Back in February 2009 Steve Ellis wrote in the Financial Times that gold would go into backwardation.
“The long-term story for gold, however, is a remonetisation play as investors lose faith in fiat currencies. Keep an eye on gold lease rates; a spike would be a good lead indicator that gold is about to punch higher as this would reflect a shortage of lendable bullion. Rising lease rates will cause gold to go into backwardation as holders of gold may not want to sell their gold under any circumstances.”
Fast forward to today and consistent backwardation has arrived – The following chart shows the Gold Forward Offered Rate (“GOFO”)* which has been negative 31% of the time over the last year.
(*GOFO is the rate borrowers pay for USD loans if they post gold collateral. Otherwise they would pay Libor and not post gold collateral. Therefore GOFO is secured as far as the lender is concerned so GOFO should be LESS than Libor (ceteris paribus). In this normal situation lease rates (Libor – GOFO) should be positive by the premium lenders are placing on demanding gold collateral. When GOFO is negative (ie true backwardation) this implies participants are lending USD for a negative return; just to receive gold as collateral.)
But why is backwardation in gold so important?
“The answer to this relies on the fact that a permanent and steep backwardation in gold prices would shake the core of everything we implicitly believe about gold prices. When I bid or offer gold in the course of managing my fund, I assume that gold is unperishable and that every ounce of gold ever mined since the beginning of time (around 150,000 tonnes or 60 times current annual production) still exists somewhere and in some form. Importantly I deduce that higher and higher spot gold prices would eventually entice that gold onto the market. But a permanent and steep backwardation in gold prices would challenge all that.”
In a nutshell a persistence of gold backwardation is evidence that:
- gold hoarding is rife and universal;
- participants prefer to be holding physical gold, rather than fiat money (paper money) earning interest “in the bank” together with a paper claim on future gold delivery;
- the steeper the backwardation, the larger the shortage of gold to trade against dollars or other currencies;
- there can come a time when there will be no gold available at any price to trade against paper currencies (the “musical chairs” moment);