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Backwardation in a down market! Gold and silver are poised to go much higher

Gijsbert Groenewegen
Posted Mar 23, 2013

What is the significance of backwardation in a down market?

We are witnessing backwardation (spot price higher than future price) in a down market, which is unusual! Why? Because backwardation normally only occurs when prices are rising and there is such strong demand and such limited supply that the prices for spot are higher than the future prices, which include interest and storage costs. Backwardation especially happens just before the harvest of agricultural (consumable) commodities when there is a lot of demand and no supply yet and when a situation of scarcity exists. The situation is different for precious metals because there is no scarcity of above ground gold and silver inventories. The main reason for backwardation in the case of precious metals is that the supply is extremely scarce because holders of gold and silver don’t want to dispose of their physical gold and silver, not because there isn’t enough gold or silver, but because the gold and silver investors don’t know if they will be able to get the physical back in the future if they sell it spot, now.

Investors don’t trust giving up their physical gold in exchange for a paper delivery in the future, in sixty or ninety days. In other words they don’t trust a paper delivery, that gold will be available for delivery in the future, investors believe there is increased counter party risk (paper risk) following increased uncertainty in the markets. In other words it is paper versus physical.

The Fed has a vested interest in suppressing gold and silver prices

The fact that gold and silver holders don’t want to separate from their physical in a down market is in my point of view even a stronger signal that a strong rise in prices can’t be too far off. I believe it could be explained basically as a signal that the paper market (facilitating government and bank manipulation) wants to put downward pressure on the gold and silver prices whilst the physical market (real demand) states loud and clear that they don’t want to sell! It is a stand off between the paper market (government and banks (Fed)) and the physical market (real investors). The ratio paper versus physical gold is estimated to be 100:1. It is easy to create a piece of paper that creates an obligation with a certain quantity of gold as the object though the physical delivery of the gold is a totally different story. Most future contracts are settled in cash and not the physical though when too many parties would start asking for physical delivery the Comex still has the power to call it “force majeure” and impose a cash settlement.

The Fed wants to suppress the gold and silver prices despite the ongoing QEs causing the debasement of the currencies and foremost the debasement of the reserve currency, the US dollar, which has an inverse relationship with gold! The reason for the suppression is that strongly higher gold and silver prices would be a red flag to the improving stock markets indicating that there is something sincerely wrong in the markets. The whole consumer confidence building, healing exercise would be destroyed and thus the monetary authorities in the US have a strong incentive in keeping the gold and silver prices from rising too quickly and too strongly. Though one should understand that ultimately the physical will always win it from the paper, if investors can’t put their hands on the physical and the paper markets tries to suppress the price what is that telling you? Only one thing: I need to buy physical gold! The proof is in the pudding.

When is the collapse imminent?

Anyway it is clear that we are witnessing a tremendous false expansion of credit, which is created out of thin air, and which will collapse ultimately. So what could be the signal that the collapse would be imminent? In my point of view this will be the case when the backwardation will increase and gold will not come to the market despite even higher prices. The moment investors don’t want to sell their physical gold for US dollars, doesn’t matter what amount, the US dollar will have lost its value.

In the quest for safe havens gold and the US dollar could rise in tandem

Though for the moment it looks like the US dollar is strengthening. In fact I believe we are at crossroads in the markets with the US dollar breaking out on the upside, upward pressure and a most likely break out of the interest rates and a still relatively very low Vix index, clearly indicating huge complacency about the state of the markets that show a 85% correlation between the equity markets and the size of the Fed’s balance sheet!

As a friend of mine rightfully observed the precious metals have lately behaved actually very well considering the rising US dollar index (USD) from 79 on February 1, 2013 to 82.75 on March 21, 2013 a 5% rise. Gold fell from $1,667/oz to $1,615/oz a decline of 3.3%. The US dollar and gold and silver are inversely correlated. They are each other opposite. Only for short periods the precious metal prices and US dollar have moved in tandem although I think that might soon happen again in the quest for safe havens in order to preserve capital.

The Cyprus situation clearly illustrates the need for safe havens

The intricacies and potential consequences of Cyprus situation clearly support the need for real safe havens. The Cyprus situation has put into doubt the sanctity of property rights and the validity of deposit guarantees. Where will the discretionary behavior of monetary authorities and politicians stop? What could happen next weekend? Why would holders of deposits, one of the pillars of the banking system, have to pay for the irresponsible behavior of the bankers that get away with huge bonuses every year because they know that a “healthy’ banking system is a “condition sine qua non” for a healthy economy. Anyway my point is that the quest for real safe havens is more necessary than ever. Gold and silver are obvious safe havens because they have real value of their own and “can’t be manipulated”, better said they can’t be printed. Other safe havens are currencies that “are backed” by large gold reserves or healthy economies, such as the Swiss Franc, the Norwegian Kroner, the Australian Dollar or the Canadian Dollar though these pools are too small too handle the large influx of funds looking for a safe haven. What is left, despite its poor fundamentals, is the US dollar with world’s largest money market with a size of $10trn. Though be aware of having bank accounts, having physical gold or silver in personal possession looks like the safest option. You don’t want to hold your gold in deposit boxes in the banks. Ask the people in Cyprus if they could get their money out of the banks now there is a crisis in Cyprus. Wake up!

The US dollar index likely to break out of downtrend since 2001

As mentioned here above the US dollar has been rising since February this year and when the US dollar index exceeds the 83 level (which it did last week before being pushed down aggressively!?) on the point & figure chart it will break out of its downtrend since 2001 and will most likely show a strong move upwards.

(Click on images to enlarge)

The US dollar actually reached an 83.1 high last week before falling sharply wiping out two weeks of gains. Though the real question now is for how much longer the “manipulators” can keep the US dollar down. On March 21 the US dollar closed at 82.75!

What could be the factors behind a strong rise in the US dollar index

In my point of view there are 5 reasons why the US dollar is rising:

1. The economy is perceived to be really improving. I sincerely dispute this view because I don’t think there is sustainability of economic growth because we have surpassed the tipping point (Debt/GDP in excess of 77%-90%). The IMF estimates that the US economy will expand by 2% in 2013, that Japan will grow 1.2%, the UK 1% and that the Euro-zone will contract by 0.2%. China is forecast to grow by 7.5% in 2013.

The Fed’s $3trn buying program has inflated the markets dramatically. Where would the Dow Jones be if the Fed hadn’t injected $3trn and where would 2% 10y bond yields be? 4%, 6%, 8%! Wall Street might be doing well though Main Street isn’t. Wages are not really rising and the labor force participation rate at 63.5% is at a 20 year low and food stamps are at all time highs. The middle class, the buffer in the economy, is obliterated.

Net household formation, an estimate of the future number of households, was coming off an unusually low level of approximately 400,000 to reach nearly 1 million. Though the main question is if we will see 1.4 million, 1.6 million or 1.8 million? In other words is the improvement in the housing market sustainable? While sales of existing homes were hitting a three-year high there is a lack of natural first time buyers (only 30% of sales) with “unnatural” institutional investors buying up REO for Rental homes from the banks and then re-renting them out or securitizing them, accounting for 25% of sales. Similar to the bond and equity markets the housing market improvement is very artificial.

Anyway lets just assume that the economy is really improving than inflation shouldn’t be far off when the velocity of money (the number of transactions) increases. Especially with the ballooned $3trn Fed balance sheet. This would inevitably lead to much higher interest rates and thus a declining bond market. The so-called “Great Rotation” bares the seeds of its own destruction although very few people want to see this and use the argument that the money has to go somewhere. Next to that with current yearly interest expenditures of $250-300bn one has ask himself what these expenditures of the US government will be when interest rates really start to rise, $500bn? $750bn? $1trn? When you break out of a 32-year downtrend (as off 1981) interest rates are not going to stop at 3% or 3.5% be convinced of that. Every investor will go for the gate!

2. Or is it because the outlook for Europe in 2013, and thus the Euro, is not particularly rosy. Despite the fact that European stocks are approaching a five year peak (probably a result of a continuation of unchanged dividend payments and the suffocating search for yield) dismal conditions at home outweigh growth overseas. Fourth quarter profit for European companies fell 5.2% from a year earlier. And the outlook for the economies for 2013 is not much better with increasing austerity measures and uncertainty of what the future will bring.

3. Investors buy the dollar because the increasing energy self-sufficiency. A stronger dollar in this scenario in my point of view only works when one has a strong underlying economy otherwise prices are likely going to fall below the break even price for a barrel of oil due to strongly reduced economic activity.

4. The flight to a safe haven because investors don’t believe the euforism in stock markets and want to take out a hedge just in case the so called improving fundamentals don’t add up. Especially in the light of the resurging European problems (the US media doesn’t report at all on the massive demonstrations taking place in countries such as Romania, Spain and Portugal) with an emphasis on the Cyprus situation where savers are in danger of being punished with a haircut in order to pay for the bad policies of the bankers (contagion from bad Greek loans) and the lax Government. The proposed haircut would undermine the sanctity of ownership and open the floodgates towards erosion of property rights. Next to that it would completely undermine the deposit guarantee credibility not only for Cyprus but also for the rest of Europe. And as emphasized here above in times of distress investors tend to park their money in the most liquid and largest pool of money, the $10trn US dollar market, n’importe quai the bad fundamentals.

5. Geopolitical developments. Disturbing developments coming out of North Korea. That nation issued fresh threats of a possible nuclear strike against U.S. based in Japan or Guam where the B52s are based. Any escalation in tensions between the U.S. and North Korea could send investors into safe-haven assets like gold or the US dollar. Next to that the Iranian capability of creating a nuclear bomb is getting closer and closer. Obama was quoted saying "We think that it would take over a year or so for Iran to actually develop a nuclear weapon, but obviously, we don't want to cut it too close," he told an Israeli television station. Yes and the Israelis are going to wait a year! Next to that there were also reports that chemical weapons were used in the Syria civil war, which bear the potential for American intervention.

6. Or because interest rates are being forced up in case of another downgrade of US debt following the inability to execute serious measures resolving the structural problems. The USA got away with its first downgrade though I don’t believe that investors will regard a second one as a non-event. The downgrade of sovereign debt worldwide is an ongoing process and is definitely not in its last innings. We are only in the beginning phase with all this “Monopoly” money being thrown around.

Concluding there are ample reasons why the US dollar index is likely to go up.

The gold and silver bull market is definitely not over if anything it is only starting. Central banks are diversifying into gold.

The gold and silver bull market over? If so please tell me when we had the blow off top! Next to that Central banks have begun to reduce reserve portfolio allocations to US dollars and euros in favor of alternative reserve assets. The ‘IMF COFER data’, show that official reserves for all central banks have grown from US$2tn in 2000 to greater than US$12tn in 2012, over a span of only 12 years. An analysis concludes that central banks retain 65% of their reserve assets in dollars and euros and that central banks try to find the most optimal asset mix for the remaining 35%. Assets like Japanese yen, British pounds, and gold have been consistently held by most central banks over the past several decades. Though purely through portfolio optimization analysis the renminbi, gold and Australian dollar assets emerge as the most important for diversification.

A portfolio optimization analysis furthermore concludes that gold, with its lack of credit risk and deep and liquid market, is one of the most attractive alternatives in this diversification process. Accordingly, building gold reserves in tandem with new alternatives is an optimal strategy as these markets need time to develop and allocations to gold remain largely below optimal levels of around 8% of their official reserves. In 2012 Central banks bought more than 500 tons of gold. Especially the Bank of China is aggressively buying gold, through its own hedge funds, to add to their reserves and as a hedge against their $3trn in mainly US dollar denominated forex reserves. They don’t trust the reserve currency, the US dollar, following the inability of the politicians to solve the structural budget and debt problems which signify the final chapter of the aging and less productive baby boomer generation.

In my point of view the break-out of the USD index above the 83 level signifies an anticipation of a false improvement of the US economy but I believe it is more likely a move for a “safe haven”. The US dollar market with its $10trn size is the largest asset class funds can move large amounts in and out off without influencing the price too much. And completely contrarian to what one would expect following a financial crisis in Europe, the US dollar will likely go up for a while despite its very weak fundamentals.

The real benchmark for risk and valuation is no longer interest rates but gold!

The real benchmark of the state of affairs is the gold and silver price. These are the real benchmarks, the constants of valuation and risk and no longer the heavily manipulated interest rates or currencies. The transformation from a paper (US dollar) based system to a gold backed system has been underway since 2001 and the quest for yield is increasingly being replaced by the intensifying need for preservation of capital.

As is illustrated by this gold chart of McHugh’s Market Forecasting & Trading Report, since 2007, every time the stochastic of the gold price fell to approx. the 20 level it was followed by a strong rally.

Time, or should I say events, will tell but I believe soon there will be a crucial inflexion point whereby investors don’t believe the Monopoly money game of the Fed any longer. Hence why we are already witnessing the volumes in the stock market getting lower and lower the closer we get to the peak in the markets. Gravity will ultimately have its way. No height fear, when the S&P 500 trades above the 1600 level? Comfortable? Have a reality check and see the VIX, the “complacency” index, trading at historic lows of between 10-14. When all the conditions are in place only a small event is necessary to trigger the domino effect.

I believe that when the market finally realizes the bankrupt state of the economies, as illustrated again by the problems of a small country like Cyprus, that the US dollar and gold will rise in tandem. Though at one stage the US dollar will drop like a stone, when people realize what kind of dire straits the US economy and finances are in, and that will be the moment that we will see gold and silver going stratospheric! In my point of view gold and silver look very cheap and very attractive and the backwardation can be explained as a clear indication that the monetary authorities are very nervous about gold and silver taking off.


Mar 21, 2013
Gijsbert Groenewegen

Groenewegen Report

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