The price of gold shot up over $60 this week. The price of silver moved up
proportionally, gaining over $0.85. The mood is now palpable. The feeling in
the air is that of long suffering suddenly turned to optimism. Big gains,
if not the collapse of the price-suppression cartel, are now
inevitable.
The headlines and articles, screaming for gold to hit $10,000 to $50,000,
are pervasive. Today we won’t dwell on our favorite point that if the price
of gold hits $50,000 then that means the price of the dollar has collapsed.
If you own an ounce of gold, then you may have a lot more dollars. But
unfortunately, each of those dollars is worth a lot less.
Today, we want to look at this new alleged precious metals bull market.
Does it have legs? Are we likely to see silver hit $20, much less $1,000? We
will support our analysis with a new graph to show the big picture.
Let’s look at the only true picture of supply and demand fundamentals. But
first, here’s the graph of the metals’ prices.
The Prices of Gold and Silver
Next, this is a graph of the gold price measured in silver, otherwise
known as the gold to silver ratio. The ratio was down slightly this week.
The Ratio of the Gold Price to the Silver Price
For each metal, we will look at a graph of the basis and cobasis
overlaid with the price of the dollar in terms of the respective metal. It
will make it easier to provide brief commentary. The dollar will be
represented in green, the basis in blue and cobasis in red.
Here is the gold graph.
The Gold Basis and Cobasis and the Dollar Price
We actually had to expand the range of both axes. The price of the dollar
fell off the bottom, currently about 24mg. The cobasis (which is our measure
of the scarcity of gold) also fell off the bottom, while the basis (which is
our measure of abundance) rose above the top.
As the price of gold continues to rise, it becomes more abundant. Indeed,
we can hardly say “scarcity” any more with a cobasis below -1%.
Look, the supply and demand fundamentals could change at any time.
However, as of this moment, the picture painted by the basis is not $10,000
or $50,000. It’s more like $1,235. More on this below.
First let’s turn to silver.
The Silver Basis and Cobasis and the Dollar Price
The first thing you’ll notice is that the red cobasis line (i.e. scarcity)
has not been falling to match the falling price of the dollar measured in
silver (i.e. rising price of silver, measured in dollars) the way it has in
the gold chart above. However, two factors mitigate this. One, the silver
cobasis is much lower on an absolute basis (no pun intended). In gold, the
cobasis is -1.1%, whereas for silver it’s -1.4%.
Two, silver has a much stronger tendency to a falling basis and rising
cobasis as each contract nears expiration. In times of greater scarcity, it
causes temporary backwardation—each contract tips into backwardation
before it goes off the board. This phenomenon begins to distort the silver
chart much farther out than in gold, and to a greater (numerical) degree. It
has already taken hold in the July silver contract.
This segues into our next chart, a view new to this Report. We show the
August and December gold contracts and the September and December silver
contracts. Just the basis only, to make the chart easier to read.
The Gold and Silver Basis with LIBOR
You can see another aspect of our previous point. Even this far out, the
silver contracts show more volatility than gold. And the two different months
deviate from one another more than in gold.
Note the strong rising trend starting around mid-January.
So what is this showing, really? The basis is the real-world profit you
would make to carry metal. Suppose you buy a bar of metal and simultaneously
sell a futures contract, storing the metal in the meantime. You pocket the
carry spread. If we quote it in terms of dollars, it’s about 14 cents for
December silver. We quote it as an annualized percentage, so that you can
easily compare it to other investments (more on this in a moment).
The trend for the past few months is that carrying is more and more
profitable. What does that tell us? It means that more and more firms will
enter the carry trade. A profit attracts people, for some odd reason or
another having to do with wanting to make money or something…
Anyways, we know that more market participants are carrying metal because
it’s more profitable than it was. Whatever number of people wanted to do it
when the profit was 7 cents, we know that more will do it for 14.
What is this telling us about the state of the market for metal? If more
and more metal is going into carry trades, then the marginal buyer of metal
is this trader who carries metal—whom we often call the warehouseman.
The marginal demand for metal is to be carried. This is a
dangerous state, because when it flips around, then this marginal demand
disappears and then the marginal supply of metal is coming out of carry
trades. This is hardly the picture of a shortage driving a durable bull
market.
We included two different LIBOR rates on the chart. It’s interesting to
compare the basis to LIBOR. Now, in gold, carrying is about the same as
6-month LIBOR. In silver, the return is above that, and at one point got
above 12-month LIBOR.
We have one final point. These traders are carrying metal to earn a small
spread, with no price exposure. They are arbitragers. The activity
of the arbitrageur always causes compression of the spread from which he is
profiting. In this case, the carry trade involves buying metal in the spot
market and selling it in the futures market. This tends to push up the price
of spot metal and pull down the price of futures contracts.
So we have a growing group that’s pushing to compress the basis spread—basis
is futures minus spot. Yet the basis is widening despite that. What could
cause something to rise, when there’s a powerful and growing force trying to
make it fall? What is the even-bigger force at work here?
It is the fast and furious buying of speculators, who bid up futures
contracts on leverage. Paper gold is rising, and it’s pulling up gold metal.
Paper silver is rising, and it’s pulling up silver metal.
For now.
© 2016 Monetary
Metals
