Gross gold sales by central banks amounted to 584 tonne, of which nearly 75 per cent were outside the public domain. The report says that Russia was primarily responsible for a part of this, but even after an allowance for the Russian sales, there is still a very sizable residual. Gross central bank purchase of gold amounted to 164 tonne, this included the Chinese purchase of their own domestic production.

Central bank lending activity had increased to 4,750 tonne, an increment of 375 tonne over last year. Producer hedging activity increased the supply by 484 tonne, which is only 20 tonne short of an all time high in 1997. GFMS believes that a record amount of new producer hedging in the first three quarters of the last year were added. Average cash cost of the producers have come down to an average of $197 ($207 last year), and the total costs have come down to $257 (last year $261) per troy ounce.

This makes it more profitable for producers to book outright forwards at the present 5.50 per cent levels for one year, which means the producer would get approximately $290 after a year, where his average total costs are $257, a very decent average net profit margin of at least 13 per cent.

The outlook for the gold price for the current year is between $250 and $300. The points are going to be the critical factors impacting the gold markets in the future. We have some sort of a schedule of the central bank gold sales plan. There would be larger non-declared sales, but it seemed the markets are worried more about the smaller quantity of declared sales rather than the larger amount of non-declared sales.

Also with a larger pool of lending, but a smaller demand from borrowing gold, primarily from the producers, is likely to have ample short term liquidity. With the US interest rates rising and not likely to decline, at least this year, the gold contangos would remain high, thereby deterring the producers to short spot gold. They would rather book outright forwards and play safe, not only because they have burnt their balance sheets heavily but because their shareholders would make a lot of noise about using rampant derivatives to increase profitability. In fact, one of the better plays at present is the following:-

Short gold is at present at $275 levels, with a stop loss at $279 (of course this is actually a huge stop loss, but I am giving an extreme example). The stop loss limit can also be determined by using the one month volatility. Borrow gold with a one month perspective, at 0.25 per cent. Use that money to create US dollar assets at one month LIBOR at about 6.05 per cent, or alternatively putting the money in daily depo for one month. Even if the stop loss were to get hit, and we were to take a loss on shorting gold, our overall cost of funds would be 4.05 per cent. This is, of course, assuming that the price of gold were to shoot up.

The closer it stays to $275, our cost of funds come down. Needless to say that if the price of gold, at the time of buying it back, were lower than $275, it would have negative cost of funding. Even in the worst case scenario, there is a neat 2 per cent spread. This type of trade is now more comforting as the short-term liquidity in the gold leasing markets is ample, and there is likely to be less demand as the producers would remain vary to hedge. This is assuming no Duisenberg effect takes place in the time period of the gold carry game.

The Indian drought affected the global gold physical demand. But a reminder here would be that the larger gold demand comes from southern India, which is not as badly affected as the north like Gujarat and Rajasthan. This would attract some gold sales and also receding demand is expected in anticipation of poor monsoons, but not probably, as feared. Also the state run Centre of Mathematical Modelling & Computer Simulation, has estimated that India would receive timely and normal monsoons this year of 789mm (compared to 840mm last year). Of course, this is a political issue and the Government should ensure return to normalcy.

Gold has broken the $279 levels, and has tested the 2000 low of $274.50, this week. With the Indian marriage season coming to end and the lesser Indian demand on account of drought, the physical market support of $275 can be broken easily. But it has to convincingly break the $274.50 level, to tread into a lower trend. I expect the markets to be quiet in the $274.50 to $280 range, as it appears to be short ahead of the expected Swiss sale. If the Swiss sells the gold like the Dutch, it will only declare after it has sold, while the shorts may be awaiting it, which could lead to a short-term rally, but within the range.

(The author is a fund manager and the opinions expressed are solely his. This is not intended as an offer or solicitation to buy or sell, or methods to trade)