Let me start with a definition of the term 'backwardation' for readers that are not familiar with it. A commodity like e.g. crude oil that trades in a futures market, has many different contracts trading concurrently, for different delivery dates in the future. Normally, the contracts for later delivery will trade at higher price than those for earlier delivery. This 'normal' state of affairs is known as 'contango'. The reason why contracts for later delivery are normally higher priced is that they must reflect two cost factors that are a function of time. One is storage costs; obviously, it costs more to store 1000 barrels of crude oil (the size of one NYMEX light sweet crude contract) until January of 2010 than until January of 2009.
The other is opportunity cost; by tying up funds for the purchase of crude oil for future delivery, these funds are no longer available for other purposes – the simplest of which is earning a risk free interest rate. Putting it differently, a futures market will normally reflect the 'cost of carry' – the cost one incurs by holding the underlying commodity from the current moment in time to the day of delivery.
However, the futures curve also reflects other considerations; the major one is the market's perception of the state of estimated current supply compared to expected future supply. For instance, at present, the futures curve in crude oil shows an unusually large contango – so large that people are, as it allows one to make very large arbitrage profits by simply storing oil and selling it forward.
Apparently the oil market currently has two major concerns:
1. current supplies are more than ample – the market is in fact oversupplied in view of a sharp fall-off in demand.
2. the low prices of today make a far less benign supply situation in the future more likely, as many oil production expansion plans are being shelved due to the recent price collapse.
Occasionally though, and at times for extended periods, oil has been trading in backwardation – meaning, that the futures curve looked opposite to its normal shape – spot oil and near delivery months traded at a (often large) premium over later delivery months.
Whenever an industrial commodity is trading in backwardation, one can be sure of one thing: current supplies are very tight relative to demand. Backwardation discourages storage by making it very costly, and is the market's way of drawing as much of a commodity out of storage as is possible, as users need it in the here and now. Thus the 'abnormal' situation of a backwardation in a futures market has an economically valuable function: it informs market participants of a supply shortage in the present, and by making storage a costly proposition and allowing for an arbitrage that makes it profitable to sell a commodity in the present and buy it in the future, it draws supplies out of hiding, which will eventually tend to alleviate the shortage.
A gold backwardation is different
Let us now proceed to looking at the recent backwardation in gold (in the meantime the market has reverted to a slight contango, but this seems poised to reverse again, as gold forward rates have resumed falling).
After reading the above paragraph on backwardation and contango, one might be tempted to conclude that a backwardation in gold is no different from one in say crude oil, or copper. However, this is definitely not the case.
Many readers of this blog are probably familiar with Mike 'Mish' Shedlock's blog 'Global Economic Trend Analysis' and may have followed the recent back and forth between Dr. Antal Fekete and Mish on the topic of the recent brief gold futures market backwardation.
It began with Dr. Fekete's somewhat alarmist (but nevertheless quite interesting) article 'Red Alert: Gold Backwardatio!!!n', from whence it proceeded to one of Mish's frequent conspiracy-debunking blogs entitled 'Nonsense About Gold Backwardation, Ameros,Yuan Devaluations, etc.', which prompted Dr. Fekete to reply, a bit miffed, with 'There Is No Fever Like Gold Fever', followed by another rebuttal by Mish 'No Fever Like Gold Fever: Response'.
This latter article quoted me, following an e-mail exchange with Mish in which we discussed the situation. Since Dr. Fekete's article struck me as overly alarmist at the time, and I thought that the backwardation was probably mainly a short term anomaly, I was rather dismissive of the claims made therein.
For one thing, the gold forward curve is supposed to be quite flat at present – after all, official interest rates all over the world have been slashed to the bone, and this lowers gold's cost of carry commensurately – the opportunity cost of holding gold has declined sharply.
Secondly, we know that demand for small denomination physical gold has recently soared, which has surprised refineries that now have difficulties to deliver all the gold demanded in a reasonable time span.
Thirdly, it has been known for some time that gold lenders (mostly central banks) have become reluctant to lend out gold, due to rising concerns about counter-party risk. This can be inferred from the gold lease rate, which has recently risen quite sharply. Since it is also a well known fact that forward selling on the part of gold miners has become very rare , a rising lease rate can only mean that the supply of gold for lending purposes has tightened (what little forward selling there is done is almost always tied to project development debt finance, but this is still easily overwhelmed by the ongoing covering of stale forward sales by large established producers like e.g. Anglogold, that has only fairly recently adopted a 'no more hedging' policy under its new CEO).
The LBMA's 3 month gold lease rate, courtesy of. There has been a recent spike indicative of tightness in the gold lending market – click on chart for larger image.
I did however mention that a backwardation had to be regarded as bullish, and I conceded that in the case of Zimbabwe, Dr. Fekete was perfectly right: it does not matter anymore how much money in terms of Zimbabwean government scrip one offers to a holder of gold in Zimbabwe – he simply won't sell. This, as I put it, is what happens once an inflationary conflagration of a fiat currency reaches the 'point of no return'.
Hyperinflations have several distinct stages that have been observed throughout history – in the course of the acceleration of inflation to ever higher rates of change, there always comes a certain threshold point – what I refer to as the 'point of no return'. This is the point at which the public realizes that the inflation is a deliberate policy that is set to continue, for the simple reason that the government issuing the money in question is technically bankrupt. What usually happens then is that the decline in the respective money's value begins an irreversible acceleration that stops only with the complete repudiation of the money concerned, even if the government stops printing more money, respectively prints far less than would be indicated by the acceleration in price increases.
We can actually observe this in Zimbabwe, where the government's bankruptcy has proceeded to the stage where it can not even afford the paper and ink anymore that it would need to print additional currency. Thus there is now hyperinflation (recently estimated at 500 billion percent annualized) concurrently with a deepening cash shortage.
In essence, the market has declared the government's scrip to have no value at all, and economic activity is increasingly reverting to barter. Once the 'point of no return' threshold of an inflation is crossed, one can not hope to get any more gold in exchange for the government's scrip. One may be able to exchange other goods of value or foreign currency for gold, but not the fiat money in the throes of hyperinflation. There may still be gold prices quoted in the inflating currency, but this is strictly a technicality, respectively illusion.
So why then did a slight backwardation in gold futures lead Dr. Fekete to exclaim that the irredeemable fiat dollar was about to meet with a similar fate? You may need some background on what makes gold different from industrial commodities – my brief article 'Misconceptions about Gold' posted under the nom-de-plume Trotsky at Mish's blog a while ago can be used as a primer.
The thing is, gold normally never goes into backwardation. One of the reasons why gold has been chosen as money by the free market is the fact that a large above ground supply exists – a supply so far in excess of the amount of newly mined gold added to it every year that it promises both to be stable and ample enough to successfully serve as money.
This large supply also ensures that normally, the gold futures curve will always be in contango – there can be no 'shortage' of gold similar to, say, a shortage of copper or oil. The contango in gold futures meanwhile changes largely along with changes in the Fed's administered interest rates – expressing the either falling or rising opportunity cost of holding gold relative to the government's irredeemable scrip.
Copper and oil inventories can and are, usually measured in 'days or weeks of demand'. These are commodities that are used up in industrial applications, for which the annual primary supply/demand situation is quite important and determines the size of the inventory and consequently the shape of the futures curve. There can be a shortage of copper, respectively a supply situation that is so extremely tight that a shortage seems imminent. When that happens, the copper curve will be in backwardation, often markedly so.
In light of the above, one must concede that Dr. Fekete has a point, even if he went overboard with his declaration of imminent monetary Armageddon. If we look at the going-ons in the December GC contract specifically, it elicited a large demand for physical delivery, with about 12,000 contracts (equivalent to 1,2 m. oz.) standing for delivery in spite of a temporary backwardation that makes a 'sell now, take delivery later' arbitrage profitable.
The LBMA's 3 month gold forward rate (a.k.a. 'GOFO'), also courtesy of– the only time this forward rate temporarily spiked into deep backwardation since 1990 was just prior to the announcement of the 'Washington Agreement' that limited central bank gold sales and gold lending activities; a huge short term surge in the gold price ensued. It is notable that GOFO usually tends to reach very low levels just prior to major bull moves in gold – this is only natural considering that a flattening of the forward curve is indicative of a falling opportunity cost of holding gold – click on chart for larger image.
Concurrently we observe a fairly regular increase in the gold holdings of the gold ETF GLD; recently these holdings have reached a new record high of 670 tons. Over the past several months, the gold holdings of the ETF have either remained fairly stable or have risen regardless of the gyrations of the gold price itself. This is a microcosm of sentiment among a certain – important – group of gold buyers.
These buyers represent exclusively monetary(or investment)demand, and they buy irrespective of short term price movements. Clearly, this group of buyers is very worried about the recent systemic crisis, and considers gold as an important form of insurance.
Exchanging promises for more promises
Anyone with assets to protect has probably given some thought to gold's ability to serve as a long term protector of wealth in light of recent large scale failures in the financial system.
If one has a large amount of money deposited with a bank, one has to confront the these days very real risk that the bank might go under; the bank's promise to produce one's money on demand looks a lot shakier than it once used to. One possibility is to buy government bills, notes and bonds, something that countless big investors are in fact doing lately, inter alia because no other market is more capable of digesting very large sums without a hitch. The liquidity of the government debt markets is unparalleled.
However, one simply exchanges the bank's promise to pay for the government's promise to pay – and both the bank and the government only promise to pay in yet another promise to pay, namely the Federal Reserve's, in the form of the bank notes it issues. Furthermore, here is where things become circular, lately with a twist. While the bank notes represent the central bank's liability, it normally has government debt on the asset side of its balance sheet – a promise to pay 'backed' by a promise to pay.
The 'twist' these days is that the asset side of the Fed's balance sheet increasingly consists of all sorts of garbage as a result of its countless special lending facilities, and fewer and fewer treasury bonds (the percentage of t-bonds has fallen from roughly 90% to a mere 22% of all assets held by the Fed).
As I have illustrated in this article that appeared at Mish's blog a while ago, this is a modern day update on the tally stick scheme.
The real 'backing' – the thing that ultimately stands behind all these promises – is the government's force monopoly, enforcing legal tender laws, the certainty that it will collect taxes in the form of this scrip and the fact that it accepts the scrip for payment of taxes (certainly no-one would accept irredeemable pieces of paper with ink slapped on them as 'money' in a true free market setting).
Investors have faith that the industrialized nation states will continue to be able to keep this scheme going, and that the possibility of government going bankrupt is remote – after all, there is a lot of accumulated wealth that can still be plundered, and also a reasonable expectation that in the long term, more wealth will be created (even though the process has met with a hitch for the moment, due to the bust that is now underway). This is certainly a reasonable expectation, based on historical experience.
However, this does certainly not mean that investors are completely discounting the possibility that the current monetary system itself could eventually fall into crisis. After all, what keeps it going is mainly confidence. Should confidence in the system's viability evaporate, the only form of money still acceptable would be the one that is not a mere promise to pay – the money of last resort, gold.
A simmering crisis
I would in fact argue that signs of a simmering crisis of the fiat money system are increasingly in evidence. Take for instance the wild volatility of the fiat currencies relative to each other. It is as if capital were constantly fleeing from one corner of the burning building to the other (see the charts at the bottom). Take the flight into government debt, that has taken on bubble-like characteristics. At one point last week t-bill discount rates briefly turned negative – investors were prepared to pay the treasury for the privilege of lending it money – of course, in reality they were paying the treasury for keeping their money 'safe'.
Consequently, Dr. Fekete does have a good point when he says:
'lasting backwardation in gold is tantamount to the realization that ‘gold is no longer for sale at any price’. (emphasis mine).
The important point is 'lasting' – the recent backwardation looked more like a short term aberration, a technicality basically, but was perhaps also a first warning shot regarding what may lie in store in the future.
One should keep a close eye on the gold forward curve. Should a backwardation eventually become deep and entrenched, it would be a strong signal that the financial crisis has progressed to the point where the monetary system itself becomes the center of attention.
Below a number of charts illustrating the 'simmering crisis' situation – click on charts for larger images.
Wild gyrations in the Swiss Franc. As both a 'safe haven' and former carry trade currency, it is especially prone to sudden explosive moves.
The Yen has gone ballistic – this is the highest level since the 1995 spike high.
The dollar index – from overbought to oversold within days – the recent correction looks more like a crash than a correction actually. The recent moves in currencies are not indicative of a healthy system. One should add that these moves are exacerbated by the actions of trend-chasing quant funds, most of which usually tend to end up sitting on the same side of the boat just before it capsizes.
The US treasury long bond – can you say 'buying panic'?
central bank data:
The sudden death of monetary prudence – base money is now growing at a 360% annualized rate.
A longer term view. One can see both the Y2K monetary pumping panic (which gave us the blow-off phase of the Nasdaq bubble) and the post 9/11 spike. Both spikes used to really stand out on this chart as historical aberrations. No longer.
A few more charts from the Fed highlighting the situation.
Gold holdings of GLD via– a new all time high.
Charts by StockCharts.com, Dailymarketsummary.com, Federal Banks.
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