What is backwardation ? With gold, or any commodity, the price of a future, or a term contract, is usually higher than the spot price. Because, to ensure delivery of a commodity in the future, one must borrow money to acquire it today and store it for an eventual delivery at a later date. This represents a cost which is reflected with a future price higher than the spot price.
That is in a normal situation. However, it sometimes happens that the spot price is temporarily higher than the future price : it may happen when strong demand is coupled with low supply. Supply can’t cope with demand, and we get what is called backwardation (the opposite of backwardation is contango, which corresponds to a normal situation).
This phenomenon is understandable with a commodity, because stocks can become almost exhausted, but it’s less understandable with gold, which is not a commodity. It is not destroyed or transformed when acquired, but simply stored.
The quantity of gold in the world never diminishes; it even increases regularly with mining extraction. Thus, normally, gold should never be in backwardation. One must understand that such a phenomenon is theoretically impossible, because all one has to do is sell one’s gold for cash and buy it back through a future contract to pocket a profit without any risks. At a time when the market is monitored day and night by thousands of professional investors using more and more sophisticated tools, such an anomaly should only last but a few seconds, right ? But it has lasted several days, at times.
Only one thing can explain the backwardation in gold : loss of confidence. Potential buyers of futures reckon there is a significant risk that the contract might not be fulfilled, i.e. that the physical gold might not be delivered. Even if they could make a profit, they don’t use arbitrage, and they hold on to their precious physical gold.
Backwardation lasts as long as the confidence crisis endures. And we’re talking about confidence in the monetary system itself here ! So, if backwardation becomes permanent, then gold will not be for sale at any price. Those holding gold bars won’t want to sell whatever the price, simply because they will not trust the paper money that will be offered in exchange for them (and this will certainly be the prelude to hyperinflation).
Historically, the gold market has always been in contango but, since the start of 2000, it has followed the interest rates movement and has continued its downward movement (the cost of money diminishes, so future delivery is less costly). Gold was in backwardation for several days the first time in December 2008, right after the Lehman Brothers bankruptcy, when there was tremendous pressure on the markets. And again in May 2012, when the Eurozone crisis expanded to Spain and Italy. And it’s happening at this very moment (Zero Hedge), which is a telling sign of major tensions, even though the prices are relatively stable now... but for how long ?
Anyway, this is a phenomenon worth keeping an eye on that confirms, once again, that gold is really the money of reference for the paper currencies.
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The information contained in this article is for information purposes only and does not constitute investment advice or a recommendation to buy or sell.