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By Antal E. Fekete
Here is an update on the backwardation in gold that started on December 2. It
continued and worsened on December 3, 4, and 5. So far this is the most
serious signal of the economic crisis: the world is rushing headlong into a
Great Depression, possibly worse than that of the 1930’s. Please
remember the following analogy: the serial devaluation of currencies starting
with that of the British pound in 1931 meant a drastic drop in the velocity
of gold circulation. This spelled a contraction in world trade that proved
catastrophic to employment and economic health in general. The gold
confiscation in America in 1933 only made things worse, in particular, it was
the direct cause of the decline in interest rates that, in its turn, was the
chief cause of the widespread destruction of capital and bankruptcies. I have
discussed this correlation elsewhere.
Right now the backwardation in gold also means another drastic drop in the
velocity of gold circulation, and it will also cause a tragic contraction in
world trade. It will also be catastrophic to employment and economic health
in general. Interest rates will continue to fall with a deleterious effect on
capital. I don’t see that confiscation of gold is in the cards this
time. It could not be enforced. People would not comply. Gold confiscation is
a trick that can only be pulled off once. A con-game won’t work for the
second time.
What I see coming is that gold will be declared ‘extralegal’ by
the U.S. government to prevent gold from becoming a world currency, by
withholding legal protection from contracts made in terms of gold. For example,
if crude oil was bought for gold and the supertanker carrying it was
hijacked, and if the U.S. Navy captured the boat from the pirates, then the
U.S. government would confiscate the oil as ‘contraband’, arguing
that it was paid for in gold. No court in the world would give relief to the
rightful owners.
I have received several inquiries how to explain the simultaneous occurrence
of gold backwardation and a further fall in the price of gold. Here is my
answer. Comex is at the verge of bankruptcy, at least as far as its gold
trading is concerned. The trouble is twofold.
First, Comex has a problem that the shorts are overextended opening
themselves to a squeeze or, ultimately, to a corner. These are attempts on
the part of gold bulls to buy up the gold certificates, instruments of
delivery against gold futures contracts. These certificates give you legal
title to the metal deposited in Comex-approved warehouses. Such a squeeze
would cripple the operation of the exchange and make Comex lose its credibility
as a viable market. When the cupboard is empty, the game is up.
Second, Comex can no longer attract sufficient quantities of gold from
investors to its warehouses which, in consequence, get more and more
depleted. Such a gold flow is the lifeblood not only of Comex, but of the
irredeemable dollar as well. There is a world of a difference between the
irredeemable dollar with the gold window of Comex open, and the irredeemable
dollar with the gold window of Comex closed. The institute of the gold futures
market is the prop keeping the global game of musical chairs of fiat money
going. The music stops when Comex closes its gold window.
But Comex will eventually have to declare “liquidation only”
policy, effectively closing its gold window. The phrase means revoking the
right of holders of contracts to demand delivery on their expiring gold
futures under certain circumstances. Clients have to accept settlement on
their contracts in cash. This has happened in the past, e.g., in silver and
palladium, although it has never happened in gold. It is not widely known
that Comex would not go bankrupt de jure if it declared “liquidation
only”. Small print in the contract makes allowance for this option in
case of force majeure. Nevertheless, Comex would be considered bankrupt de
facto in the eyes of the public if it declared “liquidation only”
on its gold futures contracts. Comex is the residual source of the
world’s only currency that is not the liability of some government,
gold.
Moreover, by implication, it would also be the end of the irredeemable dollar
as we know it. I am convinced that the managers of the irredeemable dollar
are not afraid that their prodigious dollar proliferation policy endangers
the value of the currency, Quantity Theory of Money notwithstanding. What
they are afraid of is that the gold bulls will force Comex to close its gold
window by cornering the supply of gold certificates. When that happens, it
will be not only “gold is not for sale at any price” but also
“oil is for sale only against payment in gold”.
We have to understand that what has kept up the paper dollar’s value
through thick and thin, through war and peace, and through the burgeoning
trade deficits and budget deficits since 1975, is Comex. This is the reason
why the Chinese still take the irredeemable dollar in payment for real goods
and services, and large quantities of food can still be purchased against
payment in irredeemable dollars. But once Comex is forced to close the gold
window, the dollar will lose its main prop and bearings and, with them, its
purchasing power, even if miraculously the U.S. could cut its trade and
budget deficit to zero.
The Quantity Theory of Money is no science. It is a model, a didactic tool.
It is applicable to an imaginary linear world. This world of ours, however,
is highly non-linear.
I am convinced that the clearing members of Comex are desperately trying to
avoid permanent backwardation in gold. Not only is the gold futures market
extremely profitable for them, but their bets have been backed by central
banks gold sales and leases. All the central banks have a vested interest in
maintaining the global regime of irredeemable currency. The clearing members
want to have their cake and eat it: they are the consistent short sellers who
keep the gold price from breaking out on the upside. But this makes gold
cheap causing mass withdrawals of gold from the warehouses, gold which they
want to keep in the warehouses for window-dressing purposes.
Please note that these are not naked short sales. The clearing members are
convinced of gold’s upside potential, no less than you are. Their game
plan is that, instead of gambling with their own gold, they want to gamble
with yours and mine, and with the gold of the tech-funds. They let us buy
gold futures; they let us make money occasionally. But they know that we have
to take profit from time to time because we are undercapitalized. They know
that we have to use stop loss orders to avoid bankruptcy. What is worse, our
stop loss orders are an open book to them. We are sitting ducks which they
shoot at for fun. So we have to sell.
But whether we buy or sell, we buy into strength and sell into weakness,
which is exactly the wrong way to do business. The clearing members’
advantage is that they always buy into weakness and sell into strength, as
they take the other side of the trade we have initiated. They don’t
worry about being undercapitalized, because they can change the rules of the
exchange capriciously, and they enjoy a back-wind due to central bank policy.
So far they have succeeded.
But something ominous is happening. Most recently central banks have changed
their policy. They have stopped selling and leasing gold. Their commitment to
bail out the clearing members with gold has been changed to a commitment to
bail them out with paper. This is not the same thing. Central banks have
stopped feeding the market with gold sales and leases. Here is the proof.
Take Mr. Gordon Brown, the prime minister of Britain. As the Chancellor of
the Exchequer he ordered the Bank of England to sell one half of the
nation’s gold reserve in one fell swoop. He even overruled the Governor
of the Bank who first refused. The sale took place at the average price of
$250 in 2000, a major multi-year bottom. Nice shot, Mr. Brown! The Chancellor
has earned the name of the bottom-picker of the century.
Now, as prime minister, he could order the Bag Lady of Threadneedle Street to
sell the other half. If she did, it would be a sale fetching a price three
times higher. Better still, she could buy back the gold in 30 days at a
discount. (This is the meaning of backwardation in gold.)
But look who isn’t selling on these unbeatable terms? Why, Me-too Gordy
isn’t, that’s who. He has learnt that a bird in hand is worth a
dozen in the bush. He knows that if he falls to the temptation of
‘risk-free profits’, he may never see his gold again. It would
disappear in the black hole of irredeemable currency, where the other half
did. Gordy has made himself the laughing stock of the world once as the
bottom-fisher of the century. He does not want to do it again. Who can blame
him? If he did, he could earn a second nickname: the sweetest-singing crow of
the century, and he doesn’t want that.
As you may recall, Aesop in one of his fables relates the story of the crow
perched on a tree holding one big loaf of cheese in his beak. The fox beneath
is hungry and salivating. He decided to get the cheese by hook or crook. He
knew he could not get it by brute force, but he might get it through
flattery, by massaging the bird’s vanity. The fox calls the crow his
friend. He is telling his friend that of all the singing birds he loves the
sweet singing of the crow best. Would his friend be kind enough to sing for
him?
After a bit of coaxing the crow started crowing, but the fox did not stay to
listen. He made off with the cheese as fast as his legs would take him.
Mr. Brown can print pounds galore, and even swap them for dollars. But he
cannot print gold. Neither can his colleague, Helicopter Ben. That’s
why he is willing to airdrop an unlimited amount of paper, but would not
airdrop even one grain of gold to alleviate the economic crisis of his own
making. These gentlemen still think that the present crisis is a subprime
crisis and it can be tackled by flooding the system with newly created money.
Scarcely do they see that, instead of being a real estate crisis, a stock
market crisis, or a banking crisis, this is a gold crisis. It can only be
resolved by involving gold, in particular, by remobilizing the world’s
gold reserves. The most straightforward way of doing this would be to open
the U.S. Mint to gold (more precisely, to the seigniorage-free and unlimited
coinage of gold on private account), as Sir Isaac Newton, Master of the Royal
Mint of London had done in the year 1717. Unfortunately, this option is no
longer available because the trust in the irredeemable dollar has been
fatally undermined by the backwardation in gold. No longer will people be
coaxed out of their physical gold by the promise of risk-free profits, however
large, payable in paper.
One possible explanation of the backwardation in gold is that the clearing
members of Comex, who could have prevented it from happening by allowing gold
to break out on the upside, have changed tactics and decided to step aside
and let backwardation do the job. They hoped that it would pull in gold from
the moon. The risk-free profits that backwardation promises to yield would
tempt holders to swap cash gold for paper gold.
Well, so far it is not happening. Fewer than 10,000 ounces of new gold was
registered at the warehouses during this episode of backwardation so far, not
enough to deliver on even 100 contracts. By contrast, an extra 132 December
contracts were presented for delivery by their holders.
A second possible explanation of the backwardation in gold and the decline of
the gold price to $740 on Friday, December 5, is that the clearing members in
desperation attempted to demoralize the bulls by their persistent selling of
cash gold and December futures. Hefty margin calls went out to intimidate
holders of the December contract. But the tactic seems to have backfired:
while both the cash price and the December futures price fell, the futures
price fell more. Backwardation was the result. The bulls refused to swap their
cash gold for the December futures, in spite of further decline in the basis
(making the swap more tempting still). The contest between the good guys
(longs standing for delivery) and the bad guys (the clearing members) may not
be resolved until December 31, the last day when the latter must deliver, or
declare ‘liquidation only’. Right now it looks as if the longs
are quite prepared to call the bluff. They are willing to face further
decline in the gold price to force the issue. They know full well that the
last thing the clearing members want is to declare force majeure, because
that would kill the goose laying the golden eggs for them.
Please remember that the bad guys have another secret weapon. They can raise
the margin requirement to any level higher than the value of the underlying
contract. Nasty, isn’t it? The idea is to force the longs to sell their
contracts and, in doing so, give up their right to take delivery. Such a
measure, however, would betray the utter helplessness of the clearing members.
It would be oil on the fire, triggering a world-wide rush into cash gold,
ruining other paper gold markets (including ETF’s) in the process.
A third possible outcome is that all the gold demanded will be delivered in
December, and the deterioration in the warehouses’ holdings will be
papered over in January. No matter, the battle is already shaping up for the
February confrontation when the bad guys will be in an even weaker position.
To sum up, the gold price is not the issue right now. The low gold price is a
side show trying to scare the longs out of their cash gold positions. Here
the iron rule of the commodity markets applies: you can squeeze the bears,
but you can never squeeze the bulls. The reason is that the best you can do
to shake the bulls out of their position is to tempt them with risk-free
profits to give up physical gold against future gold. That is happening right
now. But it appears that, for the first time, cash gold can no longer be
coaxed out with paper profits. After all, gold is gold, and paper is paper.
This is why this battle is so crucial: it is the first real confrontation
between physical gold and the paper dollar. Paper gold is marginalized. We
know that, in the long run, the paper dollar cannot stand up to physical
gold. However, as Keynes has warned us, in the long run we are all dead. This
time it’s different. The long run ends on December 31, 2008.
The “last contango in Washington” refers to the end of the
hegemony of the irredeemable dollar that is in no position to throw its
weight around any more. The advent of backwardation means that a writing has
appeared on the wall: “Mene tekel, upharsin”: the dollar has been
weighed and found wanting. On the last day of this year of economic and
financial surprises we shall know whether the backwardation in gold is
permanent, or whether it will become permanent only after the inauguration of
the new president, at the expiration of the next active gold futures contract
in February.
Either way, this is a contest the bad guys cannot win. They are at the end of
their rope. The low gold price means that they are left with just enough rope
to hang themselves.
References
The Last Contango in Washington, June
30, 2006
Red Alert: Gold Backwardation!!!
December 4, 2008
This and other articles of the author can be accessed at the website
www.professorfekete.com
Note: the author is writing a follow-up piece:
There’s No
Fever Like Gold Fever
Stay tuned.
FOFOA
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