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Red Alert: Gold Backwardation! Lease rates falsified to hide gold backwardation

IMG Auteur
Published : July 27th, 2010
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Category : Gold University





Did I get your attention with the title? Good! It's a great headline, isn't it? Well, stick with me for a minute and I'll try to live up to my seemingly feigned hype.

And for you noobs that weren't attracted like moths to a freeway headlight by this title, you can get up to speed
here, here and here.

First, let me ask you a question. Which of these two scenarios should be more instrumental in the transition to Freegold?

1.) A bottom-up shift in value perception as millions and even billions of small savers use their meager dollars all at once to bid up the price of gold.

2.) A top-down shift in risk perception as the very few physical gold holders of size in the world all at once withdraw their physical from the marketplace.

Just think about this question. That is its only purpose. And one more; Would either of these events be exclusive of the other?

One other item I would like to touch on before I get started is the distinction between loaning or leasing your gold to someone else versus putting your gold up as collateral for a fiat loan that you need, sometimes called a "swap".

In the former case you are handing over your gold to someone else in exchange for an income stream (the lease rate) as well as the promise that your gold will be returned at a predetermined time in the future. In the latter, you are handing over your gold to someone else in exchange for a lump sum of money, usually close to the full value of your gold, as well as the promise that you can buy your gold back for that same amount of money plus a fee (interest rate) at a predetermined time in the future.

In the former case, when leasing out your gold, you are generally said to be "deploying a 'dead' asset in pursuit of a yield." While in the latter case, putting up your gold asset as collateral for a loan, you are likely trying to keep other creditors at bay, paying them off with cash from this new loan rather than letting them take your gold. And, depending on who your new creditor is, you may be said to be "protecting your gold asset" from those other creditors who had intended to take it away for good.

I wanted to clarify this distinction because I read one article where the analyst seemed to view these two acts as one and the same, and in so doing, in my opinion, drew the wrong conclusion about the recent BIS gold swap.

The Gold Backwardation Story

Do any of you check the GOFO rate from time to time just to see if it is getting close to zero? GOFO is a relatively good proxy for the gold contango because it represents the cost basis a dealer calculates to take either side of a 'gold for currency swap' over a fixed length of time. It is also a good proxy for liquidity in the gold market. It should never turn negative because that would mean it costs more to borrow gold than to borrow dollars. (GOFO = $ interest rate - gold lease interest rate) In other words, if GOFO goes negative, the message is that gold is more precious than dollars.

As long as the GOFO rate is positive, the borrowing of dollars will cost you more "elbow grease" (debt service) than borrowing gold. So it can be said that there is a bid from gold for dollars as long as the GOFO is positive! When it turns negative, it can be said there is NO bid from gold for dollars.

Dollar forward mechanism – LBMA

I check the GOFO rate every few days, but more for amusement than analysis lately as it has been rising!

(A side note: Last week when I clicked my
GOFO bookmark that I have been using for years, for the first time ever it asked me to log in, which apparently costs "an application fee of £1,000 (which is not refundable if the application is rejected for whatever reason) and an annual levy of £2,500." I'm sure this was just a normal LBMA site improvement though, because they put the new URL for free GOFO data in the small print down at the bottom. And they also improved the actual GOFO data by reducing the font size to tiny, compressing the columns, and reducing the contrast to light-gray on white background making it much easier on these tired old eyes.)

LBMA "website improvements" - Click image to view actual size

Looking at the 3 month GOFO rate for the calendar years of 2005, 2006 and 2007 (
here) we see a steady gradual rise at an average annual clip of 34%, with a maximum of 79% in 2005 and a minimum of 1% in 2007. Yet so far this year we have a 221% rise from Jan. 29 through July 23 alone.

That 221% rate change in 6 months is pretty high volatility for this normally stable metric except in the remote instances of impending doom. But surprisingly, the rapid rate change this year has been in the direction of "nothing to see here, folks."

So here is the basic story of gold backwardation. On September 29, 1999 gold went into backwardation for the first time in modern history. The cause is commonly cited as the
Washington Agreement on Gold that happened three days earlier in Washington, DC. This backwardation manifested itself in three common metrics. First, the price of gold shot up.

Second, the gold lease rate spiked. And third, the GOFO rate went negative in all five durations, from 1 month to 12 months.

What is important here is both the meaning of these anomalies and the message they send to the marketplace. The GOFO rate is basically a measure of unencumbered physical gold's desire to bid for dollars. And the lease rate is the banks' bid to borrow your gold so they can sell it and then do whatever it is that banks do with your money.

So the message of a high lease rate is "lease us your gold, PLEASE, and we'll pay you handsomely for it." Remember, a lease is where you "rent out" an asset to derive an income stream. And a swap (like GOFO) is where you need a loan, so you offer an asset as collateral and then YOU pay the income stream to someone else. Only with a negative GOFO rate, you retain control of the gold PLUS you receive the income stream coming in, so why would anyone LEASE their gold in this backwardation scenario?

For that matter, why would you even SWAP your gold in this scenario? Unless, perhaps, you were desperate for dollars and you were swapping your gold with someone you knew for a fact would hold it safe for you and do nothing else with it. Like a "rich uncle" perhaps?

I know this is complicated, but just take a look at the lease rate and GOFO charts from Sept. 29, 1999:

The point to take home here is that the spikes in these charts DO represent potentially imminent collapse of the dollar, but they are not the cause of the potential collapse, they are the system's response to it. In a way, these charts are to a collapse like a thermometer is to the temperature. Or like a body's immune response is to a bug.

They don't show the actual backwardation, they show the "immune system" response to it.

These images ARE what backwardation looks like. But in a strange way backwardation is kind of like AIDS to the fiat money system. Once it's in there, you can't get it out. And you can't actually see the HIV virus. All you can see are the antibodies that attack it. That's how you know it's in there, eating away at the system.

A few years after the Sept. 29, 1999 backwardation event the following conversation was revealed and can be found on many gold websites:

"In front of 3 witnesses, Bank of England Governor Eddie George spoke to Nicholas J. Morrell (CEO of Lonmin Plc) after the Washington Agreement gold price explosion in Sept/Oct 1999. Mr. George said "We looked into the abyss if the gold price rose further. A further rise would have taken down one or several trading houses, which might have taken down all the rest in their wake.

Therefore at any price, at any cost, the central banks had to quell the gold price, manage it. It was very difficult to get the gold price under control but we have now succeeded. The US Fed was very active in getting the gold price down. So was the U.K."


Jump forward nine years to 2008. On Thursday, November 20, in the middle of the unfolding global financial crisis, the 1 and 2 month GOFO rates suddenly turned negative. By November 25 they were back to positive again. The lease rate also spiked as you can see in the chart above.

Four years earlier, in 2004, Antal E. Fekete had written a paper in which he explained what backwardation in the gold market actually means. Very simply, gold backwardation signals the permanent end of the current system and the beginning of dollar hyperinflation [FOFOA: and the beginning of Freegold?]. Here is his 2004 paper:

What Gold And Silver Analysts Overlook, May 1, 2004

...As it is not set up to satisfy demand for delivery on 100 percent of the open interest, the gold futures market will default. Exchange officials will declare a “liquidation only” policy to offset long positions in gold. At that point all offers to sell cash gold will be withdrawn. Gold is not for sale at any price. The shorts are absolved of their failure to deliver on their gold futures contracts.

...Previous descriptions of hyperinflation purporting to explain the descent of a currency into the abyss of worthlessness do so in terms of the quantity theory of money. My explanation of the hyperinflation that is staring us in the face is very different. I dismiss the quantity theory of money as a linear model that is not applicable.

...Moreover, previous episodes of hyperinflation affected isolated countries which had embraced the regime of irredeemable currency out of desperation, while the rest of the world stayed the course of monetary rectitude. In the present situation the entire world has been inflicted with irredeemable currency.

...My description of hyperinflation is not in terms of the quantity theory of money, but in terms of a model where the relentlessly declining gold basis leads to backwardation destroying the gold futures market.

The dollar and other irredeemable currencies will go the way of the assignat...

Backwardation in gold should therefore be considered the self-destroying mechanism for the regime of irredeemable currency that “only one man in a million may identify and understand” (my thanks to Keynes for the felicitous phrase). This is where supply/demand analysis is utterly useless. The huge stocks of monetary gold are still in existence, yet zero supply confronts infinite demand.

Fekete followed this paper up with several more in 2006 and 2007 on the subjects of the gold basis and backwardation:

The Rise And Fall Of The Gold Basis, June 23, 2006
Monetary Versus Non-Monetary Commodities, June 25, 2006
The Last Contango In Washington, June 30, 2006
Gold, Interest, Basis, Mar. 7, 2007
Gold Vanishing Into Private Hoards, May 31, 2007

Over the years he became well known as possibly the only person in the world ringing this particular warning bell. Then, on Dec. 5, 2008, Fekete published
(Yes, that's where I got the title.)

But Fekete wasn't watching the "reactive" GOFO and Lease rates, he was carefully analyzing the gold basis, looking at specific trading prices in the spot and gold futures markets. And on Dec. 5 he announced the beginning of gold backwardation as of Dec. 2.

Fekete not only believed that when backwardation finally turns permanent it will end the fiat dollar, but he also boldly proclaimed that the gold basis was the foolproof metric! That it could not be falsified!

When contango gives way to backwardation in all contract spreads, never again to return, it is a foolproof indication that no deliverable monetary [metal] exists. People with inside information have snapped it up in anticipation of an imminent monetary crisis.

What he meant was that the gold basis, the difference between the price of cash gold and contract futures of different maturities, could not be manipulated! And he not only proclaimed this loud and clear, but he also put his money where his mouth was, developing an investment fund that would profit from tracking the gold basis.

At this point, in late November/early December '08, everyone and his brother was on "backwardation watch". Backwardation quickly became associated with the expected COMEX default. (
COMEX Default & Backwardation?) Fekete's articles were prolific, and everyone was eating them up, myself included. Remember this site? Vaporize COMEX countDOWN « Meltdown It was started on Nov. 29, 2008 and later abandoned.

Fekete followed that Dec. 5 piece with several more on the subject, and "backwardation watch" continued in earnest for at least the next quarter:

There Is No Fever Like Gold Fever, Dec. 10, 2008
Backwardation That Shook The World, Dec. 14, 2008
Backward Thinking On Backwardation, Dec. 18, 2008
Forward Thinking On Backwardation, Dec. 21, 2008
The Vanishing Of The Gold Basis and its implications for the international monetary system, June 23, 2009
More Dress Rehearsal For The Last Contango, Aug. 25, 2009

To this day I believe that Fekete was absolutely correct that backwardation is THE existential threat to the system that he said it was. Where he went wrong was in his assertion that the gold basis was the only metric that could not be rigged. He has since admitted as much.

The Gold Basis Is Dead -- Long Live The Gold Basis!, Oct. 17, 2009

A year ago I conducted a Seminar on the gold basis and backwardation in Canberra, Australia. I suggested to my audience that the gold basis (premium in the nearby futures on spot gold, with negative basis meaning backwardation) was a “pristine indicator that, unlike the gold price, cannot be manipulated or falsified by the banks or by the government. Thus it is a true measure of the perennial vanishing of spot gold from the market, never to return, at least not as long as the present fiat money system endures.”

That was then. Today we are one year older and that much more experienced. We now know that the banks and the government have in the meantime found a way or two to manipulate the gold basis as well. Next month I have another Seminar coming up in Canberra. I shall address the problem of gold basis, giving a full account of what we know about the efforts of the powers that be in trying to falsify this most important indicator, the guiding star of refugees who have entrusted their fate to a golden dinghy on a stormy sea. To the government, the gold basis is like the naughty child who blurts out unpleasant truths. He must be gagged and silenced at all hazards. Fool’s gold basis is even more important than fool’s gold in terms of the number of people victimized.

Goldman Sachs

I would now like to draw your attention to this March 25, 2009 research paper put out by Goldman Sachs:
Forecasting Gold as a Commodity

The inventory-demand curve is quite stable and downward sloping, with less inventories of gold being held on the COMEX as gold lease rates increase. Following the onset of the current financial crisis in the second half of 2007, however, the gold lease rate began to climb to a much higher level than would have been expected, given the level of physical gold inventories...

The link between the current financial crisis and the increased demand for physical gold inventory can be seen explicitly by looking at the correlation between gold lease rates in the recent period and the TED spread or the difference in (one-year) interest rates between LIBOR and the US Treasury...

As the degree of counter-party risk increases, so too does the demand for physical gold… the gold lease rates are well explained by the TED-spread and the level of COMEX registered gold inventories.

...COMEX inventories and nominal interest rates drive the shape of the gold forward curve, specifically the price spread between near- and long-dated contracts. High inventory levels place downward pressure on near-dated prices relative to long-dated prices, as the market anticipates inventories returning to more normal levels over time.

...The gold lease rate is the interest that must be paid (in our case in US dollars) to lease, or borrow, physical gold for a specified period of time. Consequently, this can be viewed as the explicit cost of borrowing gold to hold for a period of time or the opportunity cost of holding one’s own gold and not lending it out to another.

Clearly, someone at Goldman Sachs was studying the gold basis, the related lease rates and the relationship of these metrics to the dwindling COMEX inventories in late 2008/early 2009. And, of course, why does Goldman Sachs study any market metric? I know you know the answer to this question.

Goldman Sachs studies market metrics to figure out HOW TO RIG THEM! Then they publish a paper about how their findings would work in a normal free market, and then they laugh all the way to the bank. Oh wait, they are the bank. So I guess they just spin in their chairs laughing, huh?

Lease Rates and COMEX Inventories

It is a curious observation that published gold lease rates have been decidedly negative ever since Goldman Sachs released that paper, isn't it?

And as Izabella Kaminska at observes, "negative [lease] rates should suggest some pretty hefty Comex gold stocks," even by the logic in Goldman's own paper. But oh, so mysteriously, COMEX "registered gold" has diverged during this same timeframe from the overall picture painted by negative lease rates.

She also points out that COMEX registered stock hit a significant multi-year low in Dec. 2009 and then "magically" recovered. And I'll add that the GOFO rate hit very close to zero a month later and then also "magically" recovered.

Dollars Bidding for Gold? Or Gold Bidding for Dollars?

When you think about the message that the lease rate sends, it is directly tied to the liquidity the dollar desperately needs. On Sept. 29, 1999 the message was "lease us your gold, PLEASE, and we'll pay you handsomely for it." Today the message is "we don't need to borrow your gold, and if you insist on lending it to us, it'll cost you."

Now, if I am a liquidity creator for the dying $IMFS - a bullion bank - how do I create dollar liquidity? I take a piece of unencumbered physical gold (owned or borrowed) and I fractionalize it. I sell it off to the extent that the probability of a delivery demand is lower than my physical reserves. And in the process, I am creating DEMAND FOR DOLLARS because my "golden tickets" are bidding on dollars. Remember what ANOTHER said...

Date: Fri Jan 23 1998 19:01

All modern digital currencies do not go into an investment, they move THRU it... There is an alternative. Gold! It is the only medium that currencies do not "move thru". It is the only Money that cannot be valued by currencies. It is gold that denominates currency. It is to say "gold moves thru paper currencies".

This is the key to EVERYTHING!!! It is not "gold liquidity" that the bullion banks create... it is DOLLAR LIQUIDITY. Dollars bidding on MSFT stock set the value of that stock. If dollars are frantically bidding on MSFT (high velocity), the stock skyrockets. If dollars stop bidding for MSFT all at once (low velocity), the price falls to zero. This is true for everything in the world except gold.

Gold bids for dollars. If gold stops bidding for dollars (low gold velocity), the price (in gold) of a dollar falls to zero. This is backwardation!

Fekete says backwardation is when "zero [gold] supply confronts infinite [dollar] demand." I am saying it is when "infinite supply of dollars confronts zero demand from real, physical gold... in the necessary VOLUME." So what's the difference? Viewed this way, can anyone show me how we are not there right now? And I'm not talking about your local gold dealer bidding on your $1,200 with his gold coin. I'm talking about Giant hoards of unencumbered physical gold the dollar NEEDS bids from.

Think about it. You can't make it cold in July by simply rigging the thermometer.

And in my - purely speculative - analysis, "the BIS gold swap" CONFIRMS this view!

What the bullion banks do is they take a piece of gold and they inflate it 1,000% and sometimes up to 10,000% so it appears to be a SUPER BID for dollars. And they prefer to do this by LEASING gold (borrowing your gold) rather than buying it outright. It's a lot cheaper that way.

But right now the signal going out to the marketplace is "we don't need to borrow your gold, and if you insist on us borrowing it from you, it'll cost you." It is a completely bogus signal, and has been for more than a year now!

And just as with all bogus signals that the government, the Fed and Goldman Sachs create, the response is the same. The marketplace withdraws from games with bogus signals. Volume dries up, and Goldman Sachs ends up playing against itself to create the show. Just like price controls create shortages... SAME EXACT CONCEPT.

So Goldman Sachs (the $IMFS) has rigged the GOFO as a big F-YOU to Antal Fekete.. but it shot itself in the foot in the process.

Just like unemployment isn't really 9%, I think it is possible that gold is actually in permanent backwardation at this very moment and may have been for a while now. You can't change the temperature by simply rigging the thermometer. But you can't know the exact temperature either.

The dollar NEEDS voluntary bids from private physical gold to survive. My guess is that pool of REAL bids of size is bone dry and cracking. And "dollar liquidity" is just a cheap façade at this point. This is why the dollar NEEDS a rising gold price. As the price (for selling, not borrowing gold) rises, weak little bits of gold here and there will bid for dollars.

Of course that won't be enough (dollar demand from gold) to float the dollar for long. Gold must EXPLODE to reach equilibrium. And the knock-on effects of that explosion will kill the ability to run perpetual deficits, which will kill the value of all outstanding dollar debt, and on and on and on. It's all connected.

I don't view gold backwardation as only its simple metric signals that can be falsified. I view it as the terminal disease behind the metrics that has been present in the system and periodically erupting since 1999. I don't need a working thermometer to notice that it's hot outside and I don't need an accurate blood test to see that the patient is already dead.




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