UGL - Buy UGL: Gold Lease-Rate Support Hasn't Been This Bullish Since 2008

2023-10-25 07:25:07 ET

Summary

• Rising implied gold lease rates indicate tight physical supply, with higher prices likely.
• Historical data shows that periods of spiking lease rates have been bullish for gold prices, making it a sound investment backed by logic and precedent.
• The worsening U.S. fiscal deficit/debt problem has pushed overseas central banks to diversify their foreign exchange holdings with extra gold.
• Recent turmoil in the Middle East and U.S.-China tensions over Taiwan provide additional incentives to hold gold.

I have increasingly talked about the bullish implications of rising implied gold lease rates (premiums for futures market deliveries) since last autumn. The spike in rates measured from late August 2023 is a serious tell that big banks/brokerages are finding it difficult to find physical supply to buy. Today, nominal lease rates are at their highest level since the important late 2008 bottom in gold quotes. After Lehman Brothers was allowed to fail, global financial system turmoil (from a real estate and banking collapse in America) led to massive QE bond buying under Federal Reserve Chairman Bernanke , alongside central bank money printing at modern record levels all over the world.

In my research, we may be getting close to another pivotal point in bank health and credit policy, where a recession soon forces a shift again toward oversized central bank easing to prevent a prolonged and deep economic downturn. On top of this rising probability for gold investors, recent turmoil in the Middle East and expanding friction between the U.S. and China over Taiwan are adding extra incentives to hold gold (the ultimate form of money and store of wealth). In fact, I wrote about the strong odds of escalating Chinese buying to support the Yuan, almost surely influencing the gold price in an important September article here .

The really good news for gold bulls is the latest climb in 12-month lease rates to a multi-year high is rare, and the last 4 setups with similar characteristics have been incredibly bullish for gold bullion pricing 6-12 months (or longer) down the road.

My investment conclusion is owning gold now is backed by sound logic and historical precedent. So, leveraging the idea with a 2x ETF product goal is well justified. I continue to rate the ProShares Ultra Gold ETF ( UGL ) as a Buy to Strong Buy , like I have for better than a year. Let me explain why.

U.S. Dollar Under Attack

Perhaps the primary reason for the jump in gold futures price premiums and implied lease rates for lending physical gold is the modern record amount of gold purchased by central banks around the world during the last 18 months. 2022 witnessed 1,136 tonnes purchased by central banks, the greatest sum since records have been kept back to the 1950s.

Why all the buying? It's an effort to de-dollarize their foreign exchange reserves. Everyone is worried about America's Treasury debt mess. It is now mathematically impossible for U.S. citizens to repay all of the federal government's IOUs in constant dollars. Any effort in 2024 to significantly cut spending or raise taxes will almost surely push the economy into deep recession, and actually RAISE the level of deficit spending/borrowing.

Honestly, the U.S. now requires a span of tremendous devaluation of our currency vs. other fiat creations just to keep Uncle Sam solvent. Of course, rising inflation will be the real-world result businesses, consumers, and investors experience.

The Fitch Treasury ratings downgrade in August was a two-fold decision, where a lack of political will in Washington DC to cut deficit spending is combined with the rotten math of a slower economy with rising interest expense allowing for an even worse debt/deficit picture in 2-3 years. More bad news was released last week for fiscal year 2023's final deficit tally of $1.7 trillion (adjusted to an actual $2 trillion in new borrowing). Such was a huge leap from 2022's $1 trillion total. And, if we get a recession, $2 trillion annually in required borrowing (on top of refinancing $33 trillion in past debt) may be the new floor for the U.S. sovereign deficit.

So, that's the fundamental background story banks, financial institutions, and investors are trying to hedge with gold purchases. Overseas central banks that sit on the U.S. dollar as their largest currency reserve by far (with more than 58% of all foreign exchange holdings in the U.S. paper/electronic currency) are now quite motivated to diversify into even safer gold reserves.

Lease Rate Picture

Amazingly, gold lease rates and futures premiums were under zero 18 months ago. There existed very little demand vs. normal. I could even argue the 2020 pandemic rush to buy gold (and silver) was being deflated/reversed by a rising stock market, COVID reopenings, and resurfaced confidence that life was getting back to normal.

However, since the summer of 2022, premiums and lease rates for physical gold bullion have been on a relentless incline. Today, the implied lease rate level is the highest since late 2008, in the 1.5% to 3.2% range for loan periods of 1-year or less. What this indicates is large gold buyers are finding it difficult to find immediate supply and are bidding up future delivery schedules.

Here's my bottom line. Some of the most bullish intermediate-term periods for gold have occurred right after 12-month lease rates reached multi-year highs, while the whole yield curve sat near or above 1% annualized.

Below I have marked the last 4 instances reaching this buy-signal threshold. The periods include the major bottom of 2008 (circled and quite similar to today in my view), the late 2015 cycle low, early 2019 bottom, and the Q4 2022 circumstance (each highlighted with a green arrow).

The larger the jump in rates across the whole lease rate curve, the better for long-term pricing. After the 2008 occurrence, gold prices more than DOUBLED from around US$800 an ounce to $1900 in 2011. The 2019 bottom witnessed a +60% gold quote jump into August 2020, 18 months later, from under $1300 to $2050.

ProShares Ultra Gold

Now let's review how the 2x leveraged gold product, ProShares Ultra Gold, performed after comparable lease rates spikes. Although UGL suffers through decay and compounding issues in a negative way during bear markets in gold, it has a terrific history of delivering returns around 2x the same-period gold bullion performance when prices are rising. If you believe gold is due for a decent run higher, like I do, considering this financial product for your portfolio makes plenty of sense.

October 2008 - August 2011

December 2015 - September 2016

March 2019 - August 2020

September 2022 - Present

Final Thoughts

What we find from the empirical evidence is previous lease rate rises/patterns, similar to the jump over the last several months, have flashed major buy signals for astute gold investors. If you want to throw out all the prognostications and noise about when to own gold by analysts of various stripes, and just focus on lease rate changes (premiums in futures trading), you might become an expert on the gold market faster than many other players.

A physical shortage of metal is the outcome explained by high and often inverted lease rates. If new wars are beginning in the Middle East now and over Taiwan next year, central banks remain skittish about holding hoards of dollars on their balance sheets, and another round of central bank fiat money printing is approaching fast, NOW may be the smartest time to own gold in decades.

How could a bullish gold position turn into a loser from today? That's a great question. My answer would be the opposite of the above paragraph will have to play out. Namely, peace needs to break out around the world, foreign banks and investors need to believe the U.S. debt/deficit problem is not that big a deal, and interest rates need to stay high and/or continue rising during 2024. In other words, you have to believe not only in happy endings, but most all geopolitical problems and financial realities are easy to fix.

I rate UGL a Strong Buy for most accounts, following the evidence of physical supply shortfalls telegraphed by rising lease rates.

I would note, my bullish rating is using a 12-month outlook. I strongly suggest selling portions of your position into strength, locking in gains. The leveraged 2x design is not recommended as a buy-and-hold forever idea like regular equity in a blue-chip business. When bear markets do hit gold, UGL will absolutely experience large losses in tandem.

Thanks for reading. Please consider this article a first step in your due diligence process. Consulting with a registered and experienced investment advisor is recommended before making any trade.

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