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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.
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
Gold and Silver in Backwardation: What Does It All Mean?
San Francisco School of Economics, June-August, 2009
Money and Banking, a ten-week course based on the work of Professor
Fekete.
Antal E. Fekete
www.professorfekete.com
Professor,
Intermountain Institute of Science and Applied Mathematics
Missoula, MT 59806, U.S.A.
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.
Copyright © 2002-2008 by Antal
E. Fekete - All rights reserved
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