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On Friday, December
12, backwardation on gold was still in force at an annualized discount rate
hovering around 2% in the December contract, and 0.3% in February contract. Many
readers have asked me how it is that so many other observers fail to see the
backwardation. The discrepancy is due to differences in methodology. Most
analysts calculate the basis as the difference between February and December
futures prices which gives them a positive reading. They use the December
futures price as proxy for the spot price. This is clearly wrong. The
December futures price is not the same as the spot price, even though
we are in December.
My methodology is to
calculate the basis as the difference between the asked price for the
December futures and the bid price for spot gold. The logic behind
this is that if you wanted to transfer your costs of carrying gold to the
futures market, then you would have to sell physical at the bid price
of spot gold and buy it back at the asked price of the December
futures.
The opportunity cost
of carrying physical gold is known as the carrying charge. It covers
interest, insurance, cost of storage, and all other incidental costs
including taxes and fees, if any. The carrying charge is the upper bound of
the range within which the gold basis can vary. Holders of gold would never
allow the basis to exceed the carrying charge. If it did, they would keep
selling cash gold and replace it with gold futures until their arbitrage
would eliminate excess contango.
Exactly the same
theoretical argument can be used to prove that the basis cannot go negative. And,
indeed, it never has for more than a few hours that it takes to send out a
wake-up call to alert sleeping arbitrageurs.
That is to say, the
gold basis has never gone negative -- until December 2, 2008. On that
ill-starred day gold went to backwardation for the first time ever in
history, and got stuck there. This gave rise to a controversy that is still
raging. What is the significance of this event? The majority of observers
shrugged: so what? Others, including the present writer, warned of the
extremely serious consequences threatening the international monetary system
and the world economy because of the highly corrosive nature of the
backwardation in gold.
Why is it that the
same theoretical argument is foolproof in the case of full contango, but it
is fallacious in the case of backwardation? The reason is that full contango
in gold (maximum reading on the gold basis) implies full public confidence in
fiat money; backwardation (minimum reading on the gold basis) implies the
collapse of public confidence in fiat money.
Let us put this into
context. We have had a strange and ominous phenomenon lasting well over three
decades which mainstream economists have been utterly unable (unwilling?) to
explain. When gold futures started trading in the United States in 1975, the gold
basis was close to full contango. Since that time it has shown a stubborn
falling tendency, steadily increasing its deviation from the carrying charge.
This is as if, after
a brief honeymoon in 1975, holders of physical gold started to go on strike
in ever greater numbers, refusing to take the ever increasing wage offers on
the bargaining table. They would rather go without any wages at all.
Of course, strikes
are not out of the ordinary, so the phenomenon of the vanishing gold basis
could be, and was, swept under the rug. Mainstream economists could still
lull themselves in the belief that the gold basis would never go negative. Come
to think of it, if it ever did, it would be the equivalent of employers
offering to take over from the unions the responsibility of making strike-pay
available to workers on the picket line. Now, there, such a thing would truly
be unheard-of!
Yet, surprise,
surprise, it has now happened, although not in industrial but in monetary
relations. Holders of physical gold, now on fully-fledged strike, are offered
a strike-pay by the futures market, and the offer is left on the bargaining
table, but the strikers still won't budge. There it is: the gold basis went
negative, gold has been in backwardation for over a week, and physical gold
is still not coming out of hiding.
In spite of all the
propaganda aimed at discrediting me and my theory of gold backwardation, what
we are hearing is the shrill sound of the fire-alarm indicating that the
house of the international monetary system is on fire. For many a year I have
been warning all those who cared to listen that such a fire-alarm was coming
sooner or later, and the consequences of ignoring it would be disastrous. Well,
it is sounding loud and clear now, and guess what. Fire-fighters brazenly
ignore it. Yet you can ignore it at your own peril.
What does it all
mean? Not only does it mean that the market is willing to pay all your carrying
charges involved in holding physical gold, but it is also willing to pay
you (allegedly) risk-free profits for the privilege of relieving you from
carrying the burden! "Let me take over your yoke just for a few
days; I shall pay you handsomely for the honor"
- so the clearing members of Comex plead.
It is as if the bank
was paying all your utility bills without charging it to your account. Nay,
the bank is actually offering you a bonus for you allowing it to do you the favor. Suppose, for the sake of argument,
that all the banks in the world offered all their account holders to
take over responsibility for paying their utility bills. Would it not evoke
some searching questions about the hidden agenda of the banks? Wouldn't
people become extremely suspicious of the preposterous offer? Yet here we go,
the futures market in gold, the world's residual source of cash gold, is
making the same preposterous offer, and nobody is asking questions. Timeo Danaos et dona ferentes (I fear my
enemies most when they bring me gifts, Virgil, Aeneid,
II. 49.)
I warn the world
again that the futures market would not go to backwardation in gold if the
house of paper money were not on fire. There is just no prima facie
reason for a shortage in physical gold. A very large part of all the gold
produced throughout history still exists in monetary form, sitting in vaults
doing nothing. (Under the gold standard it used to be doing heavy-duty work
in financing production and world trade.) Unlike all other commodities with
the exception of silver, for gold the stocks-to-flows ratio is a high
multiple (by contrast, the stocks-to-flows ratio of copper is a small
fraction). And, on the top of privately held gold, there is central bank gold
amounting to one quarter of all the gold ever produced since the dawn of
history. Why are central banks unwilling to take advantage of risk-free
profits by releasing gold? Could it be that, in possession of inside
information, they have reason to be afraid that the regime of irredeemable
currency may soon collapse and, with their gold gone, they don't want to be
left holding the bag? Could it be that the Babeldom
of the debt tower is already crumbling, but the fact is being covered up?
There is simply no
explanation for the backwardation in gold, absent monetary science. And since
monetary science has been exiled from the world's universities for the past
fifty years (this is what I call "Lysenkoism
-- American style", see References below), people are dumbfounded. They
don't understand the phenomenon of holders of gold passing up the opportunity
to earn risk-free profits.
Monetary science
gives a clear and unambiguous explanation. Here it is, and please remember
that you have heard it here first. We are facing a
pathology of the international monetary system based, as it is, on
irredeemable promises to pay. People are enjoined through 'legal tender'
legislation to use these irredeemable promises as if they were the ultimate
means of payment, even though they are not, and the world would rather use
gold and silver as the natural and ultimate extinguisher of debt. But gold
and silver have been coercively eliminated from monetary circulation for the
competition they offered to synthetic debt-liquidating devices. Mainstream
economics pretends that the issue has been settled for once and all. It
asserts that liquidation of debt through the coercively maintained payments
system has no threat to the national and world economy. Yet what is happening
is that the government keeps kicking the toxic garbage upstairs which keeps
accumulating unobtrusively in the attic, only to come crashing down in its
own good time to cause untold amount of social damage.
In the real world it
is natural law, rather than man-made coercive laws, that prevail. The
pathology of the regime of irredeemable currency has not been attended to,
and day of reckoning has dawned. Our pathological monetary system has allowed
the burgeoning of debt beyond all rhyme and reason. It has no mechanism to
extinguish debt. It pretends that transferring debt to the banks, and
ultimately to the government, is tantamount to extinguishing it. However, the
truth of the matter is that only gold circulation is able to extinguish debt.
When it is stopped in its tracks, as it is under conditions of backwardation,
debt explodes.
The debt tower is
toppling. Central banks work overtime printing money to plug the holes in the
leaky foundation, but their traction that they could once take for granted is
gone. The money they print goes into either gold hoarding or into government
bonds. The monetary system has short-circuited and is in the process of
burning out. Practically no money is going into the production of goods and
services. The bloated economy is contracting fast. Great Depression II is
upon us. The monetary system is past the point of repair. This is the story
that the backwardation of gold is trying to tell those of us who have ears
for hearing and brains for comprehending.
Backwardation in
gold is the sweet siren song that is trying to tempt Odysseus to his doom. But
Odysseus was smart enough to have himself tied, fist
and foot, to the mast and had the ears of his oarsmen be plugged with wax. His
ship is sailing through the dangerous waters without unloading gold.
Backwardation also
gives a signal to those who are not so fortunate as to have some of the
precious yellow in hand. It tells them to be prepared for a thunderous
collapse of the international payments system, worse than the collapse of the
twin towers of the World
Trade Center. Backwardation means
the inevitable contraction of the world economy, the beginning of an era of
diminishing enterprise and employment, an era of snowballing business
failures and poverty. Printing more irredeemable promises to pay will make
this condition worse, not better.
* * *
It can be seen that
the $80 rise in the spot price from $740 to $820 during the week that just
ended has not been able to compel holders of spot gold to exchange their
holdings for a promise to deliver gold a mere 18 days later, the bait of
'risk-free' profit notwithstanding, in spite of the unprecedented
discount on gold futures. To tell the truth, the promised profits are not
risk free. The risk is that the gold will never be returned and those who
have listened to the siren song will be left holding the bag.
Events of last week
show the heroic resistance of the bulls: they have so far refused to listen
to the sweet siren song of the clearing members. They unearthed the golden
hatchet and have not let themselves be led astray from the warpath. On
Thursday, December 11, 12,588 contracts in the December futures month (an
increase of 139 contracts from the previous day) stood in line waiting for
delivery. This is equivalent to 43% of registered gold in the warehouses! As
is known, the clearing members have till December 31 to deliver; otherwise
they have to declare "liquidation only", effectively closing the
gold window. If that happens, it would be a historical first, likely to
cause a much bigger stir than the appearance of backwardation on December 2,
which caused a yawn. The world would be shaken out of its lethargy. This
backwardation would break the grip of the regime of irredeemable currency on
the world.
The clearing members
have used the carrot to no avail. Will they now use the stick, increasing
margins on long positions to exceed the value of the underlying contract? We
don't know, but obviously they are hesitant to make a rash decision. Such a
move could easily backfire. It would betray their desperation, which could
provoke even more notices demanding delivery of physical gold.
Who is going to
blink, the good guys or the bad? It is too early to say. At any rate, even if
the good guys blink, they will be back in force in February for a showdown to
face a much-weakened opponent.
* * *
Mike (Mish) Shedlock published a
rejoinder to my There Is No Fever Like Gold Fever (see References
below). According to him I have stated that "gold is not for sale at any
price", here and now. What I have said was that if Comex declared
"liquidation only", in effect closing the gold window,
and backwardation became a permanent fixture of gold futures trading, then it
would be tantamount to "gold is not for sale at any price". Mish also puts words into my mouth suggesting that I
considered this an equivalent of the gold price shooting up to infinity, a
kind of initial salvo to mark the beginning of hyperinflation in the United States.
I have been very
careful to avoid any prognostication that backwardation in gold would trigger
backwardation or price rises in other commodities. I am not even talking
about a price rise of gold itself. The truth is that my own position on
deflation in the United
States is, and has been, very close to
that of Mish. Backwardation in gold has nothing to
do with the opening salvo for hyperinflation. "Gold is not for sale at
any price" is not the same thing as a runaway gold price. Rather, it is
an indication that it has dawned on people how foolish it is to accept
irredeemable promises to pay in exchange for gold, the ultimate means of
payment.
What Mish seems to be missing is that it is not unthinkable
that gold futures trading stops altogether for want of deliverable material,
while the price of oil, grains, and other highly marketable commodities keep
falling along with the rate of interest -- symptoms of deflation. This is
precisely the problem that need to be researched,
but no university or government think-tank is doing it.
Mish says that the United States is not Zimbabwe. Who
said it was? However, the United States
dollar and the Zimbabwe
dollar are no different in principle, if not yet in practice. They are both
an irredeemable currency. Managers of the U.S. dollar are just making the
first tentative steps to join the managers of the Zimbabwe dollar in Dante's Inferno.
The eighth of the nine circles in Hell is reserved for perpetrators of fraud
and false pretenses, among others, the managers of
irredeemable currencies. As Dante describes it, their punishment is to be
kept submerged in a cesspit full of excrement. Honestly, they don't deserve
to be washed clean by Mish or anybody else.
Rumors that there may be a
failure of delivery in the December contract turned out to be surprisingly
accurate. Mish is premature in doubting that such a
failure is in the cards. Backwardation-deniers must not jump the gun. A
titanic struggle is taking place right now, out of earshot and out of sight: the
bull fight at Comex. In this bull ring it is not always the toreador who
kills the bull. Sometimes the bull kills the toreador. The fight takes place
on weekdays from 8.15 a.m.
to 3 p.m. EST. While it is not carried on TV, it is carried by the wire
services. The last fight is scheduled on December 31 -- unless the toreador
resigns beforehand and the bulls win by default.
Mish says that actually he hopes
that there will be a failure of delivery in December gold. Be careful what
you wish for, you may just get it! Especially if you have not made a study of
what backwardation of a monetary commodity means, because you don't know what
you are wishing for. It is no picnic. It is more like a monetary earthquake
measuring ten on the Greenspan scale. Hyperinflation is not the only hell on
earth! Hyper-deflation ushered in by backwardation in gold could well be
worse.
* * *
I have received the
following letter from a reader.
Mr Fekete:
I always read your
articles as part of an effort to educate myself about the gold market. Thanks
for sharing your expertise and I look forward to your future articles.
In your most recent
articles you harp on Mr Sprott for no longer
supporting your University.
I don't know Mr. Sprott personally but I have to say he has every right to
support or not support whatever endeavours he choses.
Your constant
negative referral to him diminishes your credibility, imo.
Give it a break!
Kevin Southwest
I have sent this
answer:
Dear Mr. Southwest:
Thank you for your
kind words. I am delighted that you have found my writings of some value.
You are right in
saying that Mr. Sprott can do with his money as he
pleases. What you don't know is that I have not approached Mr. Sprott asking for money; he has approached me offering
it. Under these circumstances I thought I could expect the courtesy of an
advance notice of his decision to terminate the arrangement. Instead, he just
cut me off and ignored my repeated inquiries. When I insisted on an answer,
he sent me a letter with the insulting remark that "results do not
justify the expense". For your information, the grand total of his
"expense" was $22,500 Canadian.
I am sorry that you
find my repeated reference to this humiliating incidence annoying. Please
allow me to be the judge whether my procedure diminishes my credibility or
not. After all, nobody is forcing you to read someone with impaired
credibility.
Yours, etc.
Here is another
letter:
Hi Antal,
This letter is to
thank you for and congratulate you on your priceless contributions to the
education of your fellow men.
I have said this to
you before, but now I repeat it: Your lasting legacy to history will be
your work on the 'basis'. I am sure that a hundred years from now you
will be quoted favourably by authors of financial articles and books. You
have become a truly great financial intellectual power.
Constructive
criticism: I do understand your disappointment at the cancelling of financial
support for Gold
Standard University
Live by Eric Sprott. I am sure this was a business
decision. If so, it was a bad one. Time will prove this.
But you are much too
big and important of a person to let it drag you down. Get over it! Let it
go! Move on! We all have great respect for you. Your written sideways slaps
at Eric's bad decision do not hurt him but rather diminish you.
Give him credit for
the assistance he did provide. Rise above the hurt feeling slipping into your
writings.
I do hope you
understand that this is sent to you by a friend who intends only the best for
you.
Regards,
Frank
I have answered this
letter as follows:
Dear Frank,
Thank you for your
kind words and encouragement. I can assure you that Eric's decision in no way
drags me down. Nor have I ever had any intention of hurting him.
Every week my
readership is increasing by hundreds of newcomers seeking knowledge which
they could not get from any other source. I have the right to inform them
about the reasons why Gold
Standard University
Live had to fold tent.
I have never doubted
that you have but the best intentions towards me.
Your friend, Antal
References:
Tainted Research: Lysenkoism
-- American Style, June 4, 2003
Monetary versus Non-monetary Commodities, April 25, 2006
The Last Contango in Washington,
June 30, 2006
Red Alert: Gold Backwardation!!! December 4, 2008
Has the Curtain Fallen on the Last Contango in Washington? December 8, 2008
There Is No Fever Like Gold Fever, December 10, 2008
These and other articles of
the author can be accessed at the website www.professorfekete.com.
The Nonsense about Gold Backwardation, etc.,
by Mike (Mish) Shedlock,
December 7, 2008, www.globaleconomicanalysis.blogspot.com.
No Fever Like Gold Fever: Response, by Mike (Mish) Shedlock (ibid.)
Acknowledgement:
The author wishes to express his thanks to
Mr. Sandeep Jaitly of Soditic Ltd., London, England, (e-mail: Sandeep.Jaitly@soditic.co.uk) for tracking
the gold basis for him.
Calendar of events:
Szombathely, Martineum Academy, Hungary, March 28-29, 2009
Encore Session of Gold
Standard University
Live.
Topics: When Will the
Gold Standard Be Released from Quarantine?
The Vaporization of the Derivatives
Tower
Labor and the Unfolding Great Depression
Is There Life after Backwardation?
San Francisco School of
Economics, June-August, 2009
Money and Banking, a ten-week course based on the work of Professor
Fekete. TheSyllabus of this course is can be seen
on the website: www.professorfekete.com.
Antal E. Fekete
Professor, Intermountain Institute of Science and Applied Mathematics,
Missoula, MT 59806, U.S.A.
Gold
Standard University
aefekete@hotmail.com
DISCLAIMER AND CONFLICTS
DISCLAIMER
AND CONFLICTS
THE PUBLICATION OF THIS LETTER IS FOR YOUR INFORMATION AND AMUSEMENT ONLY.
THE AUTHOR IS NOT SOLICITING ANY ACTION BASED UPON IT, NOR IS HE SUGGESTING
THAT IT REPRESENTS, UNDER ANY CIRCUMSTANCES, A RECOMMENDATION TO BUY OR SELL
ANY SECURITY. THE CONTENT OF THIS LETTER IS DERIVED FROM INFORMATION AND
SOURCES BELIEVED TO BE RELIABLE, BUT THE AUTHOR MAKES NO REPRESENTATION THAT
IT IS COMPLETE OR ERROR-FREE, AND IT SHOULD NOT BE RELIED UPON AS SUCH. IT IS
TO BE TAKEN AS THE AUTHORS OPINION AS SHAPED BY HIS EXPERIENCE, RATHER THAN A
STATEMENT OF FACTS. THE AUTHOR MAY HAVE INVESTMENT POSITIONS, LONG OR SHORT,
IN ANY SECURITIES MENTIONED, WHICH MAY BE CHANGED AT ANY TIME FOR ANY REASON.
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