September 1, 2009 - You often mention backwardation. What is it, and why is it important?

James Turk replies: Backwardation occurs when a future price of gold is less than the spot price.  To explain why it’s important, you have to look at dynamics of the spot price of gold, which is the interaction of all gold trading, paper and physical. 

There are professional traders who do nothing but arbitrage these two markets – paper gold and physical gold.  For example, if the price on the Comex is out of line with the physical market, a bullion bank may sell the overpriced market and buy the underpriced one to earn the spread.  It's a lot more complicated than that because of the various costs involved, but that is the basic principle.

Here’s the significance of backwardation.  The current spot price is an accurate record of the real spot price of physical gold as long as people are willing to exchange currency for gold at that price, which is why backwardation is so important.  If gold goes into backwardation - which is rare, but it happens - then the physical price is diverging from the paper price.  No one is willing to arbitrage.  The reason is that they are worried about two possible events.

One is default, i.e., someone won't make good on their paper promise to deliver.  The other is debasement, i.e., the government takes some action to make the currency less valuable relative to gold.  So rather than selling their physical metal today and holding currency until someone delivers gold back to them in the future at a lower price - enabling them make a profit from the arbitrage - the holders of physical metal choose not to sell.  They are willing to give up a profit to keep their bullion safe, rather than exchange it for a national currency and the risks of default or debasement.

It can be difficult to determine during the trading day whether gold is in backwardation.  Various intraday prices posted on the Comex do not necessarily reflect the spreads (the difference between spot and the future price of different futures contracts), and the spreads are essential to know whether or not there is backwardation.  Single contracts can trade at disparate prices during the day and be out of whack with each other relative to the spreads.  Only settlement prices at the end of the day captures the accurate spreads. 

Settlement prices are important for margin purposes, so the exchange is careful to make sure they are accurate.  Therefore, if during the day you want to determine whether there is backwardation, you need to ask a floorbroker for the spread between the months you are interested.

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