system', or out of the London bullion market.
So how do these two contradictory forces play out? Well, let's have a look at two recent periods in the history of the gold market. One that kicked the gold bull market off in September 1999 and the other that looked like ending it in November 2008.
In both these periods the GOFO rate fell below zero. This almost never happens. A negative GOFO rate says banks will pay you to swap US dollars for gold. It suggests they are desperate to get their hands on gold...physical gold.
In late September 1999 the GOFO rate fell to an unprecedented -4%. Look what happened to the price at that point. It exploded higher in a matter of days. The gold market needed a higher price to entice some gold back into the system.
Source: StockCharts
Now let's look at November 2008. On November 20, 21 and 24 the one-month GOFO rate went negative, meaning physical gold was again in high demand in the bullion banking system.
If you look at the chart on those days you'll see that the gold price bottomed right at this time. The stress in the market was so great that a higher price was guaranteed.
After hitting a low of around US$700, gold surged to over US$900 dollars in a matter of months. Paradoxically, the demand for physical gold (within the bullion banking system) seems greatest when the selling of paper gold (which sets the price) is heaviest.
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