1 month GOFO moved from -0.08% to -0.185% yesterday, and 2 month GOFO recorded -0.145%, which is the lowest level since the 1999 Washington Accord gold supply panic.
This negative gold forward rate is a true backwardation of gold prices. It means participants can sell physical gold now and instantaneously buy it for delivery in 2 months time at a 0.145% discount. Not only that, but the entrepreneurial arbitrageur can also invest the proceeds from the spot sale in risk-free securities over the period. In two months time, they will have their gold back, have banked 14.5 basis points profit, have banked the risk free security return and will have save on 2 months storage and insurance of the physical gold.
This is why backwardation of gold is so fascinating, it just should not happen. The arbitrageur may not be so smug if the future delivery never occurs (in trying to make 0.145% he has lost 100% of his gold), and that is the risk which backwardation effectively prices in.
Why it is happening now is due to one of two things. Either it means there is the sniff of panic around physical gold buyers, in so far as the gold inventory they require over the next two months may not materialise. Or it means the demand to short the gold market has become so high that financial investors are prepared to borrow gold (to short it) at rates higher than borrowing unsecured funds such as Libor.
So in other words we have a situation where physical gold demand is rising but financial demand is weak, in fact financial demand has become so weak it’s turned into financial supply. Which side do you think is taking more risk in this scenario – the buyers of physical gold who use their savings to accumulate gold they never intend to sell or the sellers of financial gold who use borrowed money to short gold they will one day have to buy back!
Looking in more detail at the first reason, imagine you are the Perth mint or a Chinese or Indian bank or gold merchant with a steady stream of physical gold buyers on your customer list. Then imagine that prices have fallen dramatically and your buyers are calling you all hoping to take advantage of the lower prices. Suddenly you order books are filling up fast which is great, but what if your smelting contacts advise you there’s a problem with casting the required volume of bars and you’ll only get a portion of your order unless you pay a premium for spot delivery. This premium amounts to a “convenience yield” which is more common amongst commodities that can “run out” if production stops like the oil products. In other words you can have more, but you’ll have to pay more for today’s gold, than if you’re prepared to wait and lock in a price for future (uncertain) delivery. If a real global run on physical gold occurs spot prices will sky-rocket compared to contractual claims on future delivery. Products like Gold Backed ETFs and financial futures prices will trade at an even greater discount to spot gold delivery. Spot gold physical markets will trade at a premium and gold backwardation could become the norm. In that scenario anyone prepare to lend gold to a starved physical market can almost name their yield (lease rate). Who will be saying that gold has “no return” in that environment?
I’ll elaborate on the second reason in another post.