SILVERAXIS - TODAY IN SILVER

First, I’d like to state that I greatly appreciate the public discourse on backwardation that Professor Antal Fekete has largely created through his own diligence and efforts. I would also like to thank the Professor for all that he has taught me in the past, continues to teach in the present, and will teach in the future. His suggestions, guidance and thinking have helped to greatly expand my own understanding of the gold and silver markets, monetary science and economics in general. I know there are numerous other people who feel the same way.

While it may be true that the Professor and I have some significant differences of both opinion and interpretation when it comes to gold (and silver) backwardation, I continue to subscribe to the Professor’s theory that persistent backwardation is a signal that gold is serving to fatally discredit the fiat currency in which it is nominally priced. By no means, however, does this mean that I foresee a doomsday scenario of lawlessness and decline of civilization. In fact, I believe the Professor’s own theories about the unmatched fitness of gold and silver for monetary purposes will ultimately herald a new monetary regime as a direct result of the permanent backwardation in gold. This is in stark contrast to the Professor’s latest emphasis on the dark future that gold backwardation portends but such speculation is not a subject I am prepared to discuss at great length because it is just that — speculation. In other words, I am nearly 100% certain that permanent gold backwardation will herald a major monetary and economic change but I have almost zero insight (as does everyone, else, the Professor included) as to what that change will look like.

With that generalization out of the way, I would like to address in detail the Professor’s recent critique of my own observations in his latest commentary, Forward Thinking on Backwardation.

Tom Szabo observes (see References below): “If somehow short-term interest rates were to go into significant backwardation, it should be no surprise that gold and silver may go into significant backwardation. THIS WOULD NOT BE A SIGN OF IMMINENT MONETARY COLLAPSE [his emphasis]. In fact, a pretty strong argument could be made for the opposite – that the negative interest rate is a sign of excessive monetary demand (in relation to demand for capital goods and investments). I’ve looked but have been unsuccessful in finding an historical example of a monetary collapse that occurred while money was actually in high demand. Of course, high demand for money could be extremely deflationary and the only known cure for this is to create a high supply of money, otherwise known as hyperinflation.”

While I would disagree with the use of the word “imminent” in describing the coming monetary collapse, I must maintain my stand that a durable backwardation, such as we have experienced for two weeks earlier this month, is a premonition that there will be repeated episodes of the same kind, ever more frequent, ever deeper, ever longer, each episode significantly weakening the monetary system – regardless of the zero or negative short term interest rate. (Let us leave the question aside that zero or negative interest rates in and of themselves show an alarming pathology of the monetary system!)

I’ll admit “imminent” was probably not the best word choice as I did not mean to imply that monetary collapse would be immediate but rather unavoidable. In other words, my point was that backwardation in gold resulting from backwardation (or nearly so) in interest rates would not mean an unavoidable monetary collapse was on the horizon. Other than that, the Professor does not seem to dispute anything that I say in this quote besides hinting that zero or negative interest rates “show an alarming pathology of the monetary system”. To this I would answer that Japan has effectively maintained zero interest rates for more than a decade without a collapse in its economy or monetary system. More on Japan in a bit. In any case, I have no beef with the Professor’s stand that an episode of “durable” backwardation is a recipe for more of the same. I do have an argument, however, with the notion that the recent backwardation, if any, has been “durable”.

I have argued that we must carefully distinguish between a fiat money regime with an undisturbed flow of gold to the futures market; and a fiat money regime where the flow of gold to the futures market has been blocked by an unprecedented surge in the demand for cash gold. In the first case confidence in fiat money is high; in the second, it is low and waning fast. In the first case paper gold is an effective substitute for physical gold in most applications; in the second, paper gold has been unmasked as a fraud, and discredited beyond repair. In the first case the economy works pretty well the same way as under a gold standard; in the second, all hell is turned loose as the exchange of goods and services is on the decline and autarky on the rise.

Assuming this line of reasoning is completely unassailable (it isn’t), we would still need to confirm the existence of an “unprecedented surge in the demand for cash gold”. In fact, no such demand currently exists. How do I know this? For one, “the flow of gold to the futures market” has not been “blocked” as evidenced by the meager December deliveries and the lack of movement of metal out of the COMEX warehouses. And even if such demand did exist based on the frenzied pace of retail bullion buying and the anecdotal stories about Chinese and Russian central bank purchases, the futures market would not be the only place to observe the movement away from “paper gold” to physical gold. For example, we should see a decreased appetite for the various “paper” ETF products. Yet for now at least, observable demand for ETF and other paper gold instruments is actually getting stronger, not weaker.

Tom says that “it is incorrect to claim that gold and silver could be in true backwardation without at least some inversion of the futures price curve where the nearer contracts are trading at a higher price than the further out contracts. Well, exactly that’s what has happened at Tocom during the first two weeks of this month and is happening still. Tocom publishes its trading summary at the close of trading every day on the Internet: www.tocom.or.jp/souba/gold/index.html. I don’t understand how Tom could miss it. Backwardation is jumping off the Internet page covering the standard kilobar contract, even as I write this, on December 19.

First, and as the Professor himself points out later in his commentary, local gold prices (especially gold prices quoted in local currencies) are not to be relied upon in the study of backwardation. Thus, the Yen gold price on the TOCOM is totally irrelevant for the purposes of measuring gold backwardation as a prelude to monetary collapse of the U.S. dollar. Besides that, the TOCOM is actually a perfect illustration of my main contention, which is that interest rates by themselves can create backwardation in the gold price. The Bank of Japan’s discount rate has been under 1% since 1995 (it was 0.1% between 2001 and 2006) and, not surprisingly, for a significant portion of the time since 1995 TOCOM gold has been at or near backwardation.

I would add that gold trading on the TOCOM has a major skewing toward contracts in the outer months (currently the vast majority of contracts are in June, August and October 2009). One reason for this outward skewing is that future gold prices are not much higher than cash gold prices and often they are lower. Thus, making a deferred TOCOM gold purchase is seen as a form of “saving money” considering that the funds can be invested in the meantime to earn interest (even if it is a paltry 0.3% per annum). Of course, nobody in their right mind would make this sort of outer month purchase if there was a significant risk of contract default, which automatically defeats the argument that the current gold backwardation on the TOCOM is the result of “unprecedented surge in the demand for cash gold”. If that were the case, most TOCOM contracts open interest would be in the near, not outer, months.

Indeed, as the contango in COMEX gold has declined over the past several months, we have consistently seen a similar phenomenon of growing open interest in outer month contracts at the COMEX. The reason is simple. If you plan to take delivery of gold sometime in the far future or just intend to hold gold futures for a long time, why not buy December 2010 COMEX gold at 855.1 vs. February 2009 at 837.2 (today’s respective closes)? True, you are giving up $17.90 per ounce but that is not a bad deal considering you can forego the slippage risk of rolling each active futures contract as it expires (a total of 10 times between now and December 2010), not to mention the chance that contango will build back into the gold price (in which case the December 2010 contract will appreciate even if cash gold stays flat). In any case, just like with the TOCOM, if the (alleged) backwardation at the COMEX were the result of “unprecedented surge in the demand for cash gold” we should not expect an increase in the number of outer month contracts but rather a decrease.

Finally, allow me to point out that an examination of the historical backwardation in TOCOM gold was made by Reginald Howe of GATA all the way back in 1999. While I don’t agree with many of the conclusions or opinions in his paper, the description of the functioning of the gold market is accurate and proves that gold bugs need not fear to admit that backwardation can result from ultra-low interest rates as opposed to necessarily representing a harbinger of financial Armageddon.

Tom is complaining that the spot price for gold is difficult to ascertain: “the spot price for gold is elusive… because they are third party quotes that suffer from a variety of problems that can make them unreliable and imprecise.” I disagree. I have asked my student, Mr. Sandeep Jaitly of Soditic, Ltd., London, U.K., who is tracking the gold basis for me, to explain. Here is what he had to say on December 15: “Tom Szabo comments that spot prices are difficult to obtain. Not true! They are not. You just have to be plugged into the right feeds. My spot price quotes include all the five price fixers at the LBMA, plus everybody else worthy of quoting… The spot gold price I use is the best or highest bid (and the best or lowest offer) from 300 banks world-wide [list attached, not reproduced here]. The data I use is directly from the exchange, and the prints I see for the carry available are super precise. I can get 90¢ per oz profit on the December contract versus my spot quotes that come from every bank on earth…” Sandeep goes on, dateline December 18: “Everybody of note is inferring that gold is in backwardation because of the zero interest. Let us explore that a little further. One can achieve 0.25% annualized by carrying gold for 190 days till June 26, 2009. 190 days in maturity is about equivalent to a 6-month T-bill with a current yield of 0.18%. The cost of carry for 190 days is 0.25 – 0.18 = 0.07%. If we compare this with the cost of carry for 11 days till December 27, 2008, and, again, for 69 days till February 27, 2009, [calculation included, not reproduced here], then we get that the cost of carrying gold is as follows (all percentages are annualized)

for 11 days: 1.005%
for 69 days: 0.9%
for 190 days: 0.07%

That is pathological without any need of further explanation! It costs more to carry gold for shorter periods of time than for a longer period – according to the futures market. That puts a hole in the zero interest-rate argument, and explodes the explanation that the extra-low contango or outright backwardation in gold is nothing more than “normal backwardation” of a non-monetary commodity!”

Spot prices per se are not difficult to obtain, and my point here is being misconstrued. What is difficult to obtain is spot prices that can be reliably used to calculate the basis. Sure, you can get “gold spot prices” via Bloomberg or Reuters trading and information services. As an alternative, if you have access to a foreign currency trading platform or FX price subscription (for example through eSignal, TradeStation, etc.), you can generally obtain gold spot prices based on trading that takes place on the EBS FX platform. Unlike Bloomberg or Reuters quote feeds, the EBS data is based on actual trades, but unfortunately the trading volume is a fraction of the total global spot gold and silver market.

In addition,Kitco and The Bullion Desk, among others, provide a spot price based on the same “composite feeds” available to Mr. Jaitly of Soditic, Ltd. The Bullion Desk publishes bid and ask data in “almost real time” and is “official enough” that the World Gold Council, the SPDR Gold ETF (GLD), the Barclays silver iShares ETF (SLV) and many others have selected it as their reference spot price. I note that Mr. Jaitly’s Soditic, Ltd. is a registered financial firm and therefore he very likely has access to either or both the Bloomberg and Reuters quote feeds. But, here is the rub. These feeds are not actual “trade data” of spot gold and silver prices as they do not represent actual trades in the market (spot trading data is proprietary and to my knowledge is not available at any price with the exception of trading that takes place on the EBS FX platform). Nor is it actionable in the sense that Mr. Jaitly can call up a specific bullion bank and get the quoted “best” bid or ask since each bank will naturally have its own bid and ask price. Here is the disclaimer about these feeds from the World Gold Council website: “The composite feed is formed by pooling prices from a collection of price contributors and therefore should not be construed as a tradable price.”

Moreover, As Mr. Jaitly rightly points out, his quote feeds represent bids and offers, which brings up the question of which one to use in the basis calculation. Perhaps to be safe one would use the average. Be that as it may, the spot quotes are not even time-stamped (they are periodically updated via the composite feed) and therefore it is not possible to precisely compare them to the COMEX exchange trading data. That vaunted “90¢ per oz profit on the December contract versus my spot quotes” is quitely likely to be unattainable given that spot gold prices are likely to have moved by more than 90 cents between the time that the last COMEX trade in the December contract took place and the time that the composite feed actually reflected a spot price that could be obtained in an actual gold transaction with a specific bullion bank or dealer.

Even if that weren’t the case, 90 cents per ounce is not enough to cover transaction and other costs that would make this a profitable arbitrage trade. Let’s talk if and when the backwardation is large enough that the arbitrage was there and yet still nobody chose to go after it. That would be truly something!

In addition, the quoted spot price feeds include neither market depth (e.g., the second and third best bids and offers) nor do they carry a bid or offer size (the number of ounces of gold or silver bid or offered), both of which are important considerations for those who wish to calculate the basis much less to actually trade backwardation for the arbitrage.

For the above reasons, I have personally been leaning toward utilizing the spot FX trade data available on the EBS Live platform because it represents actual spot trades with time stamps and trading volume which is exactly the same format of the trading data available for the COMEX futures. Using EBS Live and Historical data would presumably allow precise intermarket comparisons for calculating the basis (a theory I am still testing) although the EBS platform does suffer from some periodic price discrepancies and liquidity issues because of the somewhat limited amount of spot trading that it encompasses. Whereas COMEX exchange data includes 100% of gold futures traded in U.S. dollars, EBS includes at best 10% of total spot gold (and silver) traded in U.S. dollars. Moreover, gold and silver trading on the EBS is typically speculative only with no long-term commitment to positions or the taking of physical delivery. As a result, it is possible that spot gold prices involving trades on EBS could sometimes diverge from spot gold prices involving the physical purchase of gold and silver. Indeed, this divergence is most likely to be greatest when true backwardation starts to manifest itself.

In the alternative, I feel that the chart overlays that I have produced here in the past few weeks (and others that I have not produced) are a more accurate method for calculating the basis than reliance on spot price quotes and ad hoc calculations. These charts have the advantage of displaying price trends over a period of time that have a tendency of smoothing out the outliers unlike traditional basis calculations that rely on single snapshots in time that are often subject to pricing or timing discrepancies. I encourage Mr. Jaitly and others who wish to study and calculate the basis to utilize such charts.

Finally with respect to the gold basis calculation, as I have previously mentioned but have not yet been challenged, it is no longer appropriate to use the December COMEX gold contract when daily trading volume has declined to several thousand, much less several hundred, contracts. The fewer the data points, the more likely that gold prices have moved by more than “90¢” between individual December gold futures trades, making such prices untimely.

Now let’s move on to the concept of the “cost of carrying” gold that Mr. Jaitly claims can explain away the role of low interest rates in low gold contango (or backwardation). In a sentence, most of the assumptions and calculations made by Mr. Jaitly seem to be incorrect. First of all, there are two possible “costs of carrying” gold. From the perspective of a warehouseman, it is nothing more or less than contango itself. Since contango (and backwardation) already encompass the interest rate, there is no point subtracting it. Think about it this way. Assume spot gold is $840 and gold for delivery in 6 months is $842. The annualized forward rate or “cost of carrying” is approximately 2/840 x 2 or 0.5%. End of calculation.

Nobody borrows dollars to buy gold that is then sold forward as suggested by Mr. Jaitly’s “cost of carrying” calculation. There is never any money to be made that way (simply because any profit is too simply arbitraged away via competition that keeps gold contango below the average cost to borrow) and no other conceivable reason for doing such a thing.

The only money to be made from “carrying gold” on the basis of borrowed dollars is when bullion banks lend or “lease” gold as part of filling a client’s forward purchase order. (Other methods exist but they all involve trading of some sort). This leaves the question, however, of how relevant such a “carrying” calculation would be when nobody is placing forward purchase orders. In other words, such calculation would become more and more useless as gold went further and further into backwardation.

Despite what various “experts” will claim, the gold carry trade from the borrower or “lessee” perspective is simply about a cheap source of financing and little else. The trade involves borrowing at the rate of U.S. dollar LIBOR (or less, if gold is borrowed in a currency with a lower interest rate than the dollar) and reinvesting the loan proceeds at a higher interest rate. Typically only the top banks can borrow at LIBOR but the “miracle” (or “curse” if you prefer) of the gold “lease” allows many other parties to effectively borrow at the same rate. It is important to note that there is almost never a naked short exposure to the gold price because the transaction is hedged using a forward purchase or offsetting receipt of gold. Thus, in this sense the “cost of carrying gold” is nothing more or less than the interest rate itself. Following is the formula for the gold carry transaction in U.S. dollars:

Cost of Borrowing Gold = “Lease Rate” (amount paid to borrow gold from central bank or other lender)

Cost of Gold Hedge = “Gold Forward Rate” (amount paid to bullion bank to purchase future gold for repaying the borrowed gold)

Cost of Gold Carry (Risk Free) = Cost of Gold Borrowing + Cost of Gold Hedge

Cost of Gold Carry (Risk Free) = “Lease Rate” + “Gold Forward Rate”

where “Lease Rate” = US$LIBOR - “Gold Forward Rate” (see why below)

Cost of Gold Carry (Risk Free) = US$LIBOR - “Gold Forward Rate” + “Gold Forward Rate”

Cost of Gold Carry (Risk Free) = US$LIBOR

Sorry for the formulas but they should be relatively easy to follow. Note that “Lease Rate” is equal to US$LIBOR minus “Gold Forward Rate” because lending gold at interest is functionally equivalent to selling gold and simultaneously repurchasing it for future delivery and then investing the proceeds. US$LIBOR represents the rate at which the gold sale proceeds can be reliably invested and “Gold Forward Rate” represents the cost of selling spot gold and simultaneously repurchasing it for future delivery. Also note that the Cost of Gold Carry (Risk Free) can be less than US$LIBOR if the transaction involves a different currency with a lower interest rate than the U.S. dollar (such as the Japanese Yen) or if the “lease” rate is negotiated below market levels.

The above explanation demonstrates a couple of the mistakes Mr. Jaitly has made. First, the 6-month contango in gold is currently more like 0.5% instead of 0.25%. Second, government borrowing rates (e.g., T-Bills) are not the proper rates to be used in gold carry calculations but rather the rate at which financial institutions can presumably borrow (which in the case of the U.S. dollar is LIBOR). The 6-month LIBOR is currently around 2% so the actual “cost of carrying gold” for “190 days” (which is really better expressed as a “cost of borrowing gold”) is approximately 1.5%. By comparison, Mr. Jaitly’s calculation shows a “profit of carrying gold” of 0.07%!

Even if the results were meaningful, it turns out that there is no need for Mr. Jaitly to calculate his “cost of carrying gold” because in essence it is the gold “lease” rate. Fortunately, such rate is already published by the LBMA and indeed this rate shows that the “cost of carrying gold” as defined by Mr. Jaitly continues to be more expensive for the longer maturities. Here are the “lease” rates for a recent 5 day period (1-month, 2-month, 3-month, 6-month and 12-month rates):

10-Dec-08 1.23 1.65 1.75 1.87 1.66
11-Dec-08 0.98 1.55 1.72 1.75 1.60
12-Dec-08 0.81 1.41 1.62 1.61 1.54
15-Dec-08 0.69 1.32 1.49 1.62 1.53
16-Dec-08 0.59 1.25 1.49 1.58 1.49

So yes, it still “costs” less to “carry” gold (borrow it) for shorter periods of time, as expected. Thus, the fundamental relationship between interest rates and gold forward rates cannot yet be dismissed. Note that the decline in the shortest “lease” rate between December 10 and December 16 can be explained almost entirely by a similar drop in LIBOR at the shortest maturities.

There is one item in the above “lease” rate data that bears a closer examination and it is that the 6-month rate is actually higher than the 12-month rate. When we look closer, it turns out that the gold forward curve itself is the source of this “anomaly”. Specifically, since October 22, 2008 (with a possible precursor around October 7), the forward rate of gold started to diverge at the longer maturities. Prior to that date, the shorter maturity forward rates were modestly higher. For the past two months, however, the 6 and 12 month forward rates have been substantially higher than the shorter forward rates. Then again on November 12, 2008, the forward rates were hit once more by an unseen force seemingly unrelated to interest rates.

Notably, the difference between the 6 and 12 month forward rates is greater currently than the difference between the 6 and 12 month LIBOR rates, which explains the inversion between the 6 and 12 month “lease” rates. But what explains the gaping difference between the 6 and 12 month forward rates? Clearly the shorter forward rates have been very heavily influenced by the massive drop in short term LIBOR rates, yet something happened to gold around October 7, October 22 and November 12, 2008 (among other dates) that cannot be explained by reference only to interest rates. This “something” impacted the forward curve in gold across all maturities but disproportionately on the short end of the curve. Thus, if gold’s current flirtation with backwardation turns out to be historically significant, I believe the date that will live in infamy could very well be October 7, October 22 and/or November 12 and not December 2 (the date backwardation in gold supposedly showed up for the first time).

One clue as to what the “something” that occurred on these dates is that gold forward rates are closely tied to gold “leasing” activity as I noted above. Specifically, the process of “leasing” gold will usually result in a purchase of gold futures (and vice versa) creating forward demand and helping, along with the pressure on spot prices from the sale of the “leased” gold, to drive gold forward rates higher (increasing contango) than they would otherwise be under a certain interest rate scenario. By contrast, the process of terminating a gold “lease” will result in the closing of the gold forward transaction which involves the purchase of gold in the physical market and the sale of a gold futures contract, the combination of which will drive gold forward rates lower (decreasing contango and perhaps even causing backwardation) than they would otherwise be under a certain interest rate scenario.

When I suggested at the recent GSUL 5 session in Canberra that curtailing of central bank gold “leasing” might be the most important factor in the gold market over the next few years, the theory was roundly dismissed. My suspicion, however, is even stronger now. So far, as little as a few tons of “leased” gold may have been curtailed starting in October as a result of the spreading credit crisis. Presumably the “leases” involving the worst credit risks — small jewelry manufacturers and the like — would be the first to get called in. Or to be more precise, these “leases” would simply be allowed to expire without being renewed. In any case, such “leases” would have been presumably shorter term (6 months and under), which would account for the observed inversion of the forward curve in gold with the short forward rates coming under greater pressure. And while we are probably talking about only a few tons of gold so far, a small decrease in gold “leasing” meant to reduce credit exposure is probably only the first step in what could ultimately add up to a curtailment of thousands of tons of “leased” gold assuming the gold carry trade will be abandoned and forward gold purchasing through bullion banks will be eliminated in the months and years ahead. I believe this could cause a phenomenal amount of demand for physical gold and become a (if not “the”) main driver for the gold price going forward.

Tom says that he does not see things evolving in the same catastrophic manner as I do. For example, he believes that “there will always be willing buyers and sellers of gold in some quantity if the price is right.” Buyers – si, sellers – no! That’s just the whole point. The lack of credibility of irredeemable currency will be such that no one in his right mind will accept it in exchange for gold, the ultimate liquidator of debt. Previously, people were willing to trade their gold because they could always replenish their supply from Comex warehouses. That means, in other words, that the irredeemable dollar could still be used as a liquidator of debt (i.e., gold still has a competitor). But let them close the Comex gold warehouses. This is a quantum jump; it means that the irredeemable dollar can no longer be used to liquidate debt, e.g., debt incurred by those holding short positions in gold futures. It is essential not to belittle the import of this observation.

There will be sellers of gold for irredeemable currency as long as there are debts or obligations to be liquidated that are denominated in irredemable currency. For example, my mortgage cannot be paid off in gold, I must have dollars. Whether the COMEX gold warehouses are open or closed is irrelevant as far as my mortgage is concerned. If and when the dollar price of gold is right, I will sell gold and pay off my mortgage. Even after all dollar-denominated mortgages are paid off or defaulted upon, there will still be sellers of gold if the price is right whether that price is the price of food needed for survival or the price of a productive asset available for wealth creation. Taken to its ultimate limit, the very last loaf of bread is worth all the world’s gold given that the nutritional value of gold is nil.

I do not mean to belittle the import of short positions in gold futures (or any paper gold short positions unbacked by physical gold) not being capable of liquidation using irredeemable dollars but it seems to me that government edict or fiat could adequately deal with the situation even if the consequences for paper longs in gold would be disastrous. After all, isn’t the prospect of default or partial payment on paper gold the primary reason to avoid it like the plague? I don’t see how an uncollectable debt (that of the gold short) or one that is collected at pennies on the dollar can be the direct source of the second coming of the Dark Ages.

The remainder of the critique will be addressed in Part 2 of my response to be published in a few days.

I will address the raging backwardation issue in the next post. This one is a general market and PM update.

Gold and silver are currently coming off highs achieved as a result of a major drop in the U.S. dollar due to the Federal Reserve’s desperate move last week to follow interest rates lower (something the Fed is loath to do — central banks generally like to be the ones setting interest rate policy for the markets, not vice versa). With Treasury Bills already trading near zero percent, the Fed set its own federal funds rate target at a level between 0% and 0.25%, which represents a drop of at least 75 basis points from the previous, failed, target level of 1%.

Setting interest rates essentially at zero was nothing less than a formal admission that the U.S. — and the rest of the world — now faces a deflationary threat at least as major as that confronting Japan for the past two decades. With interest rate policy now off the table, the next step is the so-called “Quantitative Easing” or as I prefer “Monetization”. This is the step that involves Fed Chairman Bernanke’s famous helicopter and is the reason why he feels so confident that modern central banking can slay deflation. That’s probably true, but at what cost?

Already Mr. Bernanke has publicly mulled the outright purchases of Treasuries by the Fed as a way of continuing to further boost liquidity. With yields on Treasuries hovering at record lows and foreign central banks indicating their willingness to dump some of their Treasury holdings (based on the recent drop in the amount of Treasuries held by the Fed in custody for foreign entities, the dumping may have already started), there might be a pretty good upcoming opportunity to do just that. If I had to guess, the net result would be a drop in the value of the dollar while Treasury yields revert back toward pre-November levels. When the U.S. dollar dropped all the way under 79 on the Dollar Index last week, it possibly achieved the majority of its move in just a few days. In under 1 month, the world’s “reserve fiat currency” retraced more than 50% of its 2008 rally and appears to be in the process of carving out a bearish head-and-shoulders pattern on the weekly charts.

If the pattern plays out, the next drop in the U.S. dollar could start as early as next week with a target around the 76 level. After that, the right shoulder would presumably be carved which takes the dollar back toward 80 sometime in January. That would be followed by the largest decline in the pattern down to around the 67 level. Ideally this would help drive gold to a new record high during the spring and perhaps even silver will play along. For this to happen I believe that some speculative elements will need to return to the PM markets, or at least stop fleeing it.

Moving on to Treasury yields, I expect the majority of the reversion to take place in a very short period of time. True, if the Fed starts buying Treasuries in large quantities, prices would be supported for a period of time. Once the Fed buying stopped, however, the subsequent drop would be fast and furious. My guess is that the next 3 months or so we will see Treasury prices zig-zag with a downward bias and then sometime in the spring there will be a major decline. This theory would be invalidated if 30-year Treasury Bonds rally substantially higher than the 140 level.

Let’s take a look at the monetary statistics. The latest reports from the Fed now show that reserve balances of banks have climbed all the way to a mind-numbing $800 billion and the vast majority of this liquidity is still being held with the Fed (as opposed to being loaned out) despite the paltry 0.25% annual interest being paid on these balances. The continuing increase in the banks’ reserve balances is of critical importance to the hyperinflation debate because the majority of monetary scientists, financial writers and other “experts” have explained the growth in reserves as being moderated by the U.S. Treasury’s Supplementary Financing Program (SFP) whereby Treasury issuances were supposedly serving to “sterilize” a portion of the Fed’s lending activities. The Fed’s injection of liquidity was supposedly mopped up in part through sales of Treasury securities under the SFP, resulting in a partial withdrawal of that liquidity from the system. There is only one little problem with such a trick — the Treasury ended up with all that liquidity, not the Fed. Did all the “experts” really think the Treasury would just sit on that money and not spend it?

Well, it turns out the SFP was nothing more than a one of several placeholders for a massive Treasury operation involving the sale of probably trillions in U.S. Treasuries. Here is how the Treasury said it:

The balance in the Treasury’s Supplementary Financing Account will decrease in the coming weeks as outstanding supplementary financing program bills mature. This action is being taken to preserve flexibility in the conduct of debt management policy in meeting the government’s financing needs.

There it is, plain as day: the Treasury is going to be using this debt to meet financing needs. So much for bureaucratic obfuscation! Whatever “sterilizing” effect the SFP may have had, it was temporary at best. Once again, my analogy of Ben’s helicopter seems to ring true: the Fed whirlybird has been loading up and dropping money but the rotor blades are creating an updraft that continues to keep the money from fluttering to the ground (for now).

Here is the critical part. As much as $800 billion is now caught in the “updraft” and this number is likely to grow. The net result is that the monetary base has already doubled form around $800 billion earlier this year to over $1.6 billion in the past week. Not only that, but the money supply has also started to accelerate in the past few weeks after spending much of the summer and fall in hibernation. For example, even the narrowest monetary measure, M1, has recently increased at an annual clip of 35% (between August and November 2008 as published in the FRB H.6 Release.) This trend will probably continue until there are measurable signs that the credit markets have become unstuck and economic indicators have bottomed. Judging by the present circumstances, we’re in the early innings. The game, however, could progress rather quickly, surprising even some of its best students. The first wave of the monetary tsunami I’ve spoken about in the past could hit as soon as the next 12-18 months, perhaps even sooner. Even perma-deflation gloomster Gary North has recently started warning his subscribers that the next monetary/economic shock will be hyperinflation, not deflation (which according to him is already happening).

Finally, let’s look at some fundamental factors in the silver and gold markets. First, physical demand remains strong as evidenced by the persistent retail bullion tightness and the recent additions of metal to the ETFs. Barclays silver iShares ETF has recently added 3 million ounces to once again approach the 220 million ounce level and Central Fund of Canada added almost 4 million ounces of silver as a result of its most-recent financing. Yet the strongest of the “silver gobblers” has been the Swiss ZKB ETF, which has now amassed over 32 million ounces of silver, a phenomenal 7 million increase since September.

On the other hand, and despite the publicized efforts to take delivery of COMEX gold, the level of delivery notices for December is truly anemic, running at only about 70% of last year’s rate. Silver is actually doing better — running about 85% of last year’s pace. Similarly, while the registered category of gold held in COMEX warehouses has barely budged since the beginning of December, there has been around 13 million ounces of drawndowns in registered silver stocks, with most of that silver apparently being kept in the warehouses but moved to the eligible category. Overall, these statistics tend to indicate that the attempt to bust the COMEX in December has been a complete bust.

Looking at the basis, we see no significant movements in the last week or so as both gold and silver remain at a very low level of contango and have not moved into measurable backwardation according to either my own proprietary methods or the publicly-available data. The flirtation with backwardation continues to be of great interest but we simply aren’t there yet. Interest rates have continued to decline with short-term LIBOR now under 1%, which I believe has helped keep gold and silver near backwardation. More on this in the next commentary.

I’ll conclude with a figure that I haven’t discussed in a while — the LBMA clearing statistics. For November 2008, the published statistics are 107.6 million ounces of silver traded per day on average, which is well off recent levels. In terms of dollar volume this is the lowest level of silver traded in London since November 2005. Of course, November 2005 was followed by the near-manic trading in April 2006, but those were very different times. For one, silver is likely to face headwinds from the commodity sector into 2009, or at least not receive very much support. By contrast, early 2006 represented the first mania phase of the current commodity bull. In light of all the rumors about the incredible physical demand for silver and the impending silver shortages, the November 2008 LBMA clearing statictics provide a sobering counterpoint. Yes, wholesale demand for silver is probably among the strongest for hard assets and commodities after gold, but it is nothing to write home about in comparison to periods like early 2006. The lack of observable extremes in gold and silver demand at the wholesale level is in fact a major reason why I am discounting the sporadic observations of backwardation.

There continues to be no sustained backwardation in gold according to my proprietary measures, my primary indicators, or the publicly-available data such as the LBMA forward rates or the quoted COMEX futures prices. Once again, this does not make the Professor’s recent commentaries wrong because there is clearly an undercurrent of demand in the physical gold market tied to monetary forces. This undercurrent was first manifested in the rabid retail bullion demand that sprang up earlier this year and it has been consistently moving toward the wholesale market. I was one of the first to discuss this, see: The Danger of a Retail-Led Silver Revolution. We’ve come quite a ways since then with the latest “revolution” being a concerted effort to take large deliveries in December gold and silver on the COMEX. In any case, it is more important than ever to monitor the basis for signs that the monetary forces are increasingly favorable to gold. So far they are but it is by no means certain that we’ve passed the point of no return.

Before providing an update on the basis, please allow me to go over a few items for clarification:

(1) For purposes of gold backwardation preceding monetary collapse, local prices such as those in India are irrelevant. We only need to look at prices where the vast majority of buying volume occurs — London and New York. Many people claim that New York and London gold and silver prices can be easily distorted by outside factors, but the truth is that local prices are much more likely to be distorted. If you want to study gold and silver as monetary phenomena, you need to utilize the prices in New York and London where the money is.

(2) Interest rates have continued to fall this week with short-term Treasury bills actually going negative into “interest rate backwardation”. In addition, even the short end of the LIBOR curve has collapsed in the past few days. In light of this, let me repeat that gold and silver contango, and thus backwardation, are highly sensitive to interest rates, much more so than any commodity. If somehow short-term interest rates were to go into significant backwardation, it should be no surprise that gold and silver may also go into significant backwardation. THIS WOULD NOT BE A SIGN OF IMMINENT MONETARY COLLAPSE. In fact, a pretty strong argument can be made for the opposite–that the negative interest rate is a sign of excessive (in relation to demand for capital goods and investments) monetary demand. I’ve looked but have been unsuccessful in finding a historical example of a monetary collapse that occurred while money was actually in high demand. Of course, high demand for money can be extremely deflationary and the only known cure for this is to create a high supply of money, otherwise known as hyperinflation.

(3) The spot gold and silver price are somewhat elusive because they are not based on actual trades that occur on a regulated exchange. Rather, spot prices are third-party quotes that suffer from a variety of problems that can make them unreliable or imprecise. Therefore it is very easy to make basis calculation errors. This is especially true considering that the basis is a fractional number. During the past few years, there have been literally thousands of instances where gold and silver appeared momentarily to be in backwardation. The next moment, however, the basis had returned to a healthy contango in the range of 3-4% annualized. Currently the gold basis is in very slight contango (and silver may actually be flirting with backwardation) as a result of some combination of low interest rates and wholesale demand, so it is not at all unusual that there would be more frequent moments when gold and silver appear to be in backwardation. In other words, the jury is still out.

(4) Historically, gold and silver have been in consistent backwardation on a closing basis for a number of trading days in a row, not just fleeting moments. These periods of backwardation resulted from one-off events that dissipated rather quickly and had nothing to do with interest rates being near zero. The reason I bring up interest rates again is that should they stay near zero for a substantial period of time, we would expect that gold and silver may also hover near or even trade slightly into backwardation for a substantial period of time. In other words, there is historical precedent for neither extended near-zero interest rates nor extended near-backwardation gold. In any case, gold was near or in backwardation during February to May 1975, November to December 1975, January to April 1976, August to October 1976, May 1977, November 1978, January 1980, March to May 1980, January 1981, November 1981, July 1985, November 1992, January 1993, etc., you get the picture.

(5) It is incorrect to claim that gold and silver could be in true backwardation without at least some inversion of the futures price curve where the nearer contracts are trading at a higher price than the further out contracts. Not every contract needs to be in backwardation, but there should be at least one pair in backwardation. This may seem confusing since the backwardation we are looking for is between the spot price and the futures prices, not between two different futures prices, but it turns out that the basis exists as a continuum and not simply as a concept suspended in space and time. Simply put, a lack of any backwardation in the progression of futures prices means that the basis continuum is broken and thus calls for backwardation are at best early and at worst presumptuous. No, it is not different this time.

(6) A claim of backwardation without specific, verifiable data to prove it is not very valuable. My prior post included a comparison between the active gold COMEX contract and the Kitco spot price for the dates December 3-5 (I was unable to go back to December 2 so it is possible that the chart would have looked different on that date but not very likely). If there was a discernable backwardation in gold, this type of chart would indicate it. I’ve updated the chart for today below.

(7) As I’ve already noted, it is pointless to use the December COMEX contract for basis calculation because trading volume is too light. If you are fortunate enough to have tick-level data for both December COMEX gold and spot gold, perhaps you can make some comparisons but it still would be a shot in the dark. Besides, December COMEX gold after the first delivery date is already essentially the same thing as New York spot gold, so what spot price is the December futures contract being compared to? If it is the Kitco spot price or other “third party” price, then you are not calculating the basis between futures and spot but rather between two different spot prices (New York and London). While there may be a valid purpose in calculating the basis between two spot prices, it is of limited value.

(8) When it comes to backwardation, it is very important to understand that we are talking about fractional amounts so precision is quite important. Single data points and ad hoc “observing the markets” are meaningless unless they reveal price extremes that are being consistently repeated for a period of time. What’s important is repeated, verifiable trades that are all occurring in backwardation, and more and more so. Alas, I see no sign of any such developing pattern up to this point although silver bears close watching.

I have no idea where Professor Fekete is getting his numbers as he did not check with me, and I did not expect him to check with me, before publishing his commentaries. I am reporting on what I see and what I know and couldn’t care less about presenting a “unified front” or ”getting our stories straight”.

Thus, I cannot comment quantitatively on the Professor’s latest article There Is No Fever Like Gold Fever other than to state my basis data says something else. I do, however, have some qualitative comments. First, what he says about the fundamental meaning of backwardation in gold is absolutely correct. He may be early in his call and he may need to take into account the near-zero “risk free” interest rate on short-term debt, but he is deadly right that backwardation, should it become entrenched, would herald the monetary ascendance of gold. At the same time, I don’t see things evolving in the same catastrophic manner that he does. For example, I believe there will always be willing buyers and sellers of gold in some quantity if the price is right such that there won’t really be universal hoarding that leads to a cessation in gold mining, loss of segregated metal deposits, and institutionalized theft of ETF holdings. I also don’t believe that the gold futures markets will go away–they will merely be marginalized. Or perhaps they will become either cash settled or an outright cash market.

Second, I note that the Professor seems to be in agreement with the idea that under the circumstance where gold is “allowed” to appreciate in a hyperinflationary scenario, it may be technically possible to delay the collapse of the fiat monetary system. Indeed, this may be why an incipient backwardation in gold could indicate that much higher prices may lie ahead. And yes, a continued move toward or into backwardation that coincides with a major rally might mean that gold is entering the ”fever” phase where it regains fully-recognized monetary status. My personal opinion, however, is that such a phase or rather phases could last for many years and therefore claims of imminent monetary and economic collapse will likely prove yet again to be wrong. In more descriptive terms, the Last Contango in Washington could turn out to be a very long, and at times boring, dance.

While gold is not in backwardation at this time, some mild backwardation appears to be forming in silver  over the past few days. The following are the LBMA forward rates for 1, 2, 3, 6 and 12 months in silver for this week:

08-Dec-08 -0.011   0.013   0.021 0.200 0.330
09-Dec-08 -0.071 -0.057 -0.051 0.174 0.235
10-Dec-08 -0.081 -0.054 -0.028 0.164 0.297
11-Dec-08 -0.108 -0.058 -0.041 0.091 0.305
12-Dec-08 -0.091 -0.041 -0.025 0.108 0.291

Note the negative forward rates on the 1, 2 and 3 month maturities. We must, however, view this in terms of interest rates as discussed in my last posting, which have been falling and falling this week to record lows on the short end of the yield curve. Here are the LIBOR rates (1, 2, 3, 6 and 12 months) according to the LBMA website:

08-Dec-08 1.836 2.021 2.167 2.400 2.465
09-Dec-08 1.706 2.049 2.215 2.350 2.474
10-Dec-08 1.520 1.958 2.127 2.273 2.325
11-Dec-08 1.303 1.825 2.037 2.230 2.223
12-Dec-08 1.131 1.722 1.946 2.111 2.127

Note that LIBOR is down substantially with the shortest maturity rate literally collapsing to around 1% today. LIBOR of course is not a risk-free rate since it is the rate that banks charge each other, but it appears the government bailouts and guarantees have made people (or at least bank managers) believe that LIBOR is nearly risk-free.

Now let’s look at the COMEX silver futures. We had the following close yesterday (December 11):

Contract Last Change Open High Low
$Cash 10.367 +0.131 10.237 10.537 10.137
Dec08 10.390 +0.225 10.120 10.445 10.120
Jan09 10.390 +0.225 10.205 10.460 10.190
Feb09 10.408 +0.225 10.470 10.470 10.395
Mar09 10.425 +0.225 10.220 10.540 10.130
May09 10.445 +0.224 10.285 10.510 10.285

Clearly there is still a mild forward price progression in the futures representing contango except that the spot month December contract closed at the same price as the January 2009 contract, which seems to indicate that COMEX silver is on the verge of backwardation. Then again, look at the high and low for the day. From that angle, the December contract was still comfortably in contango. Also, consider that the December contract traded volume was 42, January was 52 and February was 4 compared to 15,211 for March. Such light volume means that the quoted prices, even the intra-day highs and lows, in the December, January and February contracts are largely meaningless.

To determine whether or not silver was in backwardation yesterday or today, it would be most appropriate to use the March 2009 COMEX contract. Once again, let’s prepare a chart overlay as that is probably the best way to evaluate the present situation. Below is the Kitco spot silver price and the March 2009 COMEX contract for Thursday, December 11.

Well, all we can say about this chart is that there appears to be a few moments when the silver price is in backwardation but in general we are still seeing the bars (representing the March 2009 COMEX futures) riding on top of the red line (the December 11 spot price). As such, there is no confirmed backwardation in silver despite the negative forward rates published by the LBMA.

Let’s examine today to see if there is anything different going on:

Looks like the bars are a bit closer to the line and the futures even seem to be spending more time below the spot price especially during periods of large price moves but this is still not what true backwardation looks like. Close is not enough. After all, we are not talking about horseshoes or hand grenades.

Let’s finally look at gold today. I’m using February 2009 since once again there is not sufficient trading volume left in the December contract:

The above chart is for those of you who may complain that comparing bars to lines is too hard. Here, I’m using the 5-minute closing prices of the COMEX February 2009 gold contract. It is plainly visible that gold was not in backwardation today according to this measure.

Finally, below is an overlay between the December 2008 (which is a proxy for the spot price after December 1) and the February 2009 gold contracts. The darker line is the February 2009 contract and the lighter line is December 2008. Although these are daily closing prices, some degree of backwardation should be apparent on this chart if gold has in fact been in backwardation with any degree of consistency during the past two weeks. That is obviously not the case.

Going forward, I will be plotting these and other graphs as part of the Metal Augmentor service on at least a weekly basis and probably more often as conditions warrant. If you are a subscribing Founding Member and do not receive an email update about the service in the next few days (some emails have been blocked in the past), please contact me so I can send you the details directly.

I’m inclined to share this type of stuff with Metal Augmentor subscribers exclusively but since the website is still in process of being completed and Professor Fekete has released an article stating December 2 is the date that gold went into backwardation, I am posting a response here that includes a few of my “trade secrets” involving the basis.

First, here is an admission I haven’t made often before but I think it’s important to spill the beans at this point. It turns out the basis in gold and silver is quite sensitive to interest rates at certain times. This is because the cost of storing and insuring gold and silver is negligible compared to most commodities. Gold and silver have a “value density” many times that of base metals, oil, grains, etc. In other words, a given space will hold many orders of magnitude more gold by value than just about any commodity. Silver, while two orders of magnitude less in value density compared to gold (given the current gold-silver ratio near 100:1) will still take up several orders of magnitude less storage space than most commodities.

Consequently, the cost of financing, as opposed to carrying, inventory is the largest component of contango for gold and silver. This of course is one of the reasons why gold and silver are monetary instruments and commodities are not. By contrast, storage space itself is the main component of contango in crude oil. The following comment by “Jeff S.”, one of our valuable contributors to this site, confirms my thesis that an increase in contango in commodities will create spot demand and eventually lead to at least a short term balance of supply (long-term balance is achieved by reducing production):

Looks like Shell is taking advantage of the steep contango in crude oil:

http://bloomberg.com/apps/news?pid=20602099&sid=akchzyPSGYDU&refer=energy

Dec. 4 (Bloomberg) — Royal Dutch Shell PLC and Koch Industries Inc. hired four supertankers to store oil in the U.S. Gulf Coast to take advantage of higher futures prices for crude in the months ahead, according to a shipbroker.

Shell and Koch hired the so-called VLCCs, or Very Large Crude Carriers, to move oil from the Middle East to the U.S. Gulf and hold it offshore, Bruce Kahler, a broker at Lone Star, R.S. Platou in Houston, said today.

The oil futures market is now in “contango,” meaning prices get higher in later delivery months. Contango encourages traders to store barrels rather than selling them now.

Crude oil today fell below $44 a barrel to the lowest since level since January 2005. New York crude for delivery in December 2009 is trading at $57.36 a barrel.

A supertanker would cost about 90 cents a barrel per month for storage, according to data from shipbroker Galbraith’s Ltd. VLCCs can carry as much as 2 million barrels of oil.

Frontline Ltd., the world’s largest owner of very large crude carriers, or VLCCs, said Nov. 28 it leased out two vessels for storage and was working on a third such transaction.

Note that 90 cents per barrel is $10.80 per year which is about 25% of the current price of crude oil. January ‘09 crude closed at $40.81 today while April ‘09 closed at $46.27 and December ‘09 closed at $54.65. It’s obvious how one would make money with crude storage costs at 90 cents per month, no?

Getting back to gold and silver, the storage and insurance cost of these monetary metals is typically around 1.5% per annum for allocated, segregated facilities. Much less than the current 25% for crude oil! But here is my point. The actual contango in gold and silver includes an interest-rate component which we should not ignore especially when certain interest rates, such as 3-month U.S. Treasury bills, are approaching the “zero boundary”. Moreover, even LIBOR itself — which is a better proxy for the financing cost of gold and silver carried in inventory – is currently in the depressed range between 2.00% and 2.70%, down from over 4.00% at the beginning of the year.

Simply put, with interest rates falling lower and lower, we should expect the contango in gold and silver to shrink as well. We can easily test this theory using one of my primary and simplest “basis indicators”, the London gold and silver forward rates (well, gold at least because silver data only goes back to 2006). These forward rates, available at http://www.lbma.org.uk, are a reasonable proxy for the basis differential between the London spot price and the London forward/leasing price.

Here are some comparable figures from late 2001 and today:

Date            [---Gold Fwd 1-12 mo---] [----LIBOR 1-12 mo----]
———————————————————————————
28-Nov-01 1.51 1.32 1.25 1.18 1.22 2.08 2.09 2.09 2.12 2.52
29-Nov-01 1.41 1.31 1.24 1.14 1.17 2.14 2.10 2.08 2.09 2.49
30-Nov-01 1.37 1.26 1.16 1.06 1.08 2.11 2.06 2.03 2.03 2.38
03-Dec-01 1.27 1.17 1.12 1.04 1.05 2.10 2.04 2.00 2.00 2.34
04-Dec-01 1.21 1.12 1.05 1.00 1.00 2.09 2.03 2.00 2.00 2.35
05-Dec-01 1.24 1.15 1.09 1.00 1.00 2.04 1.99 1.98 1.99 2.35
———————————————————————————
26-Nov-08 0.24 0.26 0.35 0.54 0.96 1.43 2.03 2.18 2.54 2.71
27-Nov-08 0.23 0.23 0.27 0.50 0.95 1.90 2.04 2.20 2.56 2.74
28-Nov-08 0.26 0.26 0.31 0.52 0.96 1.90 2.06 2.21 2.59 2.76
01-Dec-08 0.21 0.21 0.28 0.49 0.94          
02-Dec-08 0.23 0.22 0.28 0.46 0.92          
03-Dec-08 0.22 0.21 0.24 0.48 0.91

We can see that gold forward rates and LIBOR at the end of 2001 and today were virtually identical in the 12 month maturities. In the shorter maturities, the gold forward rate is lower today compared to 2001 but LIBOR is not appreciably lower now then it was in 2001. Clearly there is something going on today other than just low interest rates that is driving gold (and silver) toward backwardation. Now of course LIBOR itself does not explain the entire forward rate and there is not a one-to-one relationship between periods or maturities. But there is a relationship, and if we wish to fully understand when and why gold and silver are approaching backwardation, we need to take interest rates into account.

As part of my own analytical work involving the basis, I have conducted historical studies that attempt to isolate the interest rate component. Although not (yet) successful to the extent I’d like, these studies do suggest that when the basis in gold and silver approaches backwardation, it is important to consider the rate of interest. In most cases, “consider” tends to mean that the observed basis reading is actually somewhat lower than what the basis would be when removing the rate of interest from the equation. In other words, when interest rates are very low and falling, an unmodified reading of the basis tends to overstate just how close to backwardation gold and silver truly are.

Even without the interest rate component, the above LBMA forward rate data indicates that, in the London market at least, there was no observable backwardation on December 2 or 3. This brings up the point that there are a number of ways to measure backwardation and by no means am I saying that the Professor’s observation is incorrect. At the same time, I am not able to duplicate it. That is to say, I am still showing gold and silver to be in mild contango. Perhaps the Professor is just a bit early?

One last note about basis calculation methodology. The professor refers to the December gold and silver contracts but I do not believe it is appropriate at this point to use these contracts because they are very illiquid. If you don’t believe me, construct 5-minute or even 10-minute bar charts of these contracts for the past week and try to find the bars where there are multiple trades. You’ll discover there are very few. In other words, most 5-minute and 10-minute periods during the past week contained just a single trade, if that, in the December futures. Under such circumstances, it becomes very difficult to try to calculate a static basis at any one point in time and my preference is always to use other methods (see below).

Aside from specific basis calculations, I have two relatively straightforward methods to check for backwardation at a glance. The first is simply to check the progression of spreads between near month and outer month futures. When we do this for COMEX gold and silver for the past few days including December 2 and thereafter, we find in fact that the progression is still positive. A positive progression where each subsequent futures is higher in price than the previous one is the classic definition of contango.

The second method, and one that I intend to use as one of the visual tools in the Metal Augmentor service, is a chart overlay. I have a number of these chart overlays, several of which I’ve already shared with GSUL 5 attendees in Canberra and will be sharing with Metal Augmentor subscribers shortly. The following is one that I’ve done ad hoc for the period of December 3 - 5 using the Kitco spot gold price and the February 2009 COMEX gold futures. In the below charts, you can see that the Kitco spot price is “underneath” the COMEX price overlay, which means the spot price is lower than the futures price and therefore, according to these charts at least, gold is still in contango. More specifically, except for a few price bars here and there during moments of high volatility, these charts indicate no backwardation in gold for the past few days. I haven’t yet done these exact same charts in silver but my data indicates we’ll get a similar result. Finally, I used the February COMEX gold contract because I found it impossible to construct chart overlays using December due to trading volume in the delivery-month contract being too inconsistent. That’s yet another reason to not hold our breaths as we await final delivery notice and warehouse figures for December.

[Click following charts to enlarge.]

Although gold and silver prices are sluggish, the declining volatility could in fact be an encouraging sign that the bloodletting is nearly over. Then there is this: Yellow expected as a bright spot for 2009. Mass psychology works in strange ways and I wouldn’t be a bit surprised to see that one of the reasons why “yellow” is turning out to be a favorite design, decorating and fashion theme for 2009 is due to some primordial “safety” connection that people have to the hue of the monetary metal of kings.

Not much in the way of new developments today except that, curiously, the very day after I mention that “even the residential real estate sector will be directly Monetized via subsidized mortgage loans to individuals at very low, below-market interest rates” we get a story like Treasury Considers Plan to Stem Home-Price Decline. I hope the wonderful experts at the Treasury and Fed aren’t getting their ideas by reading blogs!

We did get another small decline in the silver holdings of the Barclays ETF, SLV, today. The total holdings are down under 214 million ounces, which is a decrease of about 7 million ounces from the 220+ million ounce level in October. All in all, this is not a significant decrease at all but does speak to the possibility that the majority of those who were in a rush to buy silver in the past few months have now gotten their fill. Indeed, we are starting to see an increase in inventory at bullion dealers. For example. www.tulving.com has brand new Johnson Matthey 100 oz. silver bars in stock for $1.99 over spot, which is about the best deal we’ve seen in quite a while especially considering spot silver is trading under $10. If you’ve patiently waited to dole some funds into physical gold and silver over a period of time as I’ve recommended in the past, this might not be a bad place for a little bit of doling.

Following up on the commodity sector in general, the annualized contango in the 3-month spread in crude oil futures increased to as much as 36% today. By my calculation, it is possible that the contango could exceed 50% were crude to test the $40 level, which could mark the bottom of the price collapse.

My absence over the past two weeks can be blamed on a combination of being extremely busy catching up with “stuff” and major technical problems with both my internet connection and email. Fortunately, the technical problems seem to be on the cusp of being resolved at this point so I will try to go back to posting and answering emails effective immediately. If you sent an email in the past few days or weeks, I will hopefully be able to get back to you in the next day or two. If you haven’t received a reply by the end of this week, please assume I did not receive your email. So if the matter is important or urgent, please send me another email.

Also, I hope to shortly post the last day of the GSUL session for “remote” and Founding Member attendees.

Okay, now let’s get to the silver and gold markets. Truth be told, very little of new substance has occurred in the past two weeks. The PM markets seem to be stuck in “washing machine” mode with a lot of churning, twisting, turning and spinning but not much in the form of directional movement lately. Both the silver and gold charts continue to show a downtrend with no clear bottom, but gold’s repeated refusal to stay below $730 along with silver’s affinity for $10 are signs that a “stealth” bottoming process may in fact be in play.

On November 13, I mentioned the possibility of an incipient price move that I felt could play out before December COMEX option expiration. That move obviously came one day too late (the day after option expiration) and didn’t amount to anything of major significance (yet) whereas the intervening period prior to option expiration was among the least volatile of the past few months. This price action provided early warning that the much-anticipated COMEX deliveries for December gold and silver would be nowhere near the market busting spectacle that many have been predicting. Indeed the deliveries to date have been unremarkable. There are, however, still a significant number of December contracts outstanding, especially in gold, which could presumably be held for delivery. Thus it is too early to pass final judgment on the strength of December deliveries but it should now be abundantly clear to everyone (as it has always been to me) that no run on COMEX gold and silver warehouse stocks is going to take place this December, or any other December for that matter.

While most fundamental indicators of the gold and silver markets are tepid at the moment, it is important to keep an eye on the gold and silver basis as it hovers near backwardation for both. At the same time, we should be prepared to recognize the possibility that a major component of the shrinking contango may turn out to be not the result of an unusually high level of spot demand but rather an unusually low level of forward and futures demand. Indeed, the open interest for COMEX silver futures is now around a paltry 85,000 contracts, down from almost 190,000 contracts in February 2008. The current level of open interest has not been seen since late 2004 when silver was trading under $7. In COMEX gold, the COMEX open interest for gold futures is about 275,000 contracts, down from around 500,000 contracts in July 2008. The last time the open interest in gold futures was this low, it was 2005 and gold was trading under $500.

This represents an extreme reversal in speculative interest in gold and silver! Obviously, this decline in futures open interest has been a major factor in the price weakness, but given how much “hot money” has left the monetary metals, it is actually very encouraging that the price decline has not been even more severe (especially in the case of gold). Furthermore, the decline in speculative interest is a very positive development in terms of market structure.

But there is more. The price of gold has declined by about 25% from peak while open interest fell almost 50%. Meanwhile, the price of silver has declined by about 60% from peak while open interest decreased by well over 50%. By contrast, crude oil has now declined in price by almost 70% from its peak with futures open interest being down less than 30%. We see figures for many other commodities that are comparable to oil — a moderate decline in futures open interest along with a collapse in price. Clearly, there is something different happening with commodities in general as compared to gold and silver. The most obvious indication of this is that the monetary metals are nearing backwardation whereas crude oil and many other commodities are headed in the other direction. Why is this the case? I believe it has to do with the relative levels of physical supply and demand: in gold and silver, demand has remained strong and supply has been relatively static; in many commodities, demand has fallen off while secondary supplies (excess inventories) have entered the market.

Please keep in mind, the basis in gold and silver have been shrinking for just a little over two months and this occurred after both metals had essentially reached their lows for the current move. At the time (late September), many commodities like crude oil and copper were still relatively strong (oil was still over $100). In retrospect, the late September period marked the positive divergence of monetary metals from the commodity sector. In other words, this period represented the start of gold and silver outperforming other hard assets. Unfortunately, between July and late September, gold and especially silver underperformed.

Personally speaking, I plan to keep this episode in mind for the future. This is now the second straight major commodities bull market where a midterm pullback was led by silver, then followed by gold with other commodities bringing up the rear: in particular, silver peaked in early 1974 and had already hit bottom before many commodities, including corn and crude oil, reached their mid-70’s peaks.

Speaking of crude oil, the annualized contango for outer 3-month spreads (e.g., the June and September 2009 contracts) is now over 20%. As I noted in a late October posting, when contango for the major commodities starts to approach historic levels, we should expect that the commodity sector as a whole is approaching a bottom. For the reason why, please see the posting. In any case, the contango in crude oil was around 50% during the summer of 2001, which was a historic extreme. No, the current 20% contango is not very close, but it has increased from under 10% in late October. Moreover, the nearest 3-month contango (January and April 2009) is now over 30%. I think the remaining gap could easily close without much more of a decline in oil prices and therefore we could actually be closer to a bottom in commodities than most people realize. The bottom, however, is unlikely to form a sharp V barring some major market-shaking event like Iran announcing that it has a working nuke.

Practically the only market that has made a substantial move on a net basis during the past several weeks has been U.S. government bonds, which have rallied spectacularly. There are a number of complicated explanations as to why bond interest rates are falling but there is a single, simple reason that should suffice for most intents and purposes: demand for bonds currently exceeds supply. This is quite an incredible phenomenon if you think about it — fiat dollars and dollar-denominated government bonds being in high demand while the system underlying them is apparently on the verge of collapse — but entirely consistent with the widespread (and therefore wrong, in my opinion at least) deflationary expectations. And not really that surprising in the end. Indeed, duing the past few months I’ve warned quite a few readers away from investing in bearish bond funds precisely because the deflationary expectations that have been driving yields lower don’t tend to vanish very quickly. Yes, there will come a time when China and other exporting nations will no longer underwrite our national debt (primarily because they will not be able to afford it). And while that could mark a final bottom in interest rates, it is important to keep in mind that the Federal Reserve can buy an unlimited quantity of U.S. Treasury securities by simply printing money, helicopter-style. 

For now, what’s relevant is that the Federal Reserve and U.S. Treasury are still trying to figure out incremental methods to re-inflate the monetary system without any sign of success. The FDIC and other government agencies are also increasingly getting into the act lately but to no avail so far. No doubt yesterday’s unsurprising announcement that the current recession officially began in the fourth quarter of 2007 will lead to an orders-of-magnitude increase in the rescue efforts. For now, however, they continue to be nothing more than death by a thousand paper cuts despite a fancy new name — “Quantitative Easing” or “QE”.

QE is the term dejour for central bank attempts to inject liquidity when short-term interest rates have effectively reached zero percent. I’m not a big fan of this phrase “QE”. For one, it doesn’t precisely describe what the Federal Reserve and U.S. Treasury have been doing for the past three or so months and what they will be doing for the foreseeable future. For two, QE describes classically how the Bank of Japan tried to solve its deflation problem and clearly that approach has not worked. Bernanke knows this as evidenced by his famous and tragically myopic speech in which he proclaimed deflation in the U.S. was all but impossible in part because: “But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.” Remarkably, that’s about the only thing he seems to have got right in the whole speech.

A better description for the recent Fed and U.S. Treasury actions is “Monetization”, which is the government’s buying — using fiat money — of assets held by the private sector. While QE encompasses all methods of injecting net liquidity into the system while interest rates have reached the “zero boundary”, including sterilized injections, Monetization (in my book at least) refers very specifically to only those actions where the government and/or central bank increases money supply by purchasing assets from the private sector. True, the Monetization so far has been primarily of banking assets (through TAF, TARP, Citibank bailout, etc.) but clearly the effort will have to be expanded given the fact that banks are not willing to lend newly-acquired reserves as long as survival is deemed paramount in comparison to profits.

As soon as survival of the banking system is sufficiently assured by government (it is not yet but will be sooner than later), bank asset Monetization should start to percolate into the financial system. But until then, the Fed and U.S. Treasury will be forced to increasingly Monetize non-banking assets (new Freddie Mac and Fannie Mae mortgage loans, AIG, money markets, commercial paper). Before it’s all over, it is very possible that much of corporate America will be Monetized as well (the proposed “bailout” of the U.S. auto industry is probably the first of many future examples). Perhaps even the residential real estate sector will be directly Monetized via subsidized mortgage loans to individuals at very low, below-market interest rates.

At this point, it appears that the Fed believes the banking system has for now received sufficient liquidity to meet near-term lending and reserve requirements because in the latest Factors Affecting Reserve Balances report, there was a net decrease in “Monetization”, or banking sector “Quantitative Easing” if you prefer. Week after week, the Fed has been injecting $50 to $100 billion in additional reserves and now it appears they will wait and see what happens with the banks while the policy makers practice their “monetary magic” outside the banking sector.

Well, as far as the banks go, the incipient movement in money supply aggregates I noted a couple of weeks ago has not translated into a sustained trend and therefore we should not expect a monetary tsunami immediately. In fact, most monetary measures continue to remain stable or even decreasing slightly despite the massive liquidity injections that have taken place. In helicopter parlance, the dropped money is still caught in the updraft of the helicopter rotor and has not (yet) fluttered to the ground.

I could be wrong but I am getting the sense from the latest Federal Reserve statistical releases that we are now seeing some unsticking in the financial system. It is subtle and too early to represent a trend but it is the first sign in several months. Combined with a decline in the silver basis in the past few days to match the decline in the gold basis over the past two months, we could be on the edge of a monetary slippery slope that takes everyone by surprise (think opposite of deflation, even if just in the short term). Indeed, the basis in silver fell almost to zero earlier this week and remains on the verge of backwardation. Is this just anticipation of the G-20 “Global Meltdown” Summit to take place this weekend or something else?  There’s a bit less than 72 hours to contemplate the possibilities. Personally speaking, I’ll be doing more than just contemplating — I’ll be looking at some December 2008 COMEX call options in silver and gold.