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Demystifying Gold Backwardation

Despite insipid economic growth, intensifying geopolitical tensions, and the unrelenting debasement of fiat currencies, gold has sunk to four-year lows, and there’s no telling when the misery will end.

The disconnect between the price of gold and the big picture is puzzling, but it’s not the only abnormality facing the market. Since July 2013, gold has been in and out of “backwardation,” a rare market state that occurs when the price of gold for future delivery is lower than the current spot price.

There are two types of backwardation: money and commodity. Both affect gold. Unlike oil, lumber, or any other commodity, gold carries an interest rate, known as a lease rate. This rate reflects real costs associated with holding gold, including storage, insurance, and forgone interest. Commodities experience backwardation fairly regularly, but it’s considered a phenomenon when it happens to gold—until recently, that is.

Gold has been in a semipermanent state of backwardation since July 2013. History tells us that periods of backwardation are typically followed by a near-term rally, though today’s backwardation is anything but ordinary. In fact, the duration of the current episode illustrates the widening chasm between the paper and physical gold markets.

A Near-Term Shortage or Something More Sinister?

Gold enters backwardation when gold forward offered rates (GOFO) turn negative. GOFOs are the rates at which owners of gold are willing to lend on a swap against US dollars. They are reported by the London Bullion Market Association (LBMA) on 1-, 2-, 3-, 6-, and 12-month time frames. The rates are set in a manner eerily similar to London Interbank Offered Rate (LIBOR).

Negative GOFO rates signal that investors prefer to hold physical gold over US dollars. In layman’s terms, they reflect a perceived market shortage.

The 1-, 2-, and 3-month GOFO rates have been dipping in and out of the red for more than a year, indicating problems with near-term delivery. Even the 6-month GOFO turned negative earlier this month.

Could a Gold Rally Be Around the Corner?

Gold backwardation is rare but not unprecedented. The metal entered semipermanent backwardation after Nixon severed the link between the US dollar and gold in 1971. The metal would go on to gain 1,500% over the next decade.

There have only been a handful of instances of gold backwardation since then, and each prior occurrence has only lasted a few days before “contango,” or the normal market state, was restored. Price rallies—the logical response to a supply crunch—have preceded three out of the last four episodes of backwardation.

Any gold bug would welcome a rebound after gold’s abysmal performance in 2014. That said, the semipermanent nature of this phenomenon speaks to a much graver problem: the growing dislocation between the paper and physical gold markets.

A Tale of Two Markets

The paper and physical gold markets are telling two different stories. In the West, the outlook for the yellow metal is grim, while the perception of gold in the East—namely China and India—remains soundly positive.

The two markets are clearly out of sync for a few reasons. For starters, speculators run the paper market, while buyers of gold coins, bars, and jewelry typically hold on to gold for extended periods. The paper market has also far outgrown the actual gold market to the point where it no longer reflects underlying market fundamentals. Some reports estimate that there are more than 100 paper claims for every ounce of gold.

Suspicion that the paper market is overrun by manipulation is also spreading like fire. I won’t delve into the particulars, but I can’t say I blame anyone for questioning the integrity of the marketplace.

Manipulation and fraud have become sad, accepted realities of the modern investment environment. In many cases, intervention seems to be the only game in town, so much so that some investors are finding it difficult to accept the spot price at face value.

In any case, backwardation is an unsustainable market condition, for which the only cure is higher gold prices.

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