26 July 2013

Norcini: Gold is not in backwardation

In my last post I was not saying that what we see now on COMEX and with GOFO is not important – remember the mugger in Crocodile Dundee still had a knife – just that his switchblade is small compared to Dundee’s much larger “full” backwardation knife.

There is a lot of confusion about the definition of backwardation. Here is a quote from the Dummies series of books:

"When a market is experiencing backwardation, the contracts for future months are decreasing in value relative to the current and most recent months. The spot price is thus greater than the front month, which is greater than future delivery months."

Note their use of plural – "contracts" and "futures months" - as these other links also do, from the first page of a google search on "definition backwardation":

Wikipedia - "The resulting futures or forward curve would typically be downward sloping (i.e. "inverted"), since contracts for further dates would typically trade at even lower prices."
McClellan Oscillator - "Backwardation means that forward contracts are priced lower than nearer term contracts, or spot"
Investopedia - "Backwardation is the same as inverted when futures prices are lower than spot prices."

This is what I understand by backwardation when one uses that word in a general sense about a futures market. Having said that, I think it is valid to talk of a specific month being “in backwardation” even if that is not exactly a precise use of the term. What I have a problem with is describing what we are currently seeing in gold as a general backwardation and playing this up as a sign of the failure of the fractional reserve bullion banking system. It is not.

Last word on this I'll give to Dan Norcini:

"gold is not in backwardation and has not been at any time whatsoever on the Comex during the entire time this backwardation talk commenced and picked up some gullible followers"

The post is worth reading in full because he explains the need to look at current bid/ask rather than last price for the further out contracts due to lack of liquidity and the difference between backwardation and the basis (or strong basis as he calls it when spot is above futures). He also makes the following statement:

"When we do however see a STRONG BASIS PLUS a BACKWARDATION STRUCTURE ON THE FUTURES BOARD, then we have the real deal."

I covered similar ground this in 2010 post, saying that that occasional "backwardation" in the shorter months is just the start, or first sign, of a breakdown in the system. Calling what we see now in gold as backwardation proper overstates the phase we are in.

I think the other issue with backwardation is that it is a concept that comes from commodity markets. In this post I question whether such a commodity type interpretation of backwardation is appropriate for gold. Aren't we told that gold is a monetary asset with high stocks to flow, unlike commodities? If so, should we apply a commodity futures market interpretation to gold? As I say in that post "Then you see that gold hasn't went into backwardation, but that USD has went into contango."

If gold is mostly monetary with only a little commodity-like nature, it is therefore best analysed as a currency and in that respect, no one talks of currencies going into backwardation or contango, they just have different interest rates and that differential might drive a carry trade if the difference is big enough. FT Alphaville has done a whole series on this more "financialised" view of gold.

Regarding negative GOFO (which reflects the interest rate differential between USD and XAU), my current view is that it is reflecting the shift by speculators to the short side - more shorting results in more demand to lease gold, which drives up the lease rate (thus GOFO goes down). I have read that liquidation by specs out of long positions has also restricted supply of gold to lease (as the gold has been sold to those unable or unwilling to lease their gold out) and seen comments that increased physical demand has resulted in more metal being tied up in the value chain, so that results in more demand for leasing (or inventory to hedge).

So I think there is a case to say that negative GOFO as more driven by tightness in the gold leasing market. Note that shortage in the borrowing and lending market does not have to coincide with a shortage in the buying and selling market. Holders of gold may be willing to sell it (so price is low), but at the same time those continuing holding it (or the new people buying it) may not willing to lend it (so lease rate is high).
This is why it is logical for Dan Norcini to say that the structure of the futures market is not exhibiting "a true supply shortage" while at the same time we have negative GOFO and some futures contracts below spot.

So this development in leasing is probably what has driven GOFO negative, which, as Keith Weiner notes in this post, is then synced/transmitted to the futures markets by arbitrage (and has a very compelling combined chart of GOFO and the basis to prove his point). Therefore I think we are currently seeing is more a liquidity squeeze on the bullion banks, rather than a full blown distrust in them by holders of unallocated or shortages of physical (a price squeeze).
A real gold bank run will manifest itself in the wholesale markets for 400oz bars. When I see them attracting a premium and/or being difficult to source, or bullion banks desperately bidding on the Perth Mint's refining output, then we "have the real deal" as Dan says. I will let you know.
Alternatively, just watch Bullion Vault and Gold Money - which are backed by 400oz bars and which deal in that market every day - for reports of difficultlies in getting 400oz bars and restrictions on how much gold can be bought, and/or if they start to add on a "special" premium to their spot price.

Don't be complacent however. What I'm talking about above is the end of the line and things can unravel quickly - a liquidity squeeze can turn into a price squeeze - so keep your gold close or stored with non-banks, like the Perth Mint, who don't engage in fractional reserve and maturity transformation activities.


  1. A liquidity squeeze on a bullion bank implies its gold obligations, i.e unallocated, are suffering a loss of 'moneyness', or, a falling bid in gold. They are unable to roll over their obligations.

    The Palyian view would be that the bullion banks are illiquid, since liquidity is defined as the ability to meet one's obligations. A liquid bank cannot suffer a 'squeeze'. How this is any different to any other period in the last God knows how many years?

    Yet gold is still not in backwardation.

  2. "
    So I think there is a case to say that negative GOFO as more driven by tightness in the gold leasing market. Note that shortage in the borrowing and lending market does not have to coincide with a shortage in the buying and selling market. Holders of gold may be willing to sell it (so price is low), but at the same time those continuing holding it (or the new people buying it) may not willing to lend it (so lease rate is high)."

    that's a very well put, very important paragraph.

  3. Thanks for another good post.
    Nice to read reasoned opinions without the hyperbole.

  4. Bron thanks for the education, you efforts are not in vein

  5. They're not in artery either.

  6. Nor in lymphatics. Perhaps not yet in general circulation.

  7. I Re Norcini recommendation to store gold at the Perth mint. I wonder about that - why is ANZ bank bragging that it it sells 15% of the worlds gold by arrangement with the Perth mint. What is the business model here - ANZ is part of the big bankster regime isn't it!!!
    How does the Perth mint justify this arrangement - and if ANZ drives the price down who benefits?

  8. "I Re Norcini recommendation"???

    Regarding ANZ bank, the Perth Mint would love it if people would buy 5 or 6 tonnes of our coins each week but they don't unfortunately so most of what we refine is sold as gold kilo bars to bullion banks including ANZ who onsell them into Asia and India. The gold is sold to whoever will pay us the highest price/premium.