Trying to Make Sense of the Gold Market

Notice how the interviewer gets "contango" and "backwardation" mixed up.  Freudian slip?  Well, at least Bloomberg allowed a bullish gold trader to be interviewed, even if her line of questioning was slanted on trying to elicit bearish responses.

Even the title infers the "experts" are confused on why gold and silver are rising.

http://www.bloomberg.com/video/trying-to-make-sense-of-the-gold-market-2WL2EiG7T62eesbObxnmRg.html

"For example, in our office we tried to buy physical gold when it got down right around $1200 - $1250.  It's been eight weeks; we still haven't received our order of physical gold.  I think what that means is there's a huge run on physical right now.  You're seeing the prices now rally; you're seeing people want to be involved with the physical."

Gold futures hiccup indicates demand outpacing supply

Mainstream financial media outlet Reuters is going rogue, touting the shortage of physical gold.  lol

http://www.reuters.com/article/2013/07/19/derivatives-gold-idUSL1N0FP1CB20130719

Turk - Something Shocking Has Occurred In The Gold Market

I tweeted this back in June 3, 2013:

Anybody else notice 10-year Treasury yields have climbed from 1.7 to 2.1%? Um, that's not supposed to happen with QE. Fed losing control?
— Gregory Nguyen (@dakyne) June 4, 2013

Since then, 10-year Treasury yields have reached as high as 2.74%. 

http://kingworldnews.com/kingworldnews/KWN_DailyWeb/Entries/2013/7/8_Turk_-_Something_Shocking_Has_Occurred_In_The_Gold_Market.html

Yet the Fed continues to purchase more government debt, as its balance sheet last week reaching another new record high with total assets of $3.49 trillion.  The Fed is not tightening monetary policy, so why are interest rates rising even though the economy is weak and the Fed continues to purchase debt for its QE program?

I think there is only one logical answer, Eric:  Interest rates are rising because of QE.  We have reached a tipping point, meaning that QE can no longer keep interest rates from rising.  The market is now focusing on the dark-side of QE, which is the inflationary consequences of all this money printing.

Rising interest rates with QE ongoing means that we have reached the stage where the Fed has now lost control.  This result was inevitable because market forces always beat central planners and its groupies in the end.  Only the timing of this event could not be predicted.

Since the bailout of the financial system in the autumn of 2008, and the launch of QE in March 2009, desperate central planners had been hoping their crazy theories which try to create wealth by printing money would work.  But those theories never had a chance.  All one had to do was read monetary history to see that these schemes have always failed.

The key point is that the market is now responding to this central planning foolishness.  Capital is protecting itself by demanding higher interest rates, and as interest rates climb, the fallout will be immense.  This brings me to the second key event taking place:  Even the LBMA website now shows that gold is in backwardation.  The gold forward rate out to three months is negative.

Turk - The LBMA Is Moving To Cover Up Silver Manipulation

Readers need to differentiate between a contango and backwardation in silver futures prices to better understand this article by James Turk.  It applies to the gold market and crude oil occasionally as well.  Use the search function in this blog--I've entered a few entries on this topic.  To help you, here's the link.  http://gregnguyen.blogspot.com/search?q=backwardation

http://kingworldnews.com/kingworldnews/KWN_DailyWeb/Entries/2012/11/27_Turk_-_The_LBMA_Is_Moving_To_Cover_Up_Silver_Manipulation.html

Perfect Storm Sees Gold & Silver Surge – Chavez Gold Action Leads To Backwardation, Short Squeeze And ‘Havoc’ Concerns

Long-time readers of this blog know the concepts of backwardation, contango, a short squeeze, physical delivery vs. cash settlement, paper futures contracts vs. physical bullion, and the ramifications of a default at the COMEX (and at the LBMA).  For those late to the game, listen up.

And don't listen to the foolish Dennis Gartman, despite his huge following from CNBC.  He's been trying to trade in and out of this decade-long gold bull market for the last few years, frequently calling a wrong-headed "top".  His followers would have made more money if they just bought gold and sat on their holdings.

http://www.zerohedge.com/news/perfect-storm-sees-gold-silver-surge-%E2%80%93-chavez-gold-action-leads-backwardation-short-squeeze-and

Contango in gold vs. backwardation in silver

I've written several blogs on why backwardation indicates physical spot shortage and is bullish for a commodity, so readers can do a search for "backwardation" to find the previous blogs.  Also, previous blogs may have described the contango in oil markets, and how speculators were taking delivery of barrels of crude oil, and storing them in supertankers in order to take advantage of higher prices on later delivery months.  That strategy only made sense if the contango was wide enough to justify the inventory costs (as well as opportunity cost).

But since a picture is worth a thousand words, here are a couple charts on the contango in gold and backwardation in silver.  A contango is normal because it's plausible that futures prices are higher than the spot price, as markets discount in the cost of owning inventory, namely storage, insurance, and security.

By contrast, backwardation indicates an immediate physical shortage, as sellers scramble to find inventory to deliver to buyers, and are forced to bid up prices once they do find supply.  My ad hoc surveys and visits to coin dealers and the US Mint in Denver confirms the tightness in the physical silver market.

Click on images to enlarge.  Credit goes to sharelynx.com for the charts.

Gold in backwardation--again

I noticed gold went into backwardation against late Friday, signalling another run up in price in Asian trading this morning (it's Sunday night in the US right now). I've written several blogs on backwardation (please do a search for details), and what it infers. In normally functioning commodities markets, a contango exists where the spot price is lower than forward contracts, to account for storage, insurance, and security costs. This is normal in assets like crude oil or precious metals.

But when there is a physical shortage, and when buyers of forward delivery contracts demand physical delivery, in lieu of cash settlement, sellers have to scramble to find said inventory. This causes prices on the physical market to be bid up, which signals price bullishness.

Sure enough, gold and silver prices are trading up in Asian markets this morning. The huge short positions by the bullion banks will either cause a sharp pullback, or they are about to be stampeded by the long speculative funds and central bank gold buyers.

Gold backwardation--again

I was scanning the Bloomberg TV ticker tape after hours on Friday, when most traders in the US had gone home. Trading was resuming in Asia (their Saturday morning), and gold had gone into backwardation by at least $2, indicating a severe shortage in physical gold.

Here are a couple explanations on backwardation from previous blogs:

http://gregnguyen.blogspot.com/2009/01/contango-why-this-dance-is-important.html

http://gregnguyen.blogspot.com/2009/05/gold-in-backwardation-again.html

I'm not sure if the correct interpretation of backwardation means gold longs are starting to win the battle. It's probably more correct to surmise that shorts are losing the battle.

Disclosure: I am long physical gold and silver, and long gold and silver mining shares.

Contango--why this dance is important

Contango is the recent buzzword in trader's vernacular. It's basically the difference between the higher-priced futures contract and the lower-priced spot price of a commodity--like crude oil, for instance. It has recently made headlines due to the plummeting price of oil, causing the spread--or contango--to widen. Hence, big oil companies and financial institutions are taking advantage of that spread, taking immediate delivery of oil at the much lower price, and storing it for sale and future delivery at the higher price (less storage, security, and insurance costs). In doing so, they've basically locked in a guaranteed profit via the contango trade. Fundamentally, a contango exists in normal market conditions, but it's been in the news lately due to its uncommonly wide spread.

But contango's antithesis--backwardation--has quietly made some news in the precious metals market (I glossed over it last month). In a contango, the spot price is lower than the forward futures contract. However, with backwardation, the opposite is true: the spot delivery price is HIGHER than the forward futures contract. How can that be? After all, doesn't taking immediately delivery incur additional inventory costs (as described above)? To answer that, let's perform a quick anatomy on the gold market, and compare it to crude oil.

On December 2, 2008, for the first time in the history of mankind, gold reached backwardation. Gold is predominantly not a consumable asset, but is stored mostly in vaults at central banks, commercial money centers, private banks, etc. Hence, it is almost always in contango. On that date, COMEX spot prices for gold were higher than December gold futures, for December 31 delivery. Backwardation exists because of perceived scarcity, which causes investors to pay a premium for guaranteed delivery. In other words, buyers insist on delivery, instead of cash settlements. By contrast, a contango exists when there is perceived oversupply, which is normally bearish when you consider demand/supply dynamics. For instance, prior to oil's meteoric peak at $147 a barrel, a contango formed, precursing the huge decline to its present levels in the $40's.


Gold, on the other hand, is not consumable, so has been in contango into perpetuity. That is, until December 2nd. Gold's backwardation is the inverse of crude oil's 2008 contango, and subsequent precipitous decline--all you'd have to do is turn the chart upside down. Therefore, backwardation--especially for gold, as it has never occurred before--has the opposite effect—and is extremely bullish for gold. In fact, crude oil had its own backwardation in 2007, foretelling its parabolic run up in price into the summer of 2008. Backwardation reflects scarcity at current price levels, and is an indicator that gold will continue its secular bull market.

Who is shorting gold?

Regarding the gold shorts, I've read JP Morgan, HSBC, and Goldman Sachs were shorting gold futures, artificially driving the price down, while at the same time hoarding the physical bullion on the spot market at a lower price. Ironically, JPMorgan Chase and Citigroup analysts are forecasting $2000/oz gold. Looks like manipulation, especially when you factor in a ten-fold increase in short positions. Someone on the inside knew what was going on with Fed easing and tightening.

I'm not sure if it was just big money centers--I think some of the commercial shorts were mining companies themselves. If they short it and the price plummets, they've locked in a profit as the short contracts increase in value when gold declines in price. That's why gold producers use it as a hedge in the case of falling gold prices. If they sell short the futures contracts, and prices rise against them, they are forced to cover at a higher price, but then their gold inventory also increases in value, negating the loss from short sale. In other words, they profit either way--as long as they have the gold in inventory. Without said inventory, they are "naked" and must realize the losses within 5 days--or until they deliver the physical product.

If indeed manipulation is going on, it is not only illegal, it will not be sustainable. Eventually, the Fed won't be able to save the shorts, as physical bullion becomes even scarcer, and buyers insist on delivery, instead of some "shadow" paper delivery against some vault. Gold experienced backwardation for the first time ever in December--the spot price was higher than the forward contracts. In other words, buyers wanted delivery NOW--and would not sell at ANY price, as fear has gripped the markets. Under normal conditions, a contango exists, where forward contracts command higher prices. I think this backwardation is very bullish for gold, and the fact that mints are out of inventory is indicative of that.

Also, I've read statistics where central banks, especially in Europe, are no longer selling their gold inventory. If the Chinese government steps up and purchases tons of gold like they have threatened (their ratios are much lower than the US's and Europe's), that will absorb inventory and drive prices higher also. And India is already the world's largest buyer of gold, up to 20%. With the Pakistan thing going on, I can't imagine them wanting more rupees, instead of gold, which has become the de facto currency.

Bottom line: MV = GDP, and as long as the Fed provides easy credit (interest rates can't get much lower than 0%), and as long as the Treasury prints trillions of dollars, the money supply M will be poised to catalyze inflation. But once the velocity V of capital flows thru the economy, it will provide the stimulus our economy needs, but potentially kicking off hyperinflation. In other words, once bank balance sheets have been restored, they will start lending again. We would have avoided another Great Depression, but God helps us when we get runaway inflation a la the 70's. Having an extra $8 trillion floating around in our economy will prove inflationary, and interest rates will soar. Treasury bondholders with longer maturities will get crushed, as the Fed can only influence short-term maturities (T bills). With higher interest rates, the government won't be able to pay off its huge debt obligations, and we'll have stagnant growth for years. We are experiencing a credit crisis because investment and commercial banks are insolvent. When the markets realize the US government is also insolvent, all hell will break loose. The government has compounded a multi-billion-dollar debt crisis into a multi-trillion debt crisis.

I hope I'm wrong in this logic chain, but this playbook has been repeated many times before when fiat currencies are under attack by central banks. I just don't see any other outcome when your debt is almost as large as the size of your economy.