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The Hot New “Carry Trade” and Gold’s Record Run - One Chart Explains it All

Commodities / Gold and Silver 2010 May 14, 2010 - 02:10 PM GMT

By: Q1_Publishing

Commodities Best Financial Markets Analysis ArticleEvery few months institutional investors get hooked on a new trade.

The trades start off with solid fundamental ideas, then the Big Money piles in, it goes parabolic, good “stories” bring in the retail investor, and the trade eventually blows itself up.

Right now, all signs point to that is what is exactly happening with gold.

The Carry Trade Du Jour

The ongoing growth of edge fund assets and low borrowing costs for proprietary trading desks are making carry trades, when a trader sells short one asset and buys another, bigger and bigger.

The key thing with all carry trades is they start out with excellent fundamental justification. The asset that is sold short (bet against) has terrible fundamentals and the asset that’s bought has great fundamentals.

Right now, the Big Money has found a new carry trade - short the Euro and buy gold.

It makes perfect sense from a fundamental perspective.

The Euro’s fundamentals are simply terrible. There’s almost no sensible reason to buy Euros after the Greek bailout, the ECB monetizing debt, whatever actions are deemed necessary to “contain” the next Euro zone crisis, and keep the euro on the long path to destruction strategically positioned to benefit exports.

Gold, on the other hand, has fantastic fundamentals. Real interest rates, which are historically the biggest driver of gold prices, are negative and falling. Confidence in fiat currencies continues to deteriorate. Tax receipts around the world are still in decline and pushing budget deficits even higher.

So when it comes to bad vs. strong fundamentals, there aren’t too many better matchups than Euros and gold.

And, as the chart below which shows the gold’s rise relative to the euro, the Big Money has been piling in for quite some time:

Clearly, this trade is getting very crowded.

And we’ve reached a point, with gold at record highs, where the “stories” are starting to pop up.

The “Story Stage” Takes Hold

Once an asset really starts moving for an extended period of time (like the Euro/Gold carry trade), supporting stories are sure to follow. This time is no different.

The big gold headlines have made it into the mainstream media once again. And the top stories have been the installation of a gold ATM machine in Abu Dhabi and surging demand for gold coins at the Austrian mint.

Both stories are getting a lot of press, but they really don’t matter much in the short-term.

First, selling bullion has been a good business for decades. Now, with the renewed demand for gold, it’s turning into a great business as profits rise right along with precious metals prices (the margins are still similar). Naturally an industry facing increased demand would find new sales outlets. And, although I can’t find any information on the premiums charged by the gold ATMs, it’s probably a safe bet they’re higher than the ones charge by bullion dealers.

As for the Austrian mint, the story is just as like the ones when the U.S. mint seems to run out of silver ever few months. Yes, demand is soaring. The Austrian mint sold more gold coins in April than it did during the entire quarter. But we know mints are terribly run. Like all typical government agencies and government-owned corporations, they consistently fail to properly forecast demand and inevitably face shortages.

But again, the physical bullion and trading markets have very little correlation. As Julian Philips noted today in COMEX gold and silver markets do not affect gold and silver prices at all!, physical bullion demand has little to do with the market prices of gold and silver.

The Short-Term vs. the Long-Term

This is all why we recommend taking a bit of caution when it comes to precious metals right now.

As noted above, these carry trades move in fairly defined cycles: They start off with solid fundamentals, then the Big Money piles in, it goes parabolic, good “stories” bring in the retail investor, and the trade eventually blows itself up.

We’ve entered the story stage and, if history is any example, there’s not much upside left to go.

In the short-term gold prices will facing a lot of headwinds. As the current carry trade du jour runs out of steam and will be unwound. It’s looking a little too crowded.

But the long-term is as bright as ever. This carry-trade has helped further cement gold as a safe-haven asset along with the yen, the U.S. dollar, and U.S. treasury bonds. But in time, given the global fiscal situation, gold will eventually become the only safe-haven left standing.

That’s why, although we may not be very excited for the short-term prospects of the gold bull run, there is still a lot of money to be made. All signs signal there will be even more fortunes made as the gold bull market continues than the run that peaked in 2008.

Good investing,

Andrew Mickey
Chief Investment Strategist, Q1 Publishing

Disclosure: Author currently holds a long position in Silvercorp Metals (SVM), physical silver, and no position in any of the other companies mentioned.

Q1 Publishing is committed to providing investors with well-researched, level-headed, no-nonsense, analysis and investment advice that will allow you to secure enduring wealth and independence.

© 2010 Copyright Q1 Publishing - All Rights Reserved

Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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