You may have heard the term backwardation discussed in the gold market recently. We’ve posted a number of articles on this topic in the past few years ourselves with the likes of:
This phenomenon was covered in depth at a 2009 conference in Canberra with Professor Antal Fekete and Sandeep Jaitly, which we attended.
But in the past few weeks we’ve seen this term pop up a lot more, even getting mentions in the likes of the Financial Times and on Reuters in the past weeks. First up a bit of a warning. This topic takes some getting your head around and you may need to read some parts of this a couple of times.
That said, now so what exactly does backwardation in the gold market mean?
First a Definition of Backwardation
According to Sandeep Jaitly and Professor Fekete, gold backwardation is when the bid (highest price a buyer or bidder is willing to pay) in the spot market is greater than the ask (price that a seller is willing to accept) in the futures market. Or more simply, though not quite so correctly, when the price in the spot market is greater than the price in the futures market.
Why Shouldn’t This Happen in the Gold Market?
Gold has massive above ground stocks. Unlike many commodities where shortages can occur due to weather events etc and backwardation can be relatively common, gold while classed as rare is actually very plentiful in terms of how much there is above ground versus what is used up.
So there should not be a shortage of gold as such. When the price in the spot market is greater than the price in the futures market this should be arbitraged away. That is, it is logical for a large futures player to sell their gold in the spot market and buy back the nearest futures contract at a cheaper price. Thereby they’d pocket a “risk free” profit. Of course the only proviso is that this is as long as there is gold available for delivery via the futures market in a month. So the argument is then if this “risk free profit” is not being arbitraged away that there is a lack of trust in the futures market i.e. they are not sure the supply will be there and so don’t want to give up their metal.
So What Does Backwardation Mean?
From what we can see it depends on who you ask or listen to. The likes of Ned Naylor Leyland (see this link for the latest article from Ned and an interview with him) and Sandeep Jaitly believe it is very significant but definitions vary widely. Ned agrees with Sandeep that it can simply be when the price in the spot market is greater than the nearest futures contract.
Whereas the likes of “Trader” Dan Norcini (who is often featured on Jim Sinclairs JSmineset) has a different definition:
“…backwardation is a structure or condition of the futures market that occurs when the price of the nearby contract is trading above the more distant month contracts. It is a signal of a tightness in supply at current demand levels…
…It (BACKWARDATION) that that the commodity is in a serious short supply which is not able to keep up with current demand levels. What the futures board then does is to move into backwardation to entice sellers to part with the metal RIGHT THEN AND NOW instead of holding onto it later in hopes of a better price in the future.
That is done by pushing the price higher ( in the nearby months) ABOVE The back months and taking away the incentive to hold or store the particular commodity.”
So his definition is rather a measure of the price in the near futures months against more distant future months. He goes on to say:
“BASIS is an entirely different matter. Some are claiming that because the SPOT MARKET CASH PRICE of gold may be, at some times, higher than the nearby futures contract, that the market is in backwardation. AGAIN, It IS NOT.
What a strong basis means, ( when the cash market price is above the futures market price ) is that demand for that commodity, be it gold or soybeans or wheat or whatever, is STRONGER THAN AVAILABLE SUPPLY at THAT PARTICULAR LOCATION.”
The basis is what the likes of Sandeep Jaitly, Professor Antal Fekete and more recently Keith Weiner measure and to what Ned Naylor-Leyland has been referring to as being in backwardation.
So we run into the difficulty of differing interpretations. Sandeep Jaitly and co are however referring to this backwardation as being a warning sign.
From Dan Norcini comments above even though he doesn’t think a “strong basis” as he puts it should be referred to as backwardation he still comments that this means:
“that demand for… gold…, is STRONGER THAN AVAILABLE SUPPLY at THAT PARTICULAR LOCATION.”
He then goes on to discuss how the cash price for gold in India is often times higher than what it is elsewhere in the world (due to high demand) and how this doesn’t mean gold is in backwardation.
However the way we see it, in this case that location would be the COMEX futures market (where the basis is measured), which while it is not the whole world is a pretty big market! So to us while it might not mean the end of the dollar standard is here and now, it would seem to still be an indicator of something not altogether normal.
The Perth Mint’s Bron Suchecki (who has a personal blog with a lot of great content on it) has a similar definition to Norcini. He comments:
“There is a lot of confusion about the definition of backwardation. Here is a quote from the Dummies series of books:
“When a market is experiencing backwardation, the contracts for future months are decreasing in value relative to the current and most recent months. The spot price is thus greater than the front month, which is greater than future delivery months.”
Note their use of plural – “contracts” and “futures months” – as these other links also do, from the first page of a google search on “definition backwardation”:
Wikipedia – “The resulting futures or forward curve would typically be downward sloping (i.e. “inverted”), since contracts for further dates would typically trade at even lower prices.”
McClellan Oscillator – “Backwardation means that forward contracts are priced lower than nearer term contracts, or spot”
Investopedia – “Backwardation is the same as inverted when futures prices are lower than spot prices.”
This is what I understand by backwardation when one uses that word in a general sense about a futures market. Having said that, I think it is valid to talk of a specific month being “in backwardation” even if that is not exactly a precise use of the term. What I have a problem with is describing what we are currently seeing in gold as a general backwardation and playing this up as a sign of the failure of the fractional reserve bullion banking system. It is not.”
Could it be an Indicator of a Further Breakdown in Trust Though?
Bron was also at the conference in 2009 we mentioned above with Professor Fekete and Sandeep Jaitly and we recall he actually gave a talk on what he foresaw as the degrees of breakdown of trust in the system. Luckily for us he also wrote a short post on this so we don’t have to dig out our notes from four years ago!
We start to see increasing investment in gold reflected by increasing balances in COMEX or ETFs or GoldMoney etc, but the majority of people still hold fiat and stocks/shares. In respect of gold, people have no problem with storing their metal in “the system”.
We start to see occassional backwardation which comes and goes and it usually only between cash and shorter futures/maturities – 1 to 2 months. This backwardation is arbitraged away by longs who still have belief in the system(s) so are willing to take the risk to make a profit. Gold is still held in the system but growth in reported balances is slowing.
We see more backwardation periods, prolonged and now not just shorter maturities but maybe 3 month going to small backwardation. It demonstrates less interest by longs to take the risk. Possibly start to see reported balances of ETFs and less reputable custodians starting to stablise even though gold price still rising, which would puzzle ignorant commentators. A physical squeeze is developing.
Now backwardation persists, it is a permanent state in shorter maturities, increasing to longer maturities. Reported ETF balances are declining. A clear signal not all is well. Gold is being pulled and stored outside the system. The strong hands are in the majority, the squeeze is really on.
I’d say we are just starting in the 2nd Phase.”
Bron wrote that 3 years ago. From our understanding of Sandeep Jaitly’s measure the basis has been in backwardation out to 3 months as of late. (i.e. the futures price 3 months out has been higher than the spot price). Also this current “backwardation” is also more “prolonged” than past episodes such as in 2008/2009. So by Brons definitions perhaps we are edging into the 3rd phase of distrust?
For Further Confusion – Let’s Add GOFO to the Mix
From what we’ve also read recently the term backwardation has also (somewhat confusingly) been used in reference to the GOFO rate or Gold Forward Offered Rate. James Turk of GoldMoney refers to it thus in a recent article.
However the Gold Forward Offered Rate set by the Market Making Members of the London Bullion Market Association (LBMA) is not the same as a futures price (agreed between a buyer and a seller on the New York COMEX market), although it could be argued that similar factors may influence them.
“GOFO stands for Gold Forward Offered Rate. These are rates at which contributors are prepared to lend gold on a swap against US dollars. Quotes are made for 1-, 2-, 3-, 6- and 12-month periods.”
“To show derived gold lease rates, the GOFO means are subtracted from the corresponding values of the LIBOR (London Interbank Offered Rates) US dollar means.”
So GOFO is used to determine gold leasing rates by subtracting the GOFO rates from the rate of interest on cash (LIBOR).
The GOFO rate is not the price to lease gold but rather the price to swap gold for dollars.
Adrian Ash at BullionVault gave a pretty good explanation of the (confusing!) difference between a gold lease and a gold swap in a recent email:
“…in gold leasing there is a lender and a borrower of metal. And as you’d expect, the borrower pays the lender a rate of interest. It’s always positive to the lender. And because it’s an unsecured loan, that rate of interest depends on the borrower’s credit-worthiness. Simple.
Gold swaps, on the other hand, are where the gold lender pays the borrower a rate of interest. Seriously. But again it is simple. Kinda. Because as you and all other BullionVault users know, storing physical bullion safely isn’t cost-free (even if it is very cheap). Gold owners also miss out on the interest rate which holding cash instead would provide.
So if someone wants to swap your gold for its cash value today, they must then bear those two costs (storage fees and lost interest). So they might reasonably expect you to pay them to take it away, and that’s what the big bullion banks usually do.
You can see the Gold Forward Offered Rate on the LBMA’s website. Look down to Tuesday’s figures, however, and you’ll see it went negative on gold swaps lasting as long as 6 months. The gold owner, in other words, now wants to receive a rate of interest – “ rather than paying it – “ as well as the full cash value, which will be swapped back at the end of the term. In the meantime, the owner will have earned interest on that cash (see the LBMA’s middle columns, which are only updated a week late), plus the newly positive rate of interest on the gold itself (the first set of columns, where the rates are now, umm, negative because they’re positive) to get a rising return as shown in the third set of columns (again updated a week late).”
So with that explanation (we hope!) of what a swap versus a lease is…
Why Has GOFO Gone Negative?
Ash goes on to say that:
“…with hedge funds and other speculators now “shorting” gold to profit from its price drop, demand for swaps as well as leases has leapt. These traders want to borrow gold, sell it now, and then repay it with much cheaper gold in future. The same happens in every other financial market. But shorting gold is now so popular, that large gold owners willing to help suddenly have the whip hand. Which is a rare event. “
Bron Suchecki in his post quoted earlier agrees with this theory but also comments on increased physical demand also may be playing a role:
“…my current view is that it [negative GOFO] is reflecting the shift by speculators to the short side – more shorting results in more demand to lease gold, which drives up the lease rate (thus GOFO goes down). I have read that liquidation by specs out of long positions has also restricted supply of gold to lease (as the gold has been sold to those unable or unwilling to lease their gold out) and seen comments that increased physical demand has resulted in more metal being tied up in the value chain, so that results in more demand for leasing (or inventory to hedge).
So I think there is a case to say that negative GOFO as more driven by tightness in the gold leasing market. Note that shortage in the borrowing and lending market does not have to coincide with a shortage in the buying and selling market. Holders of gold may be willing to sell it (so price is low), but at the same time those continuing holding it (or the new people buying it) may not willing to lend it (so lease rate is high).
This is why it is logical for Dan Norcini to say that the structure of the futures market is not exhibiting “a true supply shortage” while at the same time we have negative GOFO and some futures contracts below spot.
So this development in leasing is probably what has driven GOFO negative, which, as Keith Weiner notes in this post, is then synced/transmitted to the futures markets by arbitrage (and has a very compelling combined chart of GOFO and the basis to prove his point). Therefore I think we are currently seeing is more a liquidity squeeze on the bullion banks, rather than a full blown distrust in them by holders of unallocated or shortages of physical (a price squeeze).”
We have read and heard interviews with others who reckon the negative GOFO rate is chiefly a sign of high demand for physical gold and that this is backed up by falling COMEX inventories (this topic is also one with many varied opinions. Another article topic we might look to comment more on soon too.).
Whoevers theory is right it seems that an increase in demand is the cause.
It may just be an increase in demand to lease or swap gold in order to short it. i.e. some players want to swap dollars for gold now in order to be able to short gold on the expectation of buying it back in the future at a cheaper price.
So this means a high level of shorting would be going on. (This theory is backed up by the high short positions shown in the COMEX futures market in recent weeks, which can often be a good indicator of a bottom in price.) So even if negative GOFO is more just an indicator of high demand for leased gold in order to then short gold, this could still be why negative GOFO has in the past (1999 and 2008) occurred around a bottom in the gold price. Therefore we still think it is an important factor to take note of.
Conclusion – Who to Believe?
So with various definitions who to believe? It could be argued most of the writers we have referenced above have their own “barrow to push”. Perth Mint and Bullionvault are both involved in the LBMA and it could be argued it’s in their interests to see the status quo maintained. It’s also interesting that Bullionvault are now partially owned by the World Gold Council and Augmentum an investment arm of the Rothschild family. http://en.wikipedia.org/wiki/BullionVault
And we have noticed that Bullionvault commentaries are more “conservative” than the likes of GoldMoney’s James Turk and Alistair Macleod.
The likes of Sandeep Jaitly sells a paid service tracking the gold and silver basis so you could argue it’s in his interest to generate some discussion of backwardation in the gold market. Of course we ourselves sell gold and silver bullion and so it’s in our interests if you buy some and we’re happy to be upfront about that. So bear that in mind when you read our conclusions too!
Also bear in mind when reading our conclusions, we aren’t involved in directly trading via COMEX or London. We don’t have a treasury handling futures hedging as most bullion refiners would do. So what we write is not based upon our current experience in the futures market but upon what we have read. (And boy have we read a lot on this topic recently!)
So with those caveats out of the way…
What do we reckon?
The bottom line, as always, is listen to all but make up your own mind. Our opinion is that we believe backwardation and negative GOFO are indicators of changes occurring in the gold market. It may not mean the end of the US dollar and global fiat money standard is here tomorrow, next week or even next year. But when it comes to insurance it is better to be years early than a day late. It is also important to note that a negative GOFO has coincided with major bottoms in the past such as in 1999 and 2008.
As Bron commented at the end of his post, while he doesn’t think the current negative GOFO and backwardation is as significant as some he still finishes off by saying:
“Don’t be complacent however. What I’m talking about above [a real gold bank run} is the end of the line and things can unravel quickly – a liquidity squeeze can turn into a price squeeze – so keep your gold close or stored with non-banks, like the Perth Mint, who don’t engage in fractional reserve and maturity transformation activities.”
Indeed. Make sure you have the real physical stuff and you know (and control) where it’s kept.
What do you think about GOFO and gold backwardation? Or are you just horribly confused? Show us you’re alive and leave a comment or a question below.