Friday, December 05, 2008

Red Alert: Gold Backwardation!!!

I always view gold bugs with a healthy degree of skepticism but Antal E. Fekete lays out a soundly reasoned warning that the global financial system is going to lock up. Soon.

Red Alert: Gold Backwardation!!! In the commodity futures markets the terminus technicus for a positive basis is contango; that for a negative one, backwardation. Contango implies the existence of a healthy supply of the commodity in the warehouses available for immediate delivery, while backwardation implies shortages and conjures up the scraping of the bottom of the barrel.

Gold going to permanent backwardation means that gold is no longer for sale at any price, whether it is quoted in dollars, yens, 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 To put it differently, all offers to sell gold are being withdrawn, whether it concerns newly mined gold, scrap gold, bullion gold or coined gold.

Negative basis (backwardation) means that people controlling the supply of monetary gold cannot be persuaded to part with it, regardless of the bait. These people are no speculators. They are neither Scrooges nor Shylocks. They are highly capable businessmen with a conservative frame of mind. They are determined to preserve their capital come hell or high water, for saner times, so they can re-deploy it under a saner government and a saner monetary system. Their instrument is the ownership of monetary gold.

They blithely ignore the siren song promising risk-free profits. Indeed, they could sell their physical gold in the spot market and buy it back at a discount in the futures market for delivery in 30 days. In any other commodity, traders controlling supply would jump at the opportunity. The lure of risk-free profits would be irresistible. Not so in the case of gold. Owners refuse to be coaxed out of their gold holdings, however large the bait may be. Why? Well, they don't believe that the physical gold will be there and available for delivery in 30 days' time. They don't want to be stuck with paper gold, which is useless for their purposes of capital preservation.

The full faith and trust in the US government to pay its promises is in question. I have read a challenge to the definition of spot price used in the article but overall it makes a good case that this is an indicator worth watching. If the commodities markets begin saying that gold can not be purchased with US dollars, no matter how many of those dollars are offered, it means a complete breakdown in the trust between nations. Scary stuff. The wave of time is towering over the mountains we know.