What is Inflation?
Inflation, is an economic concept. What the cause of inflation is, is not important to us from the point of view of this article. What is important to us is the effect of inflation! The effect of inflation is the prices of everything going up over the years.
A movie ticket was for a few paise in my dad’s time. Now it is worth Rs.50. My dads first salary for the month was Rs.400 and over he years it has now become Rs.75,000. This is what inflation is, the price of everything goes up. Because the price goes up, the salaries go up.

If you really thing about it, inflation makes the worth of money reduce. What you could buy in my dad’s time for Rs.10, now a days you will not be able to buy for Rs.400 also. The worth of money has reduced! If this is still not clear consider this, when my father was a kid, he used to get 50paise pocket money. He used to use this money to go and watch a movie (At that time you could watch a movie for 50paise!)

Now, just for the sake of understanding assume that my dad decided in his childhood to save 50paise thinking, that one day when he becomes big, he will go for a movie. Many years pass. The year now is 2006. My dad goes to the theater and asks for a ticket. He offers the ticket-booth-guy at the theater 50paise and asks for a ticket. The ticket booth guy says, “I am sorry sir, the ticket is worth Rs.50. You will not be able to even buy a “paan” with the 50paise!!”

The moral of the story is that, the worth of the 50paise reduced dramatically. 50paise could buy a whole lot when my dad was a kid. Now, 50paise can buy nothing. This is inflation. This tells us two important things.

Firstly: Do not keep your money stagnant. If you just save money by putting it your safe it will loose value over time. If you have Rs.1000 in your safe today and you keep it there for 10years or so, it will be worth a lot less after 10 years. If you can buy something for Rs.1000 today, you will probably require Rs.1500 to buy it 10 years from now. So do not keep money locked up in your safe.

Always invest money.
If you can’t think where to invest your money, then put it in a bank. Let it grow by gaining interest. But whatever you do, do not just lock your money up in your safe and keep it stagnant. If you do this, you will be loosing money without even knowing it. The more money you keep stagnant the more money you will be loosing.

Second things: When investing, you have to make sure that the rate of return on your investment is higher than the rate of inflation.

What is the rate of inflation?
As we said earlier, the prices of everything goes up over time and this phenomenon is called inflation. The question is: By how much do the prices go up? At what rate do the prices do up?

The rate at which the prices of everything go up is called the "rate of inflation". For example, if the price of something is Rs.100 this year and next year the price becomes approximately Rs.104 then the rate of inflation is 4%. If the price of something is Rs.80 then after a year with a rate of inflation of 4% the price go up to (80 x 1.04) = 83.2

So, when you make an investment, make sure that your rate of return on the investment is higher than the rate of inflation in your country. In our county India, for the year 2005-2006 the rate of inflation was 4% (Which is really low and amazing!). This rate keeps changing every year. The finance minister generally gives the official statement on the inflation rate of the country for a particular year.

What is the rate of return?
The rate of return is how much you make on an investment. Suppose you invest Rs.100 in the market and over a year, you make Rs.120, then you rate of return is 20%.

If you invest Rs.100 in the market today and you make money at a 3% "rate of return" in one year you will have Rs.103. But now, since the rate of inflation is at 4%, an item costing Rs.100 today will cost Rs.104 a year from now. So what you can buy with today’s Rs.100, you will only be able to buy with Rs.104 a year from now.

But the Rs.100 that you invested has grown only at a 3% rate of return and so it is worth Rs.103. In effect, you are loosing money!

So in conclusion, the rate of return on your investments, have to be higher than the rate of inflation.

From the above paragraphs you can note how silently, inflation eats into your money. You would not even know about it an your money would sit loosing value for no fault of yours. But inflation is not the only thing you should be considering, there are other things too that eat into you money. The first thing is “brokerage” and the second thing is “taxation”.

Gold Carry Trade Special Report:

The Real Story Behind the True Gold Bull Market

On July 24, 1998, Alan Greenspan stood before the House Committee on Banking and Financial Services and said, “Central banks stand ready to lease gold in increasing quantities should the price rise.”

That is exactly what the gold carry trade consists of. It is the process in which central banks lease out gold bullion to be sold on the open market to suppress prices.

Here’s the thing: The large majority of these transactions take place on the London Bullion Market (LBM). This is an over-the-counter (OTC) market in which there is little-to-no transparency. A number of organizations have conducted studies on the amount of gold lending that takes place. Some of the organizations include Gold Fields Mineral Services (GFMS), the World Gold Council (WGC), and Virtual Metals (VM). As a result of the lack of transparency, the numbers reported in regard to gold leasing vary slightly from one another. For the sake of argument, I will be using the most conservative figures reported.

This may be the most significant piece of the gold bull puzzle that will push gold to $2,000 and beyond. I will dig in and share my in-depth research with you, starting with how the process is carried out, then going into the market impacts of the gold carry trade, and concluding with the future of the market for gold leasing.

How Does the Gold Carry Trade Work?

Gold leasing takes three different forms: direct leasing, central bank swaps, and forward hedging.

Direct Leasing

I am going to run through this in a simple step-by-step process. Central banks don’t directly take their bullion to the market and lease it out. They use a vehicle called a bullion bank (BB).

Although bullion banks are numerous, some of the more well known are Barclays, Goldman Sachs, JP Morgan, Bank of America, UBS, and Citibank.

The central banks loan gold to the BBs at a rate of approximately 1%. The BBs take it to the LBM and sell it on the open market. The BBs take the cash from selling the bullion and in turn buy Treasuries.

So if the story were to end here, the bullion banks would just walk away with a net 4% return. But it doesn’t end, because they only have the leased gold for a certain length of time. They eventually have to give the gold back to the central banks, but now they are at risk of price swings in a very volatile market.

The answer to their problem is to go long the futures market. Essentially, they buy futures contracts to hedge their risk. In other words, they secure gold for delivery at a specific price, on a specific date in the future. Once they buy their futures contracts, it doesn’t matter what the price action of gold is.

In a perfect scenario, after the gold lease rate and price risk hedging, the bullion bank will walk with a modest 1–2% gain. The central banks will receive a return on their gold, keep the price of gold suppressed in order to keep real inflation suppressed, and get a boost in the demand for Treasuries. It’s a win-win situation for both the bullion and central banks.

Gold Swaps

Gold swaps are very similar to direct leasing. The difference is that gold swaps usually take place between two central banks. These types of transactions occur in two different forms.

The first is very simple. Essentially, two central banks swap gold reserves and then carry out the action of direct leasing of each other’s gold. The reason for this is that it just adds more confusion for the accounting of the leased gold.

The second is slightly different. This transaction occurs when one central bank exchanges gold for currency with another central bank. Like gold leased to the BBs, a future date and price are set for the redelivery of the gold back to the initial central bank.

The IMF says of this type of gold swap, “Typically, both parties will treat the transaction as a collateralized loan.” Or the CB leasing the gold doesn’t remove the gold from its balance sheets, and the CB receiving the gold doesn’t add it to its balance sheet. As far as accounting goes, no transaction has even taken place. The gold market is flush with new supply and would beg to differ that a transaction hasn’t taken place.

In other words, the CB receiving the gold loans it out on the market while it is still on the balance sheet of the initial central bank. One might refer to this practice as double-counting the reserves.Forward Hedging

Forward hedging is a form of gold leasing practiced by gold producers. The most famous of these is Barrick Gold, but there are many other producers who partake in forward hedging.

Forward hedging is when a producer presells gold on the spot market that has yet to be extracted from the earth. Most of the buyers want delivery of physical gold. So the producer leases gold from a CB, with the idea that it will pay the CB back with future production.

The problem is that these producers often sell their gold at suppressed prices on the spot market and they often sell more gold then they can produce.

On the note of Barrick, did I mention that it has recently been sued for price fixing and price manipulation of the gold market? Barrick and its bank JP Morgan have admitted to price manipulation and that they have worked with the central bank in this process.

Implications of the Gold Carry Trade

The gold carry trade has one main goal, and that is to add huge amounts of supply to the market in order to suppress the price of gold. Although there are other added bonuses along the way for the participants, the main reason for suppressing the price of gold is so the world doesn’t know the true value of worthless fiat currencies.

I would like to use some statistics to inform you as to the implications of gold leasing on the market for gold. Remember that I will use the most conservative numbers I could find.

In 2005, according to GFMS, gold leasing was estimated to have added 2,970 tonnes of supply to the market. In that same year, jewelry demand was 2,700 tonnes, world investment was 736 tonnes, and official central bank sales were 656 tonnes. Over the last 10 years, average mine production has run at an estimated 2,500 tonnes per annum. So the amount of leased tonnage exceeded all of the above-mentioned statistics.

Remember that central banks are not required to report at all on their transactions of loaned gold. So those 2,970 tonnes of extra supply were also counted in central bank reserves, or they were double-counted.

Central banks are the largest holders of gold tonnage, estimated to have around 30,000 tonnes. So they have loaned out approximately 10% of their total reserves.

How Long Can This Go On?

If you are looking at this in a practical way, you probably came up with the exact questions I did when I first started to read about the gold carry trade. When the gold enters the market via a BB, it all has to be bought back at the end of the lease contract. Doesn’t that put us back at square one with the amount of supply in the market negating any long-term implications?

The answer would be yes if there were just a couple of transactions. But there are several gold leasing contracts signed every day. All the supply is constantly being recycled in and out of the market and there is always fresh gold being leased into the market.

The length of a gold leasing contract can extend anywhere from one month to several years. This allows for the central banks to analyze these markets and best time their transactions and how long they will be, in order to suppress the price of gold.

So can this go on forever? Definitely not, and the implications of the gold carry trade coming to end will bring with it the most spectacular price actions ever seen in the gold market.

Let me tell you why the gold carry trade will not be sustainable forever. It’s very simple. All we have to do is look at the step where bullion banks have to buy back the gold sold on the spot market in order to pay back the central banks.

In order for this to be profitable for the BBs, the price of gold has to experience very limited gains during the time the gold is leased out. Or the price of the futures contract purchased by the BB has to be near enough to the price of gold when the bullion bank initially unloaded the leased bullion on the spot market. If the price of gold heads too high, it will not be profitable for BBs to partake in being the intermediary for such transactions.

All we have to do is look at the fundamentals for gold and we realize very quickly that the price of gold is definitely going to go higher one way or another, which will disallow future leasing in the gold market. You are probably well aware of the fundamentals: Every one of the major economies of the world printing money at a rate of over 10% per annum; the Mount Everest of debt from both budget and trade deficits; an inevitable recession here in the U.S.; the inability of the U.S. to raise interest rates, due to the complete mess of the housing market; rising energy costs putting downward pressure on the U.S. dollar and increasing inflation in every other aspect of the economy; mine supply at historic lows; a possible U.S. policy that would include trade protectionism against China; and, last, but definitely not least, a U.S. Federal Reserve whose main goal is to create credit by keeping interest rates below the rate of inflation (negative real interest rates).

Fundamentals are fundamentals, but there has been some action in the International Monetary Fund (IMF) recently on this very topic. Before I go any further, I just want to let you know that I don’t trust the IMF any further than I can throw it. And I don’t really expect any timely results from its actions. What is important is that the notion of the gold carry trade is coming forefront. Here’s what’s going on in the IMF.

Hidetoshi Takeda of the IMF’s statistics department recommended in early 2006 that all loaned gold be excluded from the central bank’s reserve figures. The IMF’s committee on reserve assets considered Mr. Takeda’s paper and came to the conclusion that a new definition of gold reserves excluding loaned gold needs to be officially documented. It also stated that unallocated gold loans should be disallowed. Nothing recommended in Mr. Takeda’s proposal was rejected. Full details of his report can be read here: http://www.imf.org/external/np/sta/bop/pdf/resteg11.pdf

The IMF continued its research regarding the issue and made another report with a similar conclusion. What does this all mean? Well, the IMF is currently working on another official proposal to be worked through the system making it necessary to make all loaned gold public information and to exclude loaned gold from reserve accountings. The IMF currently “encourages” central banks to record gold loans/swaps, but does not “require” the recording.

If everything goes perfectly, and I don’t believe that it will, we could see these actions implemented by the IMF at the end of 2008. As I said, it seems like a far reach, but the more people become aware of the gold carry trade, the sooner it will come to an end. And I don’t like to put my bets on the IMF to make progress with in the accounting of leased/swapped gold, but it DOES have the power to change how central banks report the reserve holdings of gold.

The eventual unwinding of the gold carry trade, whether it be from the IMF or just market fundamentals, will bring amazing action to the gold market. Remember that gold leasing didn’t begin until after the precious metals run from 1979–1980. For the bull market in gold to continue, it will need to overcome the barriers set by central banks’ leasing of gold. But when this does occur, the floodgates will open and we can expect to see the price of our favorite yellow metal skyrocket.

Special Report: 5 entirely new ways to play the gold trend. Including one hidden way to snap up gold for less than one penny per ounce… Read the entire report here.

Investment is a Marathon, not a Sprint