Facebook: King of Ads

By tothetick

41% of Facebook’s advertising revenue comes from mobile advertising today according to the latest earnings report that was published yesterday and that is already a 30% increase on this time last year. Mark Zuckerburg, Chief Executive Officer of Facebook, stated: “We’ve made good progress growing our community, deepening engagement and delivering strong financial results, especially on mobile. The work we’ve done to make mobile the best Facebook experience is showing good results and provides us with a solid foundation for the future”.

That surge in mobile advertising comes at a welcome time for Facebook as Yahoo and Google both see their revenues from advertising decrease over the same period. Facebook’s revenue growth from advertising increased by a whacking 13% and that was way higher than was previously expected by analysts.

Advertising in Newsfeed on Facebook

Facebook has a staggering 819 million mobile users today, and despite added competition from companies such as WhatsApp Messenger , for example, they have not only maintained but increased their market share. The number of mobile users is an increase of 51% on the number that used Facebook on their mobiles in 2012! While 41% of the revenue comes from mobile advertising, a staggering 88% of the entire company’s revenue is based on advertising today, whether that be on a computer or a mobile device. There are 699 million people that are active users every day of Facebook and 1.15 billion people in the world use Facebook every month, at least. The number of daily users has increased from 58% of the total number of users in 2012 to 61% this year.

So, the reasons behind Facebook’s success faced with Google’s and Yahoo’s recoiling revenues in the sphere of advertising? More and more people have access to internet via smartphones these days and mobile devices. But, that means that there is growing concern to insert advertising on such small screens and still to remain effective. What has Facebook done? It has simply inserted the advertising in the news feeds on the pages of the users of Facebook. There is a growing belief that Facebook is the place to post your company’s ads if you want to get noticed.

The new competitors coupled with the worry that news-feed embedded ads would deter users has proved to be completely wrong, apparently. According to Chief Operating Officer of Facebook Sheryl Sandberg the social network site had increased quantity of newsfeed advertising and also the type of advertising they were providing during this second quarter of the year. Zuckerburg stated that the ads represent about 5% of what is posted on the newsfeed and that means about one in twenty posts is actually advertising. The surprising thing about doing this is that burying the ad in the newsfeed means that a person that connects automatically reads the ad as they may be fooled into thinking it has been posted by a friend or family member. So, it becomes automatically more attractive. How long that will last is highly debatable. Whether or not the users will quickly become aware of the fact that they are the guinea pigs being fed the bait through advertising remains to be seen. Zuckerburg stated that now they had the quantity, they would be working on the quality of the advertising, which in itself should help users wise up to the fact that they are being used. Surely, it’s quality that should have come first.

Sandberg did state that advertising and marketing revenues were up across the board today and that people are prepared to spend more on that. But, at the moment, advertising on mobile devices only stands for 3% of all advertising spending today. The world’s figure amounts to just 2%. So, Facebook believes that the potential is enormous. That is with the added fact that people are spending more of their time on mobile devices today. So, things look set to change. Does, that mean when I check for a new car, I will be inundated by ads for new cars or I check a hotel in Rio de Janeiro that I get ads linked to that as I open my smartphone just like on the PC? Will we never escape from advertising?

Facebook: Mark Zuckerburg

Apparently, given the fact that most people use Facebook on their mobile devices while watching prime-time television in the evening in the US, the company believes that there is the added potential of using brand marketing in conjunction with other types of media. Sandberg stated that 88 million out of 100 million people in the US use Facebook in this way in the evening.

Facebook’s revenue increased by 53% to $1.813 billion in the 2^nd quarter of 2013. Analysts had previously expected revenue to be around the $1.618-billion mark. Revenue stood at $1.184 billion this time last year.

Facebook stock rose a hefty 17% during market trading yesterday and today we shall see if that continues.

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Gold GLD ETF Reverses as TLT Breaks Down

By: Anthony_Cherniawski

GLD briefly slipped above its 50-day moving average yesterday, but could not hold it as support. Today is day 26 of the new Master Cycle. The reversal in a minute Wave [iv] makes it extremely left-translated and bearish for several more months.

TLT made a downside breakout, making a low thus far at 107.45. This move breaks the retracement and opens the way for a resumption of longer-term decline. This will magnify the losses at the banks and the Federal Reserve. The only way to stop the losses is to sell, but the selling will feed on itself.

The implications for the banks goes beyond only losses. The banks have already been covering up losses since 2007. This move brings up the spectre of insolvency again.

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The Conglomerate Way to Growth

by Ricardo Hausmann

CAMBRIDGE – Countries do not become rich by making more of the same thing. They do so by changing what they produce and how they produce it. They grow by doing things that are new to them; in short, they innovate.

Illustration by Chris Van Es

Many countries have been altering their growth strategies to reflect this insight. But they are being distracted by some of the greatest – but atypical – examples of success.

We all have heard of Steve Jobs, Bill Gates, and Mark Zuckerberg – twenty-something college dropouts who built billion-dollar companies at the cutting edge of global innovation. We have heard of the many start-ups that they and others acquired for hundreds of millions of dollars - Instagram, Skype, YouTube, Tumblr, and, most recently, Waze. So why not emulate these successes?

The main problem is that these examples are peculiar to the software industry, which provides a woefully insufficient blueprint for the rest of the economy.

The software industry is unique, because it has unusually low barriers to entry and ready access to a huge market through the Internet. A start-up is typically just a group of kids with a good idea and programming skills. All they need is time to write the code. Incubators provide them with space, legal advice, and contacts with potential clients and investors.

But consider a steel, automobile, or fertilizer plant – or a tourist resort, a hospital, or a bank. These are much more complex organizations that must start at a much larger scale, require much more upfront investment, and need to assemble a more heterogeneous team of skilled professionals. This is not something at which a young college dropout is bound to excel, because he lacks the experience, the organization, and the access to capital that these ventures require.

And, compared to software development, these activities also require more infrastructure, logistics, regulation, certifications, supply chains, and a host of other business services – all of which demand coordination with public and private entities. Most important, these activities are most likely to be central to economic growth in developing and emerging countries. So, how will companies in these sectors arise, and what can be done to stimulate their formation?

Many developing-country governments are ignoring that question. For example, Chile’s government, obsessed with so-called “horizontal” policies that do not tilt the playing field in favor of any industry, recently implemented Start-Up Chile, a program with standardized rules to encourage new ventures. Although the rules were designed for all industries, the scheme attracts almost exclusively software ventures – the only ones that can be formed with the low level of support that the program provides.

Other industries face more daunting chicken-and-egg problems: countries lack the capabilities that growth industries demand, yet it is impossible to develop these capabilities unless the industries that require them are present. One way to solve this coordination problem is through vertical integration – that is, firms that can solve internally the coordination of the supply and demand for any new capability.

That is why national business groups – conglomerates – often play a key role in transforming an economy and its exports. This is especially true in developing counties, where many markets are missing and the business environment is often extremely challenging.

Conglomerates can use their knowledge, managerial skills, and financial capital to venture into new industries. They can start things at a scale that would be impossible for a start-up. They can make credible commitments to future suppliers and influence the business ecosystem to make new industries feasible.

Consider South Korea. In 1963, the country exported goods worth less than $600 million at today’s prices, mostly primary products such as seafood and silk. Fifty years later, it exports goods worth almost $600 billion, mostly electronics, machinery, transportation equipment, and chemical products.

This transformation was not achieved through independent start-ups. It was done through conglomerates, or chaebols in Korean. For example, Samsung started as a trading company, moved to food processing, textiles, insurance, and retail, and then on to electronics, shipbuilding, engineering, construction, and aerospace, just to name a few activities. South Korea’s transformation was reflected in the transformation of its leading companies.

But, in many developing countries, conglomerates have not played an equivalent role. They have focused on non-tradable goods and services – those that cannot be imported or exported – and have eschewed international competition. They have focused on banking, construction, distribution, retail, and television broadcasting.

Once these companies dominate one market, they move to another that is equally sheltered from competition and devoid of export opportunities, often using their size and political influence to keep out would-be competitors. Instead of becoming agents of change, they often prevent change. (Indeed, the big economic debate in South Korea nowadays concerns whether the chaebols are stifling innovation by preventing start-up competitors from challenging them.)

The productive transformation that developing countries need is much easier to achieve with the support, rather than the obstruction, of their conglomerates. But ensuring such support requires policies that nudge (or even shove) conglomerates toward export industries that can grow beyond the limits of the domestic market – industries in which competition will encourage the discipline that they lack as a result of dominating local markets.

To succeed, conglomerates need the support of government and the acceptance of society. They must earn it through their contribution to the growth of employment, exports, and tax revenues, and to the country’s technological transformation. That is what General Park Chung-hee (South Korea’s longtime ruler, and father of current President Park Geun-hye) pressured the chaebols to do in the early 1960’s. And it is what governments and civil societies in developing countries today should demand of their conglomerates.

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Hoisington: "The Secular Low In Bond Yields Has Yet To Be Recorded"

by Tyler Durden

Authored by Lacy Hunt and Van Hoisington via Hoisington Investment Management,

Lower Long Term Rates

The secular low in bond yields has yet to be recorded. This assessment for a continuing pattern of lower yields in the quarters ahead is clearly a minority view, as the recent selling of all types of bond products attest. The rise in long term yields over the last several months was accelerated by the recent Federal Reserve announcement that it would be “tapering” its purchases of Treasury and mortgage-backed securities. This has convinced many bond market participants that the low in long rates is in the past. The Treasury bond market’s short term fluctuations are a function of many factors, but its primary and most fundamental determinate is attitudes toward current and future inflation. From that perspective, the outlook for long term Treasury yields to fall is most favorable in light of:

a) diminished inflation pressures;

b) slowing GDP growth;

c) weakening consumer fundamentals; and

d) anti-growth monetary and fiscal policies.

Inflation

Sustained higher inflation is, and has always been, a prerequisite for sustained increases in long term interest rates. Inflation’s role in determining the level of long term rates was quantified by Irving Fisher 83 years ago (Theory of Interest, 1930) with the Fisher equation. It states that long term rates are the sum of inflation expectations and the real rate. This proposition has been reconfirmed in numerous sophisticated statistical studies and can also be empirically observed by comparing the Treasury bond yield to the inflation rate (Chart 1). On an annual basis, the Treasury bond yield and the inflation rate have moved in the same direction in 80% of the years since 1954.

Presently the inflation picture is most favorable to bond yields. The year-over-year change in the core personal consumption expenditures deflator, an indicator to which the Fed pays close attention, stands at a record low for the entire five plus decades of the series (Chart 2).

Additional factors restraining inflation are the appreciation of the dollar and the decline in commodity prices. The dollar is currently up 14% from its 2011 lows. A rise in the value of the dollar causes a “collapsing umbrella” effect on prices. A higher dollar leads to reduced prices of imports, which have been deflating at a 1% rate (ex-fuel) over the past year. When importers cut prices, domestic producers are forced to follow. Commodity prices have dropped more than 20% from their peak in 2011. This drop in commodity prices has also contributed to lower rates inflation.

Sustained higher inflation is not currently evident, and the forces that create inflation are absent. Thus, a period of sustained higher long term rates is improbable.

GDP

GDP growth, whether if measured in nominal or real terms, is the slowest of any expansion since 1948. From the first quarter of 2012 through the first quarter of 2013, nominal GDP grew at 3.3%. This is below the level of every entry point of economic contraction since 1948 (Chart 3). Real GDP shows a similar pattern. For the past four quarters real economic growth was just 1.6%, which was even less than the 1.8% growth rate in the 2000s and dramatically less than the 3.8% average growth rate in the past 223 years. These results demonstrate chronic long term economic underperformance.

Over the past year, the Treasury bond yield rose as the nominal growth in GDP slowed. The difference between the Treasury bond yield and the nominal GDP growth rate (Chart 4) is important in two respects. First, when the bond yield rises more rapidly than the GDP growth rate, monetary conditions are a restraint on economic growth. This condition occurred prior to all the recessions since the 1950s, as indicated in the chart. This condition also signaled the growth recessions in 1962 and 1966-67. Second, the nominal GDP growth rate represents the yield on the total economy, a return that embodies greater risk than a 30 year Treasury bond. Thus, the differential is a barometer of cyclical value for investors in Treasury bonds versus more risky assets.

On two occasions in the 1990s the Treasury bond/GDP differential rose sharply. Neither a quasi- nor outright recession ensued, but in both cases bonds turned in a stellar performance over the next year or longer. This economic indicator simultaneously casts doubt on the prevailing pessimism on Treasury bonds and the optimism over U.S. economic growth.

Consumer

Consumers have not yet healed from the great recession. Their income and employment situations have languished. Based on the standard of living, as measured by the real median household income, this entire recovery has bypassed the consumer sector. The standard of living has contracted regularly in recessions, but this is the first time deep into an expansion that it has continued to erode. The current standard of living is unchanged from 1995 (Chart 5).

In spite of job gains in the first half of 2013, the downward pressure on the standard of living actually intensified. Approximately three quarters of the increases in jobs were in four of the lowest paying industries – retail trade; the temporary help services component of professional and business services; hospitality and leisure; and the nursing and residential care facilities component of the medical category. These increases may reflect efforts of firms to minimize the increase in health care costs associated with full time employment under the Affordable Care Act. Part time jobs averaged increases of 93,000 per month in the first half of 2013, while full time jobs averaged increases of only 22,000 per month. Full time employment as a percentage of the adult population is currently 47%, which is near the lows of the last three decades.

Historically, when taxes are increased, the initial response of households results in a lower saving rate rather than an immediate reduction in spending. For some consumers, recognition of the tax changes in their income is a problem, particularly for those whose earnings are dependent on commissions, bonuses or seasonal work. This explains the sharp drop in the personal saving rate to 2.7% in the first five months of this year, a level at or below the entry points of all the economic contractions since 1929. The 2013 slump in the saving rate is a precursor of the painful adjustments that lie ahead, and an additional restraint on economic growth. (Note: In late July the Bureau of Economic Analysis is expected to release a benchmark revision to the National Income and Product Accounts. As a result of the revision the personal saving rate may be raised by up to 1.5%. This is due to the change in consumer ownership of defined benefit pension plans. This revision will no t change the trend of the saving rate, nor will this higher figure indicate a source of funds for immediate spending since consumers will only receive such pension benefits when they retire.)

The drop in the saving rate in 2013 also serves to explain why the primary drain from higher taxes occurs with a lag after the taxes take effect. Based on various academic studies there is a two or three quarter lag in curtailed spending after the tax increase. Thus, the main drag on growth will fall in the third and fourth quarters of this year, with negative residual influences persisting through the end of 2015. Approximately $140 billion of the tax increase constitutes what might be termed a reduction in permanent income, or its equivalent life cycle income. In addition to working with a lag, over a three year period this portion will carry a negative multiplier of between two and three.

Monetary & Fiscal

Astronomical sums of money have been expended by both monetary and fiscal authorities since the crisis. With the benefit of hindsight it is clear their efforts have not aided economic growth, but rather the balance of their actions has been counter productive. The Fed has maintained the Fed Funds rate at near-zero levels, and it has tried to lower longer term rates through a series of quantitative easings. The effect of each of the quantitative easings was the opposite of the Fed’s intentions. During every period of balance sheet expansion long rates rose, yet when securities purchases were discontinued yields fell (Chart 6). The Fed cannot control long rates because long rates are affected by inflation expectations, not by supply and demand in the market place. This is extremely counter intuitive. With more buying, one would assume that prices would rise and thus yields would fall, but the opposite occurred. Why? When the Fed buys, it appears that the existing owners of Treasuries (now amounting to $9.5 trillion) decide that the Fed’s actions are inflationary and sell their holdings, raising interest rates. When the Fed stops this program, inflation expectations fall creating a demand for Treasuries, bringing rates back down. The Fed’s quantitative policies have been counter productive to growth as interest rates have risen during each period of quantitative easing. During QE1 and QE2, commodity prices rose, the dollar fell and inflation rose temporarily. Wages, however, did not respond. Thus, the higher interest rates during all QEs and the fall in the real wage income during QE 1 & 2 served to worsen the income and wealth divide. This means many more households were hurt, rather than helped, by the Fed’s efforts.

In terms of government spending, fiscal policy has not, and will not, have a major affect on economic growth. The increased spending immediately following the financial crisis did little to encourage the economy to grow faster. Likewise, the decrease in spending associated with the “sequester” will unlikely be a drag on growth after the initial and lagged effects are fully exhausted. The research on government spending multipliers suggests that the multiplier on spending is very close to zero.

The impact of tax changes is not nearly as harmless. It has been argued that an expired “temporary payroll tax cut” would not effect spending as the initial increase in income was not seen as permanent. The facts seem to counter this opinion. The average monthly year-over-year growth rate of real personal income less transfer payments for 2011 was 3.4%, and in 2012 it was 2.2%. This year, with the payroll tax change in effect, the average is 1.8% through May. The slower income has resulted in a slowdown in spending. Like income, real personal consumption expenditures has trended lower, with average monthly year-over-year growth rates of 2.5% for 2011, 1.9% for 2012 and 1.8% through May of this year. This trend is expected to continue for some time.

A Final Consideration Favoring Bonds

In the aftermath of the debt induced panic years of 1873 and 1929 in the U.S. and 1989 in Japan, the long term government bond yield dropped to 2% between 13 and 14 years after the panic. The U.S. Treasury bond yield is tracking those previous experiences (Chart 7). Thus, the historical record also suggests that the secular low in long term rates is in the future.

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How Spain Just Made Mario Draghi's Nightmare Worse

by Tyler Durden

Yesterday, ahead of the monthly update from the ECB, we posted "What Keeps Mario Draghi Up At Night, And Why The European Depression Has A Ways To Go" in which we showed that not only has M3 in Europe terminally broken apart from bank lending to the Euroarea private sector, but that lending to European banks was growing at the slowest annual pace on record. Today, the ECB showed that Draghi's unpleasant dream is becoming a full-blown nightmare with M3 sliding from a 2.9% growth rate in May to just 2.3% in June, suggesting that whatever the ECB is (not) doing is not working and yet another stimulus round is imminent.

However, putting into question whether even such a stimulus would do anything, is the fact that actual private sector lending contracted even more, and in June declined from a previous record pace of -1.1% to a new record low of -1.6%. In other words, not only is Europe's Keynesian debt trap getting bigger by the month, but the European monetary plumbing system is completely and perhaps permanently fractured.

As long as the gray line continues to be below zero, and certainly as long as it continues to decline, one can kiss all propaganda of a European "recovery" goodbye.

Specifically, in the "loans to non-financial corporations" category, on a seasonally adjusted basis, lending declined by €12.8bn in June, following a €17.4bn contraction in May and a similar move in April. However, it was the loans to households which were the notable outlier, as lending fell by €5.1bn in June. This is only the second fall in loans to households since July 2012, and comes on the heels of a €7.7bn contraction in May. Not only are corporations deleveraging in Europe, but now, once again, households have joined the fray.

Finally, looking at the actual culprits by nation, one country stands out like a sore thumb. We will let readers spot which European nation is responsible for the accelerating European credit crunch on their own.

Indeed, despite Mariano Rajoy's urgent desperation to massage the economic data in Spain, propping up PMI at all costs and now unemployment, which in the second quarter declined from 27.2% to 26.3% due to a strong tourist season (even with 5.98 million people unemployed), what the credit data is showing is that the pain in Spain remains, and until credit creation is once more positive there is little hope for any sustained improvement in either Spain, or the entire continent. And this ignore the fact that even with the SAREB soaking up the bulk of bad loans in the country (offset by rising sovereign debt), NPLs continue to hit record monthly all time highs: something which means the Cyprus one time, "non-blueprint" will sooner or later be repeated by Madrid.

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What Drives Negative GOFO and Temporary Gold Backwardation?

by Keith Weiner

I coined the term temporary backwardation in March of last year. This is what I said:

But in the “new normal”, post 2008, the expiring gold or silver future often flirts with or even slips into backwardation for a period before expiry.  This is anything but normal.  It’s not a sign of imminent financial Armageddon, but it is a sign that beneath the surface there is a growing rot in the core of the system.

I used the word “temporary”, not to imply that this pathology would stop (I said it was the “new normal”), but to refer to the fact that each contract spends a short time in backwardation before either rising out of backwardation or expiring. I used the word temporary to distinguish from permanent backwardation, which will affect all contract months—the farthest first and most severely. Look at this  chart of crude oil. When that happens in gold, the end of the dollar will be near indeed.

Since I wrote the article on temporary backwardation, the rot in the monetary system has increased. I posted a short alert on July 8, marking the first day that the October contract entered backwardation. The rot has crept from the active month (which was still very much August) to the next contract, October. I also showed the progression of how far in advance each contract was entering backwardation (Apr: 30 days; Jun 42; Aug: 55; and Oct: 61).

Let me emphasize that I think this should be regarded as rot. Backwardation provides an opportunity for a risk-free profit. At least, it is free of conventional risk. The trade does not depend on access to credit, and it involves no price exposure. Of course, as I look at it, there is one risk. Whomever takes the bait by selling metal and buying a future risks not getting his metal back. The contract may not be honored, paying dollars at the end.

One should regard rising backwardation as one would regard rising Credit Default Swaps on a bond. Even if the yield on a bond isn’t rising exponentially (yet), rising CDS should be cause for concern. Even if the gold price measured in dollars isn’t rising exponentially (yet), rising backwardation should be great cause for concern.

While we currently have backwardation in the near contract and the next active contract, there is no backwardation beyond October. Here is a picture of the gold basis for 2013 through 2016 (December contracts shown), taken on Friday July 19. It looks similar to the idealized yield curve.

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Other than Dec 2013, which has a negative basis (it is not backwardated; its cobasis is negative), the basis is not only positive, but it is rising for each succeeding year. I acknowledge that this is open to interpretation, but I don’t see how one can look past a positive and rising long term basis curve and conclude that monetary collapse is imminent – click to enlarge.

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When distrust occurs broadly and in earnest, I expect it to creep from the farthest contracts inwards. If there is doubt about delivery, then surely Dec 2016 is much riskier than August 2013. This will be a process of the withdrawal of the gold bid on the dollar (which will look like the withdrawal of the gold offer to those who look outwards from the dollar point of view). With a rapidly withdrawing offer in spot gold, and at the same time an increasingly reluctant bid especially on far futures, there would be a large backwardation that is greatest the farthest out on the curve. In comparison, as of Friday, we have under 0.5% annualized backwardation in August and barely above 0 for October.

Nevertheless, the occurrence of backwardation in gold at all, much less two successive active contracts is serious. Recently, a related phenomenon has made the news and generated much analysis. The GOFO rate has gone negative. Let’s talk about what GOFO is. Short for the Gold Forward Offered rate, GOFO is similar to the basis. Here is a chart overlaying the 3-month GOFO with the October gold basis. I have omitted the axes, as I just wanted to show the shapes of the curves. There are some differences that cause a different scale for each data series.

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The London Bullion Market Association defines GOFO as the rate at which bullion banks are prepared to lend gold on a swap against US dollars. OK, but what does this mean? Let’s take a step back and look at the London market – click to enlarge.

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The London market offers a product called forwards, which are similar to COMEX futures with a few differences. They are not listed on an exchange, so they’re less transparent. The settlement date can be set to fit the buyer’s needs. Unlike COMEX futures, forwards always have a convenient expiry date, so there is no need for “naked longs” to sell the expiring contract. In contrast, the “contract roll” pushes the basis off the bottom of the graph. This is why I showed the October contract, rather than showing a pasted-together series of nearer contracts as they dropped.

GOFO depends on the spread between the gold forward and the gold spot market. This is why the GOFO graph looks so similar to the gold basis graph. Keep in mind that GOFO is an offer by bullion banks, not a pure spread between prices in a market. Along with a few other factors, this makes the GOFO rate less “noisy” than the basis.

After reading my articles (Why Does the “Paper Gold” Price Track the Physical Gold price?, The Gold Futures Open Interest Caper, What is the Meaning of GLD Outflows?, and Why is Gold Draining out of COMEX Warehouses?), readers should be able to guess the punch-line: it is arbitrage that keeps GOFO in sync with the gold basis.

To understand why the spread between the forward and spot gold is important to GOFO, let’s drill down into the transaction that the bank is offering to the client. It is a swap, which means each party is exchanging an asset and the opportunity to get a yield on for another asset. A swap is not a simple trade. It comes with a clause that both parties agree to return the assets to the other party after a specified duration.

In this case, the client has dollars and wants gold. In calculating its offer, the bullion bank must consider its costs and benefits in doing this transaction. Here is a breakdown of the discrete steps (all are committed simultaneously):

1. Client gives dollars to bank

2. Bank invests dollars (receiving LIBOR)

3. Bank borrows gold (paying GLR)

4. Bank gives gold to client

At the end, the client returns the gold to the bank, which delivers it to the gold lender, and the bank returns the dollars to the client.

The equation that represents the above swap is:

GOFO = LIBOR – GLR

LIBOR is a typical interest rate that could be earned on dollars. GLR, or Gold Lease Rate, is the “interest rate” that could be earned on gold. Ever since the 1930’s, of course, there has not been any real borrowing and lending of gold as money. However, there is a specialist market for borrowing and lending gold, who refer to it as “leasing” (who might want to lease gold is the topic for a separate article).

It is logical that the rate on a swap is the difference in the interest rates between the two things being swapped. Because of the mechanics of how the bank provides the swap using the forwards market, arbitrage will keep this rate close to the spread between forwards and spot. Arbitrage will also keep this forwards spread close to the spread between COMEX futures and spot—the basis.

The next question is whether LIBOR is falling or GLR is rising. LIBOR has indeed fallen slightly, from 28bps at the start of April to 26.5bps on July 19.

Let’s develop a single integrated theory that takes into account all the facts. First, we have temporary backwardation. This indicates a liquidity issue in near-dated futures, if not a broader problem in the monetary system. Second, the basis has been falling (even far-dated futures), and cobasis has been rising. Evidence of this is the increase in advance dates that each contract goes into temporary backwardation, plus we have two active months backwardated for the first time in a long time (years, to my recollection). Third, there have been many news reports since April, of higher than normal positive spread in the gold prices between London/NY and China.

I think there is a simple arbitrage that explains all observed phenomenon. For every gold bar that a bullion bank buys, it has several options for how to make money without incurring price risk. One is to “lend it on the swap” as described in the GOFO example above. Another is to carry the gold by selling a futures contract against it, earning the basis.

A third is to sell it for a premium in China. If this premium is larger than the profit of the first two options, then selling to China will be attractive. This option has another advantage. It does not expand the bank’s balance sheet, with the attendant capital requirements. It is a simple buy and sell, with the only headache being actually shipping the bar to China.

Water flows down-hill, from higher elevation to lower. Analogously, gold flows up-price, from lower price to higher. Right now the spare bars are going from New York and London to China. The result is temporary backwardation and a negative GOFO.

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Dr. Keith Weiner is the president of the Gold Standard Institute USA, and CEO of Monetary Metals.  Keith is a leading authority in the areas of gold, money, and credit and has made important contributions to the development of trading techniques founded upon the analysis of bid-ask spreads.  Keith is a sought after speaker and regularly writes on economics.  He is an Objectivist, and has his PhD from the New Austrian School of Economics.  He lives with his wife near Phoenix, Arizona.

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