Market NewsCommentThe Fed and prices of rough

The Fed and prices of rough

One diamantaire greeted me the other day by saying, "things are tough (what's new). Up until two months ago, I sat on my high quality rough inventory, which appreciated as prices kept going up. In the last couple of months, I have been sitting on that very same inventory, waiting for prices to rebound from the recent tumble".

Even if this statement is a little exaggerated, it demonstrates the state of mind of many diamantaires who really believe that diamonds in general and in particular rough diamonds are a commodity of which the price can only rise.  

During the last two years, diamantaires who had the liquidity betted on prices of rough diamonds to keep going up. These diamantaires accumulated inventories of rough diamonds (usually good qualities), believing they would take advantage of the rising prices. Practically, they invested in rough inventory the same way they would invest in a financial short term asset.

Now, for the last couple of months, the trend in prices of rough diamonds has changed, and the common belief is that the change is due to the unusually two large DTC sights in August and September.

According to the available data, the two sights together were higher by approximately $600 million, compared with same months sights of 2004.

Now, this amount accounts for only about 6% of the world's yearly rough diamond turnover, or only 10% of the DTC's annual sales. So was this excess of supply from the DTC the real reason for the price decrease which followed?

While this may have been the trigger for prices to go down, surely there were other reasons like market expectations for a price decrease in rough diamonds.

Expectations induced by the DTC's statements in the past, and by the market understanding that the inconsistency between the trends in prices of rough and prices of polished diamonds, could not go on for ever.

One more silent factor hiding in the background may have played a significant role in this cycle of rough diamond prices – interest rates.

One has to recall that the American Prime rate (the Fed rate) and consequently the Libor rate, were at lows during most of 2002, and the first half of 2003.

The Fed's prime rate decreased from about 7% in the beginning of 2001 to 1% in mid 2003. The Prime rate remained at 1% until the second half of 2004, and then started to climb gradually reaching a peak of 4% last month.

The interest rates affected two groups of diamond players.

Firstly, the wealthy diamantaires who had liquidity in the form of bank deposits or any other financial short term investment. These diamantaires were deeply concerned by the low return on their money, which reached a rock bottom of 1% per year (on cash deposits). At the time, in order to get a reasonable yield on their liquidity balances, these diamantaires had to take some risks, even if they invested in financial vehicles.

So why not take some risk on rough diamond stock, using rough inventory as a good alternative investment.

The second group were diamond companies that had the availability to borrow under their credit facilities at a ridiculous interest rates of (at times) around 3%. (Of course these diamond players had to make sure that they are left with sufficient borrowing availability, for their regular operations). 

This group speculated that the prices of good quality rough diamonds will rise higher than the bank interest rate (which was at an almost unprecedented low rate).

Both groups had strong incentives to stock the good quality rough, using it as a commodity and an investment, given the low interest rates and the rising prices of the rough.

Now that the Fed's interest has reached 4%, four times higher than during much of 2003 and 2004 (and going up), things have changed.

The alternatives for the money are more interesting (one can get up to 5% for a one year bank deposit) and the cost of borrowing is much heavier.

This, in addition to the inevitable acknowledgment that a real sustainable increase in rough diamond prices has to be supported by a similar increase in prices of polished diamonds has prompted the diamond players who speculated on rough to liquidate their inventories.

The connection between interest rates and prices of diamonds has many interfaces, from the consumer's side, through its affect on levels of consignment programs, profitability etc.
There is no doubt that this connection played a role in the price cycle of rough diamonds during the past few years.

This comment was written by a banker at a leading bank in the diamond industry who wishes to remain anonymous.

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