The mechanics of an eventual crack-up boom continue to be put into place. Last week, Alasdair MacLeod at Goldmoney made the case from a futures market perspective. What does a crack-up boom look like numerically in the futures market? His answer: It looks like permanent backwardation across all commodities. How does this theoretically happen? His answer: Negative dollar interest rates. Here I’d like to go into how this actually works, conceptually.
First of all, let's define terms. Backwardation is when the spot price for a commodity is more expensive than for delivery of that commodity in the future. The closer to the present, the more expensive the contract. Contango is the opposite, when spot is cheaper than a futures contract and the farther out in time you go, the more expensive the contract. Contango is normal. Backwardation is abnormal, and is corrected by an increase of supply, or price increases by people playing futures arbitrage.
Why is contango normal? Because a supplier delivering a commodity in the future allows that supplier to keep his dollars in the present and earn interest on those dollars. That interest is reflected in the higher price for a futures contract the farther into the future you go. Backwardation is abnormal because it means that the demand for a commodity at a certain time is high enough to counteract interest earned on dollars held. Those with a supply would gladly sell in the present to buy that cheaper futures contract and earn the difference. If supplies are short though, backwardation persists until supplies are replenished.
Backwardation from the Commodity Side
Seasonal backwardation is normal in consumable commodities. It is always a temporary phenomenon where a premium for spot is caused by a physical shortage of a given commodity at a certain time as explained above, for example, immediately before the seasonal grain harvest. This is resolved by the harvest, because then there are present supplies for futures traders to sell while buying the futures contract and profiting on the spread, lowering present prices and raising future prices. This returns the market to contango, where it usually stays until another temporary shortage may arise for whatever reason. There is nothing troubling about this and it happens in cycles.
Backwardation from the Dollar Side
Here's where Macleod adds his critical twist. He asks, what if backwardation is coming not from the commodity side of the equation like a wheat shortage before harvest, but rather from the dollar side of the equation? In other words, not from a positive desire to hold wheat now, but from a negative desire to hold dollars into the future? These are mirror images of the same phenomenon numerically at least, but the latter is in an "evil twin financial universe" if we can call it that. Here's why.
Contango, the normal situation in commodities markets, is generally caused by the logical desire to hold dollars for as long as possible. For, say, gold delivered in 2025, the seller gets to hold on to the dollars paid for that contract for 5 years. The interest he can earn on those dollars is reflected in the premium usually demanded for later deliveries. But when we suddenly introduce negative interest rates, there is an unnatural disincentive to hold dollars for longer created by central banks trying to pump asset prices. The longer you hold dollars when rates are negative, the more money you lose. The premium turns into a discount against shorter deliveries, with the highest-priced contract being the most immediate delivery available. And voila, backwardation.
Here is the crux of it. Macleod says the following in his latest piece, and this is the paragraph I want to focus on:
If the Fed introduces negative dollar rates, then distortions of time preference will take a catastrophic turn. All financial markets will move into backwardation, reflecting negative rates imposed on dollars. Remember, the only conditions where backwardation can theoretically exist in free markets are when there is a shortage of a commodity for earlier settlement than for a later one. Yet here are backwardation conditions being imposed from the money side.
Let’s work this out step by step. We will use gold here, but it applies for any commodity, because they are all traded in dollars. Let us assume that in order to counter the next recession, the Federal Reserve pushes the fed funds rate to -4%. Let’s now make two assumptions and see what happens logically. First, let’s assume a negative yield curve between the 5Y and the fed funds rate, which is what we have now. The 5Y yield is at 1.39%, and the fed funds rate is at 2.12% currently. That’s a negative spread of 73 basis points.
So assuming the same spread, fed funds rate of -4% puts the 5Y at -4.73%. The COMEX offers gold delivery currently out to 2025, about 5 years, so if 5Y yields are –4.73% and overnight is -4%, if you are a seller of gold futures for 2025 you lose 4.73% a year multiplied by 5 for that contract. That’s a total loss of 23.65% over the 5-year period due to the negative interest rates imposed on dollars. However, if you sell a contract for delivery in one month (let's use 1M rates as a proxy for the fed funds rate) you lose only 4/12, or 0.33%. Obviously, in that case, gold for delivery in 2025 would be about 24% cheaper than gold deliverable in one month.
Can arbitrage be made over this spread to return the market to contango? Let's consider. Can a speculator make a profit buying gold deliverable in 5 years and selling gold deliverable in 1 month? No, because he's going to lose 24% on gold deliverable in 5 years with negative interest rates. He can only speculate about making money on this move if he is betting on higher interest rates down the road. There is no risk-free arbitrage here as there is with wheat once the harvest comes in and backwardation becomes contango. Plus, there is no such thing as a gold shortage because gold does not get consumed like, say, wheat does. More gold supply does not alleviate the backwardation. Only higher dollar interest rates can possibly do that.
Therefore, in a negative yield curve situation with overnight rates at -4%, everyone tries to buy gold now, raising the dollar price across deliveries and locking the market in backwardation from the dollar side - NOT the gold side. Other commodities fall in terms of gold and rise in terms of dollars. The result when enough traders realize what's going on, is the crack-up boom across the entire commodity complex as the entire commodities futures market warps into backwardation due to negative dollar interest rates.
But what if the yield curve is positive? Let’s say the fed funds rate is -4% again. The highest the spread between the 5Y and overnight rates has gone is about 300bps, so let’s assume rates on the 5Y of -1%. What happens then? That means for gold delivered in 5 years, the seller of that contract loses 5% (1% a year multiplied by 5). The seller of 1-month gold loses -4%/12, or .33%. Gold is locked in backwardation whether the yield spread is positive or negative.
What could even theoretically stop this process to put gold back in contango? The only possible answer is higher dollar interest rates across the board. How much higher? Let’s say yields on overnight rates are still -4%, and yields on the 5Y move up to 1%. What would be the highest spread between them in history, but let's stick with this. Then sellers can earn 5% on 5Y gold (1% a year), lose 0.33% selling one-month gold. That's a spread of 5.33% down the delivery line, theoretically putting 5Y gold at a 5.33% premium. Unless, of course, the price inflation rate is higher than 5.33%. In that case, a seller of 5Y gold would still lose money in real terms and the premium for 1-month gold remains. Still backwardation persists.
The only thing that can take the gold market out of backwardation from negative rates is much higher interest rates across the board with a yield spread substantially higher than the price inflation rate. If, say, rates on the 5Y were 20% like they used to be in 1980, and one-month rates at 0%, then we have a 100% gain waiting 5 years for gold, and no loss for buying it in a month. That could do it, depending on the rate of price inflation and if the loop hasn’t spun out of control by that point. Price inflation would have to be below 20% a year for the market to return to contango in that case.
The big problem is, once the futures market gets locked into backwardation from negative rates, the fear Macleod expresses is that at that point, everyone starts plowing into commodities fast and price inflation explodes, making it much harder to reverse the backwardations. The Fed will not have much time to reverse the situation once it starts, if doing so is even possible without destroying the incredibly leveraged global economy.
Negative dollar interest rates are an absolute disaster waiting to happen. If it ever does happen, once we start to see nominally negative rates in the United States, the danger of a crack-up boom becomes very real. The only cure would be to jack up dollar interest rates very quickly to rates higher than the inflation rate. This was possible in the late 1970s and early 1980s when rates actually did go to 20%. Debt was so much smaller back then. But this time, the wave of bankruptcies across corporate and sovereigns would break records.
The entire German and Swiss yield curves are already below zero. It’s not causing backwardations in commodity markets though because commodities are priced internationally and settled in dollars, the reserve currency, not euros or Swiss francs. But a systemic shock to Europe could lead the Fed to introduce negative rates in the world’s reserve currency if the European Central Bank and Swiss National Bank go there first. If that happens, duck and cover.
You can either hope this doesn’t happen and assume the Fed understands the threat of backwardation from the dollar side, and therefore won’t introduce negative rates under any circumstances. Or you can prepare for it, assuming they will.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.
Additional disclosure: I am long gold and gold stocks.