The Enormous Significance Of Gold Backwardation

On the November 20, 21, and 24, gold went into backwardation:;=gofo/2008gofo
Gold Forward Offered Rates
Date 1 Month 2 Months 3 Months 6 Months 12 Months
17-Nov-08 0.04500 0.13333 0.18571 0.75714 1.11857
18-Nov-08 0.03400 0.12000 0.18333 0.72143 1.01571
19-Nov-08 0.08286 0.01571 0.06333 0.51429 0.90000
-0.08000 -0.04500 0.05000 0.46333 0.89167
-0.11667 -0.07429 0.05000 0.44000 0.86857
-0.03667 0.03857 0.10143 0.47000 0.93000
25-Nov-08 0.24000 0.26667 0.31667 0.55000 1.00286
26-Nov-08 0.24000 0.26667 0.35000 0.54167 0.96500
27-Nov-08 0.23833 0.23857 0.27429 0.50429 0.95714

When the numbers go negative gold in the forward offered rates, gold is in backwardation (ie: it's cheaper to buy future rather than spot gold). If you check the link, the numbers have been tumbling all year. This reflects the fact that buyers are willing to pay more for immediate delivery rather than future delivery.

The Enormous Significance Of Gold Backwardation

In 2004, Antal E. Fekete from Financial Sense reported about what gold and silver analysts overlook. Here are some key extracts that highlight the enormous significance of gold being in backwardation.

Translation of Key Terms
gold basis = prices in terms of gold.
monetary metals = precious metals (gold, silver, etc)
irredeemable currencies = fiat/paper currency (not backed by gold)
contango = condition whereby more distant futures prices are at a premium over the nearby.
backwardation = condition whereby more distant futures prices trade at a discount to the nearby.
monetary rectitude = gold standard
zero supply = no one willing to sell (their gold)
infinite demand = everyone desperate to buy (gold)

(emphasis mine)

Abnormal Backwardation

It appears to be a theoretical impossibility for the gold and silver market to be in backwardation for any extended period of time. Such a situation would guarantee unlimited and riskless profits for all those holding gold and silver. They could replace their cash holdings with futures at a lower price. When their futures contract matured, they could take delivery and repeat the procedure. The mere possibility of unlimited and riskless profits suggests that there is an error in the calculation. And indeed, there is. The profits are not riskless. As the ancient adage says: “A bird in hand is worth a dozen in the bush”. When cash gold or silver is replaced with futures, a risk is created, namely, the risk that it may not be possible to convert the futures contracts back into cash gold or silver at maturity. There is the risk of default in the futures markets. Of course, exchange officials, bullion bankers, and government watchdog agencies vehemently deny the existence of such a risk. But the fact remains that under the regime of irredeemable currency it is possible to corner a monetary metal. It is true that cornering a monetary metal goes by another name: that of hyperinflation.

Recall that the normal condition of the markets in the monetary metals is that of contango. Backwardation is abnormal, yet it may occur. When it does, the regime of irredeemable currency will start to crumble. People in trying to save their financial future will take flight to the monetary metals. They will scramble to mop up the dwindling supply that is allowed to trickle down. Then all of a sudden all offers to sell the monetary metals are withdrawn. Supply goes to zero, facing an infinite demand. That such a development is not fanciful but a true description of economic reality as it unfolds is confirmed by history. Supply of the monetary metals went to zero and demand to infinity many times before, in France (the assignat and mandat inflations), in the United States (the continental inflation), in Germany (the Reichsmark inflation), to mention but a few of the notable cases.

Self-Destruction of Irredeemable Currency
As the regime of irredeemable currency threatens to crumble under the weight of the inordinate debt tower of Babel, people increasingly take flight to gold. Supplies will get tight and the gold basis will fall. The gold futures market may even go to backwardation briefly at the triple-witching hour, i.e., the hour when gold futures, as well as call and put options on them expire together. Later, flirtation with backwardation may occur even more often, at the end of every month when gold futures expire. Gold will get caught up in a storm.

Backwardation in gold has a perverse effect. In the case of agricultural commodities backwardation provides a most powerful incentive for traders to sell the cash commodity and buy the futures. Not so in the case of gold. Rather than bringing out deliverable supplies of gold, backwardation tends to remove them. The more the gold basis falls the less likely it becomes that owners will exchange their cash gold for futures. Please remember that you have seen it here first. This perversion of the gold basis constitutes the self-destroying mechanism of the regime of irredeemable currency. The longs tend to take delivery on their gold futures contracts in ever greater numbers, and refuse to recycle cash gold into futures, regardless how low the gold basis may go. As it is not set up to satisfy demand for delivery on 100 percent of the open interest, the gold futures market will default. Exchange officials will declare a “liquidation only” policy to offset long positions in gold. At that point all offers to sell cash gold will be withdrawn. Gold is not for sale at any price. The shorts are absolved of their failure to deliver on their gold futures contracts.

Previous descriptions of hyperinflation purporting to explain the descent of a currency into the abyss of worthlessness do so in terms of the quantity theory of money. My explanation of the hyperinflation that is staring us in the face is very different. I dismiss the quantity theory of money as a linear model that is not applicable. Every previous episode of hyperinflation took place in the context of a war replete with shortages caused by the destruction of stockpiles and productive facilities. In this situation it is not possible to sort out the effects of an increasing demand (due to a flood of printing-press money) and a decreasing supply (due to the destruction of stockpiles and production facilities). We want to show that prices may also explode in the presence of unsold stockpiles and ongoing production.

Moreover, previous episodes of hyperinflation affected isolated countries which had embraced the regime of irredeemable currency out of desperation, while the rest of the world stayed the course of monetary rectitude. In the present situation the entire world has been inflicted with irredeemable currency. There are no gold standard countries around that could lend a helping hand to countries that want to stabilize their currency. My description of hyperinflation is not in terms of the quantity theory of money, but in terms of a model where the relentlessly declining gold basis leads to backwardation destroying the gold futures market. When all offers to sell cash gold are withdrawn, producers of essential commodities such as grains and crude oil refuse payments in dollars, and demand gold in exchange for their product. The dollar and other irredeemable currencies will go the way of the assignat.

Backwardation in gold should therefore be considered the self-destroying mechanism for the regime of irredeemable currency that “only one man in a million may identify and understand” (my thanks to Keynes for the felicitous phrase). This is where supply/demand analysis is utterly useless. The huge stocks of monetary gold are still in existence, yet zero supply confronts infinite demand.

The only way to fend off this outcome is for the government of the U.S. to come up with a credible plan to stabilize the dollar in terms of gold. Presently there is no hint that contingency plans for the rehabilitation of the gold standard exist. It doesn' t matter. Any country, e.g., China, India, Iran, could do it through the back door by opening the Mint to the free and unlimited coinage of gold and silver. The alternative may be mass starvation in the midst of plenty as world trade comes to a halt for want of a universally acceptable medium of exchange

My reaction: Although a little tough to read through and understand, this is a brilliant analysis, especially considering this was written in 2004. Here is a quick recap of what is said in the extracts above.

warning signs of hyperinflationary currency collapse are:

1) Prices drop (deflation) in terms of gold
2) Open interest declines in futures market (due to loss of trust)
3) Backwardation occurs in gold futures (due to fears of default)
4) Physical gold supply gets tight

(All these warning signs have now taken place.)

What happens next is:

1) Backwardation and calls for delivery destroy the gold futures market.
2) Gold goes to infinity and dollar to zero.
3) Sellers of goods (food, oil etc) start demanding gold as payment.
4) Gold becomes the new reserve currency due to lack of alternatives (I have also been predicting this)

Other Interesting Ideas suggested by Antal E. Fekete

1) This hyperinflationary collapse will be different from all other periods of hyperinflation, because this time the entire world is using fiat currencies. With no one on the gold standard, no currency is safe, and all paper currencies will hyperinflate together (although at different rates).
3) Without either the dollar or gold to act as an "universally acceptable medium of exchange" worldwide trade will halt and the world will starve.
2) To prevent this, countries like China, India, Iran, will produce an enormous amount of gold bullion to function as medium for international trade after the dollar's collapse.

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0 Responses to The Enormous Significance Of Gold Backwardation

  1. Frederick says:

    I too have the sense that this gold basis and contango/backwardation thing is enormously significant. Antal Fekete, has freed himself to do or at least call for "forbidden research". Stuff that the Fed, sponsor of much graduate school research, would rather not see discussed. And Fekete is on to some important ideas. I too have marked up many of his writings as you did: Annotated Antal.

    A couple of things:

    The data you cite in red are GOFO (Gold Forward Offered Rates) values.

    According to the LBMA web site, GOFO stands for Gold Forward Offered Rate(s). These are rates at which contributors are prepared to lend gold on a swap against US dollars. Quotes are made for 1-, 2-, 3-, 6- and 12-month periods.
    The contributors are the Market Making Members of the LBMA.

    This statement is VERY COY about who the "contributors" doing this lending are!!

    According to Cliff Küle, these ‘contributors’ are the central banks!!! "The central banks loan gold bullion to the bullion banks typically at a rate called the GOFO (Gold Forward) rate." This would be the ultra-low rate that enables the bullion banks to exploit the gold carry trade. If this is correct, GOFO is not anything like the interest rates implied by using spot price and the price of a futures contract you or I can buy through our broker.

    Contango seems to be defined as a situation where Spot price is higher that at least one near forward price or more specifically where futures prices are lower in each succeeding delivery month. Backwardation is essentially the opposite.

    It is not clear to me that it is more than an approximation to equate Backwardation with the negative GOFO numbers you displayed in red.

    It appears that the spot and future price defining backwardation are real, retail numbers meaningful to a gold miner producer or a 'commercial' gold consumer.

    GOFO on the other hand is buried deep within the paper money banking system and is very much a central banker policy-driven thing that can change by decision, without any market action.

    I think Antal Fekete is something of a brave genius. However, there is evidence that He defines basis as (NearFuture - Spot) while nearly everybody else defines it as (Spot - NearFuture). This makes it extremely difficult to understand even simple noun phrases like "rising contango".

    More here.

  2. Dave says:

    I love all your hyperlinks to the innards of the monetary/financial system. Keep it up!

    As for worldwide trade coming to a halt in the aftermath of a fiat currency collapse ... well, it seems that worldwide trade is coming to a halt because of mistrust, in advance of a currency collapse! Global shipping is down over 90% in the past few months. Goods are sitting on ships, ready to go, but the owners are reluctant to send them on their way for fear of getting paid.

    If this shipping boycott continues, I imagine it won't be long before food shortages start cropping up.

    I'm sure that the sellers of these goods and food would happily accept gold as payment right now. So some of the consequences you postulate following a hyperinflationary currency collapse might occur before the currency actually collapses!

    These are bizarre times, indeed.


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