Futures Markets Signal Gold Ready to Erupt

August 9, 2013
by Peter Schiff
of Euro Pacific Capital
With gold recouping some losses in its most recent trading sessions, many are asking whether or not
the bottom has finally formed for the yellow metal. Most of these gains have been simply chalked up to
short-covering and dovish remarks by Bernanke during the recent Federal Open Market Committee
meetings; however, there are some key indicators for gold which are overshadowed by the media
hubbub. Two of them in particular are important to understand, because they reveal a renewed
investment demand for physical gold over paper gold or fiat currencies.
Gold Backwardation
The first indicator to note is called "gold backwardation," which occurs "when the price of a futures
contract is lower than the price in the spot market."1This means that traders are willing to pay more for
gold that is available for delivery today, rather than lock in a futures contract at a discount for gold that
is delivered months later.
Taking this one step further, if gold stays in backwardation for some time, it means that no one is
taking advantage of a risk-free arbitrage opportunity by simultaneously selling physical gold at spot and
buying a futures contract. In such a scenario, traders can keep not only the spread between the spot
rate and the futures rate, but also their original position in gold. This is known as "de-carrying gold."
Now, if enough traders were to take advantage of this risk-free profit, gold would be pushed out of
backwardation into its normal trading state (i.e., "contango," when the price of a futures contract is
higher than the physical spot price). The fact that this is not occurring, and that gold remains in
backwardation, implies that gold is more and more decoupling from the dollar - a trend that, if
continued, could raise the dollar price of gold and other assets significantly.1
Backwardation is quite common in other commodities like crude oil or copper, but in gold and even
silver it should be exceedingly rare. Why? Because unlike the aforementioned commodities, the aboveground inventories of precious metals are mostly not consumed - they simply trade hands. Therefore, a
sudden shortage of gold is not likely - it gains value by staying stable while currencies depreciate.
Nonetheless, when gold does go into backwardation, it signals that there is not enough gold for sale to
meet market demand. In other words, gold becomes "scarce."
This is precisely what is happening with gold now, and has been happening intermittently since 2008.
Yet more recently, gold has been going further into backwardation (deeper spreads) and staying there
longer (longer contract times).
GOFO Rate

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The second important indicator of the demand for gold is a negative Gold Offered Forward, or "GOFO,"
rate.
"GOFO is calculated by subtracting the gold lease rate from the London Interbank Offered Rate
[LIBOR], the average rate banks charge each other for loans. Note that normally, given the positive
GOFO rate, people will employ gold to get their hands on dollars. In other words, gold is normally used
as collateral to secure a dollar loan with interest."2
But what happens when the rate goes negative? A negative GOFO rate means that traders would
rather give up dollars in order to secure gold bullion immediately and are willing to pay an interest rate
to do so. Similar to gold backwardation, a negative GOFO rate signals that the demand for gold is
overwhelming the available supply.
A Replay of 2008
So what's the big deal? Why are these somewhat obscure signs so important? There are at least two
reasons you should pay attention.
First, there is history. The last time we saw gold in backwardation and a negative GOFO rate was in
2008, right before gold went into its largest and longest rally - setting record highs.
Keep in mind that the broader macro-economic factors that were instrumental in the financial crisis of
2008 (bailouts, aggressive bond-buying programs, and suppressed interest rates) have not dissipated
at all, but rather increased. The Fed has maintained a relentless inflationary program since 2008 (QEI,
II, III, and so on). This strongly indicates that what lies ahead for gold could potentially dwarf its post2008 rally.
Second, the negative GOFO rate and backwardation of gold are important because they represent a
clear measure of the demand for gold. They report to us without bias that the demand for gold is
growing while the readily available supply is shrinking. What's more, they show a simultaneous decline
in the demand to hold US dollars in favor of gold. This is perhaps the most striking takeaway from
these indicators.
Ben Bernanke recently admitted that he doesn't understand gold. Peter Schiff likened this to a miner
not understanding the role of the canary - an early warning indicator for dangerous gas leaks. Gold
backwardation and a negative GOFO rate paint a picture as clear as a dead canary - investors are
taking physical gold much more seriously.
1. Source: Keith Weiner, CEO of Monetary Metals, www.monetary-metals.com
2. Source: Peter Tenebrarum ,"Gold slips into Backwardation," www.acting-man.com/?p=24578
Dickson Buchanan is a Precious Metals Specialist at Euro Pacific Precious Metals. He received his MA
in Austrian Economics from King Juan Carlos University in Madrid, Spain, and is currently enrolled in
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the doctorate program. Dickson joined the Euro Pacific Precious Metals team in 2012 after returning
from his economic studies abroad.
This article first appeared in the August 2013 edition of Peter Schiff's Gold Letter, a monthly newsletter
featuring original contributions from Peter Schiff, Casey Research, and other leading experts in the
gold market. Click here for your free monthly subscription. To learn more about Peter Schiff's gold &
silver dealer, visit www.europacmetals.com.
Euro Pacific Capital
http://www.europacmetals.com/

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