July 19 (IFR) - A dislocation in the gold futures market indicating that demand for physical delivery of the metal is now far outweighing supply has intensified in recent weeks, increasing concern in the market that the change may not be a momentary blip and participants may have become over-leveraged.
Gold went into backwardation in comparison to the three-month futures contract in early January, meaning the spot price rose above the short-dated future contact. Now that process looks set to creep out the futures curve to longer-dated maturities, signalling some cause for alarm.
“The fact that has remained and widened ... indicates that the physical market has tightened up substantially, a postulation that is corroborated by the growing premiums being paid ... and the ongoing wholesale delays in the delivery of substantial bullion tonnage,” wrote Ned Naylor-Leyland of Cheviot Asset Management in a report this month.
“What is happening now is that the absolutely inevitable ‘run’ on the 100:1 leveraged bullion banking system is truly underway.”
Backwardation is a concern in gold markets because in theory demand for physical delivery should never outweigh supply, since the amount of available gold is a known, fixed quantity. The event is not unprecedented, as it also happened during the financial crisis of 2008 - and corrected itself the following year.
The current dislocation indicates that holders of gold futures have begun demanding delivery. But because of the large amount of leverage in the market, participants are not able to deliver on their obligations.
“More and more people want their gold today, at a higher price, no matter that they can buy a future much cheaper,” said Guillermo Barba, economist at the New Austrian School of Economics in Mexico.
The high demand lately for spot physical delivery has played a part in the yellow metal’s recent rebound from its low of US$1200 per troy ounce at the end of June to US$1283 on July 18. But analysts say it is difficult to determine both the cause of the backwardation and whether it will persist.
“It could be a whole range of factors; a bullion bank may have overcommitted in the physical market, miners have reinitiated hedging programs since the April price dive and have to borrow gold to hedge, and that may have cascaded up the chain of physical demand,” said Robin Bhar, commodities strategist at Societe Generale.
“With the gold market you don’t find out the reasoning or explanation for an event until days, weeks, or even months after the event. What’s strange here is that a time of seasonal demand weakness we have strong physical demand and backwardation.”
The lack of data and understanding highlights the market’s tenuous grasp on gold prices, a fact that was reinforced by Federal Reserve Chairman Ben Bernanke’s response to a question regarding the metal’s confusing price fluctuations on Wednesday.
“Nobody understands gold prices, and I don’t really pretend to understand them either,” he said.
Usually the price of gold is seen as a measure of confidence in central banks’ ability to keep inflation under control, but some believe the shape of the futures curve has now become a more important barometer of market sentiment.
“The actual message of the backwardation is that there is behind the curtains a lack of confidence in the fiat monetary system, a de facto rejection of paper money by some people who prefer the real money (gold and silver),” said Barba.
“That’s why a fall or rise in gold prices is not so relevant anymore. The monetary ‘fire alarm’ message, courtesy of the relationship between spot and futures prices, is: run for your gold, there is not enough for all.”
Some believe the current dislocation is only a blip, as in 2009. After all, only the spot versus three-month futures relationship is currently in backwardation, as opposed to spot compared to longer-dated futures contracts.
But since January, the short end of the curve has gone into backwardation increasingly earlier and earlier, indicating the trend may soon start to move further out the curve.
The April 2013 futures contract went into backwardation 30 trading days before April 1, while the June contract went into backwardation 42 trading days before June 1. The August contract turned over 55 days before August 1, and the October contract flipped on July 8, 61 trading days before October 1.
Over the short term, some expect backwardation will spark a squeeze on paper investors in the gold market as the physical demand will force traders looking to cover short positions to bid up the spot price in an effort to shore up inventories.
“The bullion banks want to get gold back into contango and stop the movement of the remaining inventories by shaking the market lower, using paper leverage to do so,” wrote Naylor-Leyland.
“It hasn’t worked, indeed more and more investors are now seeking allocation, delivery and physical metal at the expense of synthetic products offered by the banks. The squeeze we have been waiting for is closing in, it is always darkest just before dawn.”
A version of this story will appear in the July 20 issue of IFR Magazine