A landmark in the saga of the collapsing international monetary system was
signaled on December 2, when gold went to backwardation for the first time in
history.
Backwardation is a market condition in which futures prices are lower in the
distant delivery months than in the nearest delivery month. The facts are as
follows: on December 2, at the Comex in New York, December gold futures (last
delivery: December 31) were quoted at a 1.98% discount to spot, while February
gold futures (last delivery: February 27, 2009) were quoted at 0.14%
discount to spot. (All percentages annualized.) The condition got worse on
December 3, when the corresponding figures were 2% and 0.29%.
This means that the gold basis [1] has turned negative. The backwardation
continued and worsened on December 8, 9, and 10, as shown by the corresponding
rates widening to 3.5% and 0.65%. It is nothing short of awesome.
Already there was a slight backwardation in gold at the expiry of a previous
active contract month, but it never spilled over to the next active contract
month, as it does now: backwardation in the December contract is spilling over
to the February contract, which at last reading was 0.36%. Silver is also in
backwardation, with the discount on silver futures being about twice that on
gold futures.
This is a premonition of a coming gold fever of unprecedented dimensions that
will overwhelm the world as soon as its significance is fully digested by the
doubting Thomases. The worsening of backwardation must be viewed in the context
of the gold price bouncing back from the lows of last week. It shows that the
"gold bashing" on Friday was done in the December contract. It is quite
revealing that the spot price bounced back more than the futures price. The
bulls are on the warpath. They have unearthed the hatchet. They have stopped
eating from the hands of the clearing members.
As I wrote on December 4 in my "Red Alert" note [2], the gold basis is a
pristine, incorruptible measure of trust, or the lack of it in case it turns
negative, in paper money. Of course, it is too early to say whether gold has
gone to permanent backwardation, or whether the condition will rectify itself
(it probably will). Be that as it may, it does not matter. The fact that it has
happened is the coup de grace for the regime of irredeemable currency. It will
bleed to death, maybe rather slowly, even if no other hits, blows or shocks are
dealt to the system. Very few people realize what is going on and, of course,
official sources and the news media won't be helpful to them to explain the
significance of all this. I am trying to be helpful to the discriminating
reader.
Gold going to permanent backwardation means that gold is no longer for sale at
any price, whether it is quoted in dollars, yen, euros or Swiss francs. The
situation is exactly the same as it has been for years: gold is not for sale at
any price quoted in Zimbabwe currency, however high the quote is. To put it
differently, all offers to sell gold are being withdrawn, whether it concerns
newly mined gold, scrap gold, bullion gold or coined gold. I dubbed this event
that has cast its long shadow forward for many a year, the last contango in
Washington - contango being the name for the condition opposite to
backwardation (namely, that of a positive basis), and Washington being the city
where the paper-mill of the Potomac, the Federal Reserve Board, is located.
This is a tongue-in-cheek way of saying that the jig in Washington is up. The
music has stopped on the players of musical chairs. Those who have no gold in
hand are out of luck. They won't get it now through the regular channels. If
they want it, they will have to go to the black market.
Mish Shedlock published a disdainful criticism of my theory on the worsening
backwardation in gold (see note), calling it "nonsense" (see references below).
A friend of his owns a seat on Nymex (a branch of Comex) who had this to say:
"I have seen countless commodities go into backwardation for numerous reasons,
the most frequent being a radical temporary divergence between immediate and
overall demand. I have seen backwardations that have lasted years. The article
is based on the assumption that a backwardation will necessarily lead to a
breakdown of the delivery mechanism. But for every breakdown of the delivery
mechanism there have been thousands of backwardations without a breakdown. Only
if and when an actual breakdown occurred would the conclusions that the author
drew make sense."
Well, well, one can buy himself a seat on the Nymex for sure, and the price is
hefty these days, but Nymex does not deliver the understanding of monetary
science along with the seat. Nor does any university anywhere in the world.
Mish says that "there is nothing special about backwardation, period. OK, they
are rare in gold. So what?" Here is what. There is a difference between "rare"
and "non-existent". Backwardation in gold has been non-existent, and for a very
good reason, too, as I have explained in my articles. (I also pointed out that
there have been "hiccups", or short-lived instances of backwardation. They were
temporary "logistical" bumps, always resolved within a day at most, and they
never ever spilled over to the next actively traded delivery month.)
Mish needs to educate himself on the fundamental difference between a monetary
and a non-monetary commodity before he can grasp the idea that lasting
backwardation in gold is tantamount to the realization that "gold is no longer
for sale at any price".
The bottom line is that there is no fever like gold fever. It is akin to St
Vitus' dance that swept through the Christian world just before the year 1,000
AD, affecting all the people who expected the end of the world to happen at the
turn of the millennium. It was far worse than the mania that swept through the
world affecting all the people a thousand years later who expected the 2K
disaster to happen.
The coming gold fever must be distinguished from tulipomania in February 1637,
when one single tulip fetched the equivalent of 20 times the annual income of a
skilled worker. Gold fever is as different from a bubble as real gold is from
fools' gold. It is visceral. It has to do with one's instinct for survival. It
has no patience with logical arguments. It is highly contagious, ultimately
affecting everybody. A bubble that never pops.
You may ridicule the idea that, during a prolonged backwardation, all offers to
sell gold will be withdrawn. But a serious analyst must answer the question why
hundreds of millions of people having gold coins under the mattress and in the
cookie jar refuse to take the bait of "risk-free" profits offered by
backwardation. Such a thing would never ever happen to a non-monetary
commodity.
The only successful corners in history were gold corners, aka - hyperinflation.
Keynesian and Friedmanite economists in the pay of the government thought that
gold futures trading would permanently short-circuit the forces of gold
backwardation, thus preventing hyperinflation from ever happening. They were
wrong.
In an article "The Manipulation of Gold Prices" (see references), James Conrad,
Professor Emeritus of Economics and former Dean of the School of Business
Administration at the University of Indianapolis, argues that Bernanke is
different. He understands that he needs a much higher gold price in order to
increase the efficiency of his airdrops. There is no better way to distribute
new money among prospective spenders than putting it into the pockets of the
gold bugs. (Conrad admits that he is one.) This will induce a large spending
spree, holding deflationary pressures back.
According to Conrad, Bernanke is well aware that the new money he is feverishly
airdropping has not stopped and will probably not stop the bloodbath in the
stock market. Further devastation of share prices will render pension funds
insolvent. To prevent this, the dollar needs a massive devaluation, on the
pattern of FD Roosevelt's tinkering with the value of gold. I quote:
Anyone
who reads the written works of our Fed Chairman will know that Bernanke's long
term plan involves devaluing the dollar against gold. This is the exact
opposite of the position of most prior chairmen. He has overtly stated his
intentions toward gold, many times, in various articles, speeches and treatises
written before he became Fed Chairman. He often extols the virtues of F D
Roosevelt's gold revaluation/dollar devaluation back in 1934, and credits it
with saving the nation from the Great Depression. According to Bernanke,
devaluation of the dollar against gold was so effective in stimulating economic
activity that the stock market rose sharply in 1934, immediately thereafter.
That is something that the Fed wants to see happen again."
It is only a matter of time before gold is allowed to rise to its natural
level. Assuming that about one half of the recent increase in Federal Reserve
credit is neutralized, the monetized value of gold should be allowed to rise to
between $7,500 and $9,000 per ounce as the world goes back to some type of a
gold standard. In the nearer term, gold will rise to about $2,000 per ounce as
the Fed abandons its hopeless campaign to support Comex short sellers in favor
of saving the other, more productive, functions of various banks and insurers.
Revaluation of gold, and a return to a gold standard, is the only way that
hyperinflation can be avoided while large numbers of paper currency units are
released into the economy. This is because most of the rise in prices can be
filtered into gold. As the asset value of gold rises, it will soak up excess
dollars, euros, pounds, etc, while the appearance of an increased number of
currency units will stimulate investor psychology; and lending and economic
output will increase all over the world. Ben Bernanke and the other members of
the FOMC Committee must know this, because it is basic economics.
It is to be regretted that more of Conrad's admirable paper cannot be quoted
here because of lack of space. To summarize: Bernanke is prepared to throw the
issuers of paper gold at the Comex to the wolves, as they have become useless,
even a nuisance, by now. Besides, the wolves must be appeased lest they devour
whatever remains of the US banking and insurance system.
My own position is somewhat different from Conrad's. In my view we are facing a
world-wide elemental grassroot movement: the flight into physical gold -
witness the backwardation in gold. It is irresistible, and will ultimately
overtake all other market forces. It will overwhelm official resistance.
An intriguing case can be made, as is attempted by Conrad, that Bernanke is
intelligent enough to realize all this thinking that he can harness, if not
hijack, the grassroot movement for his own purposes. This is a wee bit more
intelligence than I can give credit for to the chairman, who is a former
academic himself. I find the thought surrealistic that Bernanke wants to use
gold as the safety valve through which he can release steam from an overheating
deflation one day, and from an overheating inflation the next.
Be that as it may, the Brave New World of irredeemable currency sans the paper
gold factory at Comex will be an entirely different world from what we have
been used to for the past 36 years. I highlight the differences as I see them.
This should be helpful in the long run, even if this backwardation is temporary
and gold futures trading will return to normal, since permanent backwardation
is ultimately unavoidable.
Item 1: Barrick and other gold producers that still have an open hedge
book will go bankrupt. Item 2: Other gold miners will, one after another, stop selling gold
altogether, and go into hibernation. Item 3: Junior gold mines will put off starting production indefinitely.
They will consider their gold ore reserves in the ground a safer store of value
than paper money in an insolvent bank. Item 4: The closing of the gold window at the Comex will furnish an
excuse for other issuers of paper gold including the bullion banks to declare
bankruptcy fraudulently. Item 5: GLD and other joint depositories of gold will be under enormous
pressure to default and let the owners of the ETF shares hold the bag. Let them
sue for the gold. They won't get it: their contracts give them no right to
physical gold. They will get small change, in paper. The principals will cut up
the gold pie among themselves. No crumbs will trickle down to shareholders. Item 6: Even allocated and segregated metal account gold is not safe.
The temptation on the account providers to default will be irresistible. They
are not going to release the gold until expressly ordered by the courts, and
will make sure that no gold will be left by then. Item 7: Central banks forfeit their gold under leases due to
backwardation, causing an uproar of citizens whose patrimony was sequestered
and dissipated in such an ignominious manner. Item 8: The only market for gold will be the fragmented black markets in
various countries each charging a price whatever the traffic can bear. All
legal protection of the ownership of and trade in gold will be suspended. The
Dark Age will descend on the trading world, just as it did when the Roman
Empire collapsed.
Our present experiment with irredeemable currency can last only as long as it
is able to support futures markets in gold. The declining gold basis is the
hour glass: when it runs out and the last grain of sand drops, gold fever will
bleed the futures markets of cash gold, and the days of the regime of
irredeemable currency are numbered.
Previous episodes of experimentation lasted no more than 18 years, or half as
long as the present one, which has taken 36 years so far, a world record. Of
course, none of the earlier episodes were supported by futures markets.
Forewarned, forearmed. Get ready and move closer to the doors. When the curtain
falls on the last contango in Washington, there will be panic and some people
may get trampled to death at the exit.
Dear Mish, lower your gun. The topic of gold backwardation is not for you.
References:
Monetary versus Non-monetary Commodities, April 25, 2006
The Last Contango in Washington, June 30, 2006
Has the Curtain Fallen on the Last Contango in Washington? December 8, 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) Shedwick, December
7, 2008, www.globaleconomicanalysis.blogspot.com
The Manipulation of Gold Prices, by James Conrad, December 4, 2008,
www.seekingalpha.com
Gold in Backwardation? Not so fast ... , by "Hard Asset Investor", December 2,
2008, ibid.
The Battle against Contango, by Brad Zigler, November 20, 2008,
www.hardassetsinvestor.com
Notes
1. This edited article includes elements from Professor Fekete's previous
newsletter, Red
Alert, which initially signalled the backwardation discussed here and
includes a more detailed account of the gold basis, backwardation and contango.
2. See Red
Alert at www.professorfekete.com
Antal E
Fekete has since 2001 been consulting
professor at Sapientia University, Cluj-Napoca,
Romania. In 1996, Professor Fekete won the first
prize in the International Currency Essay contest
sponsored by Bank Lips Ltd of Switzerland.
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