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.