The March silver futures
contract first entered backwardation on Mar 9 and with a few zigs and zags
has not only remained there but has gone deeper and deeper in. The April gold
future just entered backwardation today. See the graph (backwardation is when
(Spot(bid) - Future(offer) > 0).
Larger Image
We shall see what the coming
days bring for the April gold future, but the fact that backwardation has
occurred at all is significant. The fact that it is now a
"normal" occurrence since fall 2008 indicates a deep pathology.
I have written in the past
about gold and silver backwardation (http://keithweiner.posterous.com/debunking-gold-manipulation
and The
Decline and Fall of Silver Backwardation and http://keithweiner.posterous.com/when-gold-ba...comes-permanent).
The gist is that one can look at the spread between the price of a future vs.
the price in the spot market of the same commodity.
We define the basis as the
Future(bid) - Spot(ask) and the cobasis is, as mentioned above, Spot(bid) -
Future(offer). In a normal world, the basis is positive and it is basically
given by the rate of interest. The cobasis should be negative unless there is
a shortage. A shortage of gold or silver is meaningless as people have
accumulated enormous inventories of the stuff over thousands of years.
But in the "new
normal", post 2008, the expiring gold or silver future often flirts with
or even slips into backwardation for a period before expiry. This is anything
but normal. It's not a sign of imminent financial Armageddon, but it is a
sign that beneath the surface there is a growing rot in the core of the
system. Why?
The short answer is that no
actionable opportunity to make free money should last more than a millisecond
(or less, due to High Frequency Trading). If one can see a "risk free
profit" sitting on the screen day after day, let alone if this profit is
growing, this is a sign that All Is Not Well even if one doesn't know why or
what specifically is happening. Backwardation means that anyone who has gold
or silver could simultaneously sell the metal and buy futures contracts to
recover their position, and make a profit. And, given the enormous stocks of
gold and silver, many people have lots of gold and silver.
The backwardations that are
"normal" today are too small for the retail trader to profit from,
given that he must pay commissions. But they are easily large enough for many
institutions that make a market in gold (especially compared to their
alternatives for short-term capital). The following question remains
unanswered:
Why do institutions not take the risk-free profit offered to them in gold and
silver?
I don't believe it's because
they are afraid of the risk. I make this statement in light of two facts: (1)
the near-month future expires very soon (about 5 weeks for April gold or a
week for March silver) and (2) the farther-out futures are not in
backwardation. The financial system is not going to collapse in 5 weeks, and
if it were then the farther futures would fall further into backwardation.
Trust in delivery 5 months from now would be less than trust in delivery 5
weeks or 5 days from now.
As a reminder, to profit from
contango, one must buy physical and sell a future against it to end with the
same net position plus a small profit. To profit from contango, one carries
the metal. Think of carrying as like warehousing it for a small fee. The only
prerequisite is that one needs cash (or more typically credit). Carrying will
push up the ask in physical and push down the bid in the future, thus
reducing the basis.
In contrast, to profit from
backwardation, one decarries by selling physical and buying a future.
The prerequisite is that one needs the metal. One could either sell one's own
metal, or if one had previously carried metal one could unwind the carry.
Either way, this would push down on the spot bid and up on the future ask
until the cobasis was zero or negative.
For whatever reason(s), this
is either not occurring or despite it, the ask on the future is falling
relative to the bid on spot.
For now, let's just say that
the market is tight. The metal is out there, but obviously those who have it
in an unencumbered form are not able (retail) or willing (others?) to take
this backwardation bait.
I will drill deeper into this
in another article soon.
