Is Gold Backwardation Now Permanent?
By Keith Weiner, Casey Research
The global financial landscape has seen an unprecedented surge in debt since President Nixon’s 1971 decision to abandon the gold standard. This watershed moment cut the ties between the dollar and gold, leading to a world where debt flourished unchecked. Today, this vast mountain of debt is intertwined, with one party’s liability often becoming another’s asset, creating a precarious situation ripe for defaults. As this cycle unfolds, it threatens the stability of the banking system and the value of paper currencies. Signs of this impending crisis are already visible in Europe, and while it might be overdue in Japan, it is likely to affect the USA soon. This article aims to provide insight into the early-warning signals of this complex monetary system and the pivotal role of gold.
Defining Backwardation
To grasp the unfolding financial narrative, it’s crucial to understand the concept of “backwardation.” Traders typically define backwardation in commodities as a situation where the price of futures contracts is lower than the current spot price of the same goods.
In markets, there are two primary prices: the bid and the ask. Selling a commodity requires accepting the bid, whereas buying necessitates paying the ask. In a backwardation scenario, one can sell a physical commodity for cash while simultaneously purchasing a futures contract, allowing for an arbitrage profit. Notably, this trade does not alter one’s overall position; one simply ends up with the same quantity of the commodity upon maturity of the contract.
In essence, backwardation occurs when the spot market’s bid exceeds the futures market’s ask.
Many commodities, like wheat, experience seasonal variations in production, whereas consumption is steadier throughout the year. Consequently, just before a harvest, the spot price of wheat usually spikes due to dwindling inventories. Buyers are willing to pay a premium for immediate delivery, while the anticipation of an upcoming harvest leads to lower future prices. This exemplifies backwardation.
Typically, backwardation signifies a shortage of commodities. For those holding the physical asset, it presents an opportunity for risk-free profit through delivery and later repurchase. As more traders pursue this arbitrage strategy, the differential between spot and futures prices diminishes, eventually eliminating backwardation. However, such actionable backwardations usually last only briefly, making them hard to capitalize on. In the case of wheat, while backwardation might linger for weeks, a genuine shortage restricts any potential for profit.
Why Gold Backwardation Is Important
Can backwardation occur with gold? Currently, there is no shortage of gold, which can be gauged by measuring inventories against annual mine production—estimated at a staggering 80 years by the World Gold Council.
In contrast, most other commodities (excluding silver) typically maintain inventories that represent only a few months’ production. These commodities can experience “gluts,” often leading to dramatic price declines. This stability in gold prices, regardless of production increases, makes it a reliable form of currency.
If the future price of gold drops below the spot price, it indicates a scarcity of trust in the delivery process of gold.
In conventional commodities, scarcity for immediate delivery is typically alleviated through higher prices. Ultimately, elevated prices reduce demand until supply meets the adjusted need. But how does one address a shortage of trust?
Historically, the answer has been through rising prices. Elevated prices can encourage the release of gold stored in various forms, including jewelry. For instance, in December 2008, gold entered backwardation for the first time, allowing for a 2.5% annualized arbitrage profit by trading gold for futures. At that time, gold’s price surged from $750 to $920 by the end of January.
However, should backwardation become permanent, it would signal a total collapse of trust in the gold futures market. Unlike commodities like wheat, which have limited owners in the spot market, countless individuals and institutions retain substantial gold reserves. If they cease selling, it marks a critical juncture for the entire financial framework.
Higher Prices Can’t Cure Permanent Gold Backwardation
For ordinary commodities, there’s a cap on what consumers will pay, dictated by the commodity’s utility and the availability of alternatives, as well as other financial obligations within a budget. Higher prices motivate sellers to enter the market while simultaneously discouraging buyers. Thus, the remedy for soaring costs is simply more high prices.
Gold, however, defies this logic. Unlike consumables such as wheat, gold is not purchased for its use but as a store of value. Although some hold it for speculative gains in its paper price, these speculative buyers can always be replaced by individuals valuing it as money.
Once gold holders lose faith in the financial system, no price adjustment can resurrect confidence in paper currencies. There will never be a price for gold that makes buying unattractive or selling appealing. Consequently, backwardation could not only reoccur but may also solidify in a permanent state.
In critical times, the bid tends to disappear while asks remain plentiful. Permanent gold backwardation can be perceived as the fading bids for gold in exchange for irredeemable government debt (e.g., dollars).
While backwardation should theoretically be impossible due to gold’s abundance, its recurrence suggests it may soon become a permanent fixture. The gradual erosion of trust in paper money is irreversible (with fluctuations along the way), leading to a deepening backwardation while gold’s dollar value rises—likely at an accelerating rate.
The ultimate outcome will be a complete withdrawal of gold’s bid, making the demand for paper boundless. It’s clear that without gold, the entire paper money system is destined to fail.
Conclusion
The emergence of permanent gold backwardation and the subsequent withdrawal of gold bids on the dollar mark the culmination of a debt crisis. Governments and borrowers have long exceeded their capacity to repay debts, resorting to simply rolling them over. This leaves them at the mercy of market demand for their bonds. If an auction fails to attract bidders, the game is over. Regardless of formal defaults or monetary inflation, the outcome remains the same.
Gold owners, like all others, will witness this collapse. If government bondholders react by liquidating their securities in the face of the crisis, they will only obtain paper currencies backed by the same faltering government. In contrast, gold holders possess the autonomy to sever ties with paper entirely. When this shift occurs, an irreparable divide will form between gold and currency, favoring tangible goods and services aligned with gold. Thus, within a few short months of initiating this process, paper money may swiftly lose all value.
Gold may not be the officially recognized backbone of our financial system, yet it remains an essential element. Its removal will precipitate the collapse of the global framework of unbacked paper currency.
Sincerely,
Keith Weiner
for Economic Prism
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