Gold In Backwardation? Not So Fast .. 22 comments
Hard Assets Investor
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The following is a revised version of an article that was published on November 27, 2008.
There was a lot of excitement among gold aficionados last week. A $34-an-ounce end-of-week rally did a lot to brighten their spirits. Monday's $28 follow-through punched spot COMEX gold above the $800/ounce mark for the first time since October 20.
Gold rallied because ... because ... well, just what was the reason?
Some among the chattering classes would have us believe the spike was foretold by gold tipping into what they dubbed "backwardation." Well, not gold per se. Rather, gold forward rates.
Backwardation? Forward rates?
Maybe a little explanation's in order.
Backwardation, as described in several Hard Assets Investor articles (see "The Battle Against Contango" for one), exists when the price of a commodity for immediate delivery is higher than its price for later delivery. For a storable commodity like gold, backwardation implies scarcity of supply. Ordinarily, COMEX gold is a carrying charge market - sometimes ascribed as a "contango" market - in which contracts for later delivery are priced higher than spot to reflect the costs of storage. Because gold isn't consumed and supply is so visible, there's usually enough metal to carry forward.
Forward rates are the interest charges levied by dealing banks for borrowing gold. These rates are calculated for various maturities on a swap basis against U.S. dollars. A brief explanation of forwards can be found in "Gold Liquidity Play A Setup?").
Normally, the forward market looks like any other yield curve, with near-term rates lower than those of longer maturities. Those rates, too, are ordinarily positive. What was noted as backwardation last week was the quotation of negative forward rates in the London dealer market for one- and two-month gold loans.
That sent the discussion boards buzzing. "Does this mean banks will pay us for borrowing gold?" asked more than one denizen.
Don't you wish.
Gold Forward Rates
Sense can be made of negative forward rates once you understand how the metal is traded in the lease market. Just as changes in supply and demand affect metal prices, so too do changes in borrowing demand and lending affect lease rates. If gold is readily available, lease rates will be low; if the supply of borrowable metal is tight, rates will rise accordingly. Remember, though, we're talking about gold in the lease market here, not the cash metal marketplace.
A negative forward rate does not automatically create a full-blown backwardation in the price of gold. The forward price of metal, reflecting its cost of carry, is determined on the basis of the spread between an available investment rate, such as LIBOR, and the gold forward rate, which yields a positive value unless LIBOR falls below the forward rate.
On November 20, for example, spot gold was fixed in the morning London round at $745.25. The one-month forward rate was quoted at -0.08%, but LIBOR was set at 1.40%, making the spread 1.48%. One-month forward gold was thus priced at $745.20, an apparent 5-cent inversion from spot. Keep in mind, though, that the forward price may not actually be realizable. There's no accounting for borrowers' commissions or fees here. And still, contango prevailed through the rest of the forward curve. The contemporaneously implied three-month forward price, for example, was $745.34.
In a gold swap or loan, spot's at one end of the transaction, the forward price at the other.
Backwardation, though, isn't the novelty that many observers claim it to be. At least in the short end of the forward curve. The forward market, in fact, inverted earlier this year as gold peaked, then began to slide. In late January, the one-month gold price implied by the forward curve spiked above three-month gold and was offered at a premium until April.
The current lease market reflects central bank stimulus at work, much like that your neighborhood bank employs when it wants to fill gaps in its asset-liability book. Have you ever seen certificates of deposit advertised with special rates by your bank? Certain maturities may be offered at high rates if the bank has a funding need in a particular time bucket. It's the same thing in the gold market, save for the fact that the bank here is advertising a cheap asset rather than a high-priced liability (from the bank's perspective, that is).
Bullion lenders are trying to encourage gold borrowing now, particularly in the short maturities. Central banks are liquefying their gold reserves to stimulate aggregate demand. Rates have gone negative at the short end because demand for gold shorting has dwindled (since gold borrowing necessarily results in the short sale of metal to raise investment funds for the borrower).
Gold Lease Market
The chart above illustrates that the gold "carry trade" has become more profitable as the financial markets melt down. The spread between LIBOR and forward rates widened by nearly 200 basis points (2%) in just one month's time at the front end of the crisis. This goes a long way to explain why gold didn't reach new highs during the crisis.
So, now what?
Well, let's see if we can take a lesson from the past. Only on two previous occasions have forward rates turned negative. One-month forward rates went negative on two days bracketing a weekend in March 2001, less than a month after gold bottomed in London around $257. At the time of the inversion, gold was fixed around $269. Not much happened pricewise by year's end, though ultimately, that was stage-setting for gold's current bull market. Previously, forward rates - at all maturities - went negative on two days in September 1999, which did presage a significant rally above the $300 level.
Not the strongest of bullish indicators this lease rate business. With that in mind, you're better off looking at other fundamental and technical signals for buying cues.
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This article has 22 comments:
almost 4 times!!!! your money , in a nondisclosed untaxable asset, in 7 years . man o man, i love loser trades like that. going to buy more now, just on the fact that articles like this are appearing......whewwww...
Read this article on Gold potentially hitting 1200 this year and 4000 to 5000 next year. These guys have been damn accurate on predicting these last two years.
www.minyanville.com/ar...
Buy Gold NOW!!!!!!!!
Gold does not go up during deflation. Inflation is dead.
Gold moving down in a deflationary environment is a historical fallacy. At best you can say, it may go down. However history suggests otherwise.
On Nov 27 07:44 AM CLH wrote:
> Gold is rallying but is still headed down because the dollar is headed
> up after this correction.
>
> Gold does not go up during deflation. Inflation is dead.
www.financialsense.com...
CLH, Still wrong, huh? Inflation dead? Shop much? Pay for health insurance, rent, electricity, water...
Obvious Novice
US stocks now sell for 5% of their prices a year ago. Even if their earnings are good.
US real estate sells below replacement cost and at half of the year ago market value.
To stay in their homes US citizens are selling what they can including gold to raise money to pay the bills.
Foreign investors have been hornswagoled into using their US dollars to buy what are now worthliss derivatives and have lost the dollars.
So, some fools are still selling gold to stay in their houses.
A bad investment is a bod investment. Let the bank have the asetts pledged.
US dollars are scarce .as hens teeth,. US asset holders are wipped out.
This beats the socks off 1932 as a.USA social disaster.
So, yes there is currently a lot of downward pressure on gold prices.
Look beyond the present.
Good luck.
BUY GOLD and SILVER, TAKE POSSESSION, and let's hope for the best!
Happy Thanksgiving, Merry Christmas, and Happy New Year to all you great Americans!
So is it time to nationalize the IRA's and all the pension plans and distribute them equally among the USA's population.? And Ruben , Summers, Greenspan, Paulson and the remaining Goldman Sachs, Citicorp alumni and surving Congressmen and women will be the new ROYALITY....or
Learn to invest better knowing Wall STREET is FABRICATING everything.
Long Stocks (24%) COP-CON. PHILLIPS, CVS-all the homeless poor will need prescriptions and health and beauty aids-, DEERE, ANDARKO, ALCOA, BTU, OWENS, FOSTER WHEELER, SHAW GROUP, FLR, because we need to invest in our energy future, XLB etf, WELLS FARGO becuz it is better capitalized than Citicrap....well their former staff is better capitalized than the bank actually.....oh yes the trucking engine company that BUFFETT BOUGHT because the trucking industry needs to survive and this company will build propane trucks with PCAR.
SURE 2009 WILL HAVE rough times....residential real estate is being pounded and alot of commercial property SALES are dead but small 8-20 unit apartment buildings are selling in CALIFORNIA. Alot of homes for sale and it is time to buy...in fact I had to wear a jacket today....but no snow and no need to heat ...it was a beautiful winter THANKSGIVING IN
southern CALIFORNIA.
THE SHOPPING CENTERS WERE DEAD TODAY AND I AM GIVING BOOZE FOR CHRISTMAS.... Wal Mart had a full parking lot and Ralph's was somewhat busy.. how is DEO for a long position?And 74% cash?
Lets research some more ALTERNATIVE ENERGY INVESTMENTS AND CUT BACK ON THE GLOOM POSITIONS. BAIL OUTS WILL WORK somewhat.....right????... Write your CONGRESS PERSON and express yourself.....
Diegojames
Northridge, California
PS we will have another earthquake before the economy collapses...
And I infer that there are also two opposing forces on gold prices:
1. Low gold forward rates putting downward pressure: Implying that there are institutions willing to lend gold and there is easy availability.
2. Historical -ve fwd rates implying a possible upmove: though I dont think this is a strong point, since there can be lots of external factors affecting gold price. In sep 99 gold didnt rally. It went from 300 to 325 in the short term (oct 99) but ended the year at 288. Secondly in Mar 01 again there was an immediate rally and infact gold moved up more when Spx moved down in those recessionary days.
Hence I dont whether to read this as a +ve or -ve for the gold prices? Though I might lean towards -ve pressure on the prices in the short term since I think the first point mentioned above is more logical.
I agree dollar weakness could imply (as it has historically) positve movement of gold prices, but when will the dollar start weakening is anybody's guess. So far all the arguments about flight to safety seem to be holding up and $ has been rising steadliy since July (see DXY index ) And infact in the short term most of the financial analysts expect this trend to continue (I am not saying they will be correct) and that makes timing an entry in gold tougher.
On Nov 26 11:29 PM User 307894 wrote:
> Pay attention to professor Lewis at minyanville.com/
>
> Read this article on Gold potentially hitting 1200 this year and
> 4000 to 5000 next year. These guys have been damn accurate on predicting
> these last two years.
>
> www.minyanville.com/ar...
>
>
> Buy Gold NOW!!!!!!!!
"The mainland is seriously considering a plan to diversify more of its massive foreign-exchange reserves into gold, a person familiar with the situation told The Standard."
...ah, yes, the old "person familar with the situation" gambit!...and this reference is in some hokey online financial Chinese version of "National Enquirer...perhaps that "person" have been the character quoted later in the article:
"It's the right time to increase the gold reserves, as the price is about US$710 to US$720 per ounce," said Wan Guoli, vice secretary general of the China Gold Association."
...gosh, a gold bug encouraging an increase in gold reserves -- who'd a thunk it?!...of course, given that the Chinese government is dumping money into the economy as a stimulus, maybe it wouldn't be very encouraging to the general populace if, at the same same time, the government looked like it was starting to hoard gold...brother!...gold bugs are such a pathetic lot!
On Nov 26 11:29 PM User 307894 wrote:
> Pay attention to professor Lewis at minyanville.com
>
> Read this article on Gold potentially hitting 1200 this year and
> 4000 to 5000 next year. These guys have been damn accurate on predicting
> these last two years.
>
> www.minyanville.com/ar...
>
>
> Buy Gold NOW!!!!!!!!
The guy is bs'ing. Think of Gold as a currency that pays interest rate (the lease rate). LIBOR is the USD interest rate, the forward gold price is 1 + (LIBOR - LEASE) * Day Count Fraction. This is Finance 101.
LIBOR - LEASE is the GOFO rate. If LIBOR > LEASE, gold forward price is higher therefore a contango. If LIBOR < LEASE, or GOFO rate is negative, the gold forward price is lower, or a backwardation.
Only 1M and 2M GOFO rates are negative therefore Feb Futures still is contango. But that doesn't last long either. On thursday 1M lease rate jumped 40 basis points while LIBOR stayed flat.
According to the LBMA’s “A Guide to the London Bullion Market”, GOFO is LIBOR minus Lease Rate. As someone who works in the precious metals business, I can tell you that you don't borrow gold at GOFO rate but at Lease Rates.
Therefore when discussing your chart titled “Gold Lease Market”, which has a red GOFO and blue LIBOR, you statement that the “chart above illustrates that the gold "carry trade" has become more profitable as the financial markets melt down” is totally incorrect. The spread between LIBOR and GOFO is the Lease Rate (ie the actual cost of borrowing gold outright). The red GOFO line is actually the “spread” or “carry trade” indicator and it has been going down, meaning it is less profitable to short gold. Therefore the decline in GOFO supports what the Professor is saying about backwardation.
Tom Sazbo, who works closely with the Professor, states in this article silveraxis.com/todayin.../ that “one of my primary and simplest “basis indicators” [is] the London gold and silver forward rates”. While he differs with the Professor about whether the market did dip into backwardation, he is supporting the contention that the contango has reduced substantially in the past few months.
On thing I will agree partly with you on is "you're better off looking at other fundamental and technical signals for buying cues". As I discuss in my blog on this topic goldchat.blogspot.com/... there is not strong correlation between GOFO and the price. However, this is not to say one should ignore GOFO, but it should be used along with other signals to understand what is going on in the gold market.