Speculators vs. Arbitrageurs
The price of gold rose six bucks, and the price of silver rose 26 cents last week. Before we look at the graphs, we want to address a reader question. This week, someone asked about how we calculate the Monetary Metals fundamental gold price.
The theoretical fundamental gold price (black line) vs. the market price for gold since late 2015. Worth noting: most of the time, the fundamental price is leading the market price; whenever the gap between the two prices was very large in the past, the market price would more often than not catch up with the fundamental price. Recent exceptions to this rule of thumb occurred in mid and late 2016, when market prices first rose and then fell and the fundamental price followed their lead, and again this year, when a big surge in the fundamental price failed to lead to a rally in market prices (however, on this occasion the fundamental price corrected quite sharply before an accelerated decline in market prices took hold). Since early July, the gap between these two prices has gradually widened again and has become quite sizable. It remains to be seen whether the fundamental price will work as a leading indicator this time. As noted above, in the long term it tends to lead in most cases. [PT]
This is the output of our model, estimating where the metal would be trading if not for speculators who can push the price around, using extreme leverage in the futures markets.
While the formula must remain a trade secret (and we may upgrade it in the next version of our data science platform), we are happy to discuss the theory. Every week, we show a graph of the gold basis as our picture of the fundamentals. What does this mean, and how is basis showing the fundamental situation?
The basis is the spread between the spot and futures price. It measured as the actionable trade - i.e., future (bid) - spot (ask), which is the profit that a bank or hedge fund could make. And it is expressed as an annualized percentage, so it is comparable to the interest rate or yield on other assets for the same duration.
This shows the fundamentals for a compelling, but counter-intuitive exercise in reasoning. Arbitrage connects the price of an ounce in the futures market with the price of an ounce in the spot market. They track very closely, and the difference between them - i.e., the basis - is usually small and pretty stable.
If we see the basis rising, we know that arbitrageurs are putting on more carry trades. Carry means buying physical gold at spot, selling it forward, and warehousing it in the meantime. The higher the basis, the more profitable it is to engage in this carry trade.
We don't know how many carry trades are on, but we do know that if the marginal arbitrageur walked away yesterday when the basis was, say, 0.5%, then he may take it today if the basis is 0.6%. A rising basis indicates metal is moving into warehouses. A rising basis means that the marginal demand for metal is to carry it in the warehouse.
While there could be continued momentum, this is generally not a bullish sign. The basis is rising despite this arbitrage. We say "despite" because this arbitrage compresses the basis spread. If it is rising, it shows that speculators are buying faster than arbitrageurs are adding to their carry trades.
The former are bidding up the futures price, while the arbitrageurs are pulling the spot price up behind it. This metal will come out of the warehouses and back into the market at some point.
Alternatively, if the price of gold is rising and the basis is falling, then we can be sure that fewer carry trades (if any) are being put on. The rising price is driven by buyers of spot gold. If the warehouse-men are active, they may be selling spot and buying futures, i.e., closing out their carry trades.
Our model watches the action from all angles in order to calculate a neutral price. This is the price at which spot is not pulled up or pushed down by this arbitrage activity. It is not perfect; the calculation is in part art and in part science.
And of course, the market is always changing to boot. There are times when we can see a price move counter to the fundamentals, and in due course the price reverses back to where it was. It is often tempting to say "we told you so!"
But lest we put on our hubris t-shirts, there are other times when the market price moves and the fundamentals later catch up (or down) to market prices. It could be that the speculators were right and knew what was to come. Or it could be that holders of physical metal reacted to the change in prices by buying or selling.
We will look at the supply and demand fundamentals of both metals. But, first, here is the chart of the prices of gold and silver.
Next, this is a graph of the gold price measured in silver, otherwise known as the gold to silver ratio (see here for an explanation of bid and offer prices for the ratio). It turned and fell last week.
Here is the gold graph showing gold basis, co-basis and the price of the dollar in terms of gold.
Not a big move in price, but the dollar is down (i.e., the price of gold, measured in rubber-band dollars is up) while the scarcity of gold is rising (i.e., the co-basis, the red line). At least it does in the December contract. The continuous gold basis chart shows a falling co-basis.
Last week the Monetary Metals Gold Fundamental Price fell from $1,373 to $1,358.
Now let's look at silver.
In silver, the price rose by a greater percentage, and the co-basis is falling even for the December contract. As Obi-Wan might say, this is not the signal you're looking for.
Nevertheless, the Monetary Metals Silver Fundamental Price did rise by 13 cents to $15.94. Let us see if it holds around the $16 level.
© 2018 Monetary Metals
Charts by: Monetary Metals
Chart and image captions by PT