In the last few months, gold (NYSEARCA:GLD) and silver (NYSEARCA:SLV) prices have declined significantly and the mining shares have taken a beating with it. Sentiment in the mining industry has dropped to a record low. But there is a silver lining here because I see tightness in the precious metals market coming. There are several indicators of a tight gold market right now and I want to show you this in the following analysis.
First, I should remind you that gold lease rates have started to rise again after several years. Especially, the 1 month gold lease rate which has gone positive recently (Chart 1). This is a positive for gold.
As you know, gold lease rate = LIBOR - GOFO. So at this moment GOFO is going down much more than LIBOR is going down. Let's look at those charts (Chart 2 and Chart 3).
Since February 2013, the GOFO dropped precipitously from 0.34% to 0.24%. If this continues to go down, we could even see negative GOFO rates and that means gold is in backwardation. Each time this happens it means there is tightness in the gold market and gold will move higher.
Some definitions first: GOFO, the Gold Forward Offered Rate, is the interest paid if we lend gold and borrow US$ for the same period. LIBOR is the London Inter Bank Offered Rate, the interest on an unsecured US$ loan, and GLR, the Gold Lease Rate, is the interest on an unsecured gold loan.
So why is the gold market tight? If people want their physical gold back in large quantities, that means bullion banks need to provide the gold. The bullion bank then swaps $US for gold. So they receive the gold to the unallocated account and then request allocation of the physical gold and then deliver it to the customer. But this swapping will drive down the GOFO and that is what we see happening in February.
As you may have recalled, I said that people want their gold back. We saw a jump in registered gold on 31 January at the COMEX and I thought that could indicate that people want to take delivery. I said that total gold inventory would drop. On Chart 4 we can see that playing out. The green dots (total gold inventory) are starting to drop as predicted.
Another indicator of a tight gold market can be seen in the CFTC report. As U.S. banks are getting out of their short positions, this could indicate that the gold market is bottoming out. On the other hand, U.S. bank short positions in the silver market are still at an all time high. The U.S. banks have difficulty to get out of their silver short position and this could indicate that a short squeeze is coming soon in the silver market, especially at these low silver prices of $30/ounce.
U.S. banks have made use of the 1 week Chinese lunar holiday to make the price drop in precious metals in a low volume market. Though, I believe that this low volume manipulation of the precious metals price will soon normalize in the following week, when Shanghai reopens their gold exchange.
To illustrate tightness in the precious metals market further, it is good to monitor the premiums for several dealers. For example, APMEX is still posting high premiums in the silver market of around 14% for 1-19 silver coins (Chart 5b) and Shanghai silver premiums are rising in February 2013 (Chart 5a).
As a final indicator, investors can look at the recent supply and demand numbers coming from the World Gold Council. They reported just recently that gold supply is declining by 1.4% in 2012 due to lower recycling. I already predicted this decline in gold supply in a previous article. On the other hand, the gold demand from central banks soared and will continue for at least 5 years. I also predicted this to happen in another article of mine.
Investors shouldn't worry about the gold price declining, this is a healthy consolidation phase we are entering in now. Of course, we hear about George Soros lightening up his gold positions, Jim Rogers starting to hedge the gold price and Dennis Gartman shorting gold, but I see that more as a contrarian indicator. In the long term, fundamentals will win the battle.
Disclosure: I am long AGQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.