For the first time in many months, there is a hint of backwardation in the physical gold market. It means that demand is rising, dear reader, possibly a trend change. It means that holding physical gold may now be slightly preferred to holding U.S. dollars.
Here’s how it works. The usual state of affairs for gold is called contango. If you buy gold now in the spot market and you can sell the same amount in the futures market and make a small profit, gold is in contango. This is also referred to as a positive basis. Contango means that physical gold is in good supply so it is easy to buy. It also means that the buyer of gold expects to get a higher price in the future to offset the cost of temporarily giving up the dollars used for the purchase. The implication is that dollars are in greater demand than gold.
The opposite of contango is backwardation. In backwardation, you make a small profit by selling gold now in the spot market and buying it back at a lower price in the futures market. Backwardation means that physical gold is not in good supply; the market is willing to pay up for current delivery. This is referred to as a positive co-basis. The implication is that holding gold is preferable to holding dollars. It may suggest that buyers see a risk in future delivery and want the metal now. So backwardation is obviously bullish for the gold price, especially if it continues as the price rises.
The current level of backwardation is minor in the near term (February) gold contract and it is probably temporary. However, the rising price of gold has not made gold more available because the backwardation has persisted. This tells us something. Some investors are switching their preference to gold, in spite of the higher yield on dollars now available in the market. This preference, unlike speculators buying futures with leverage, is not about betting on price. It is about choosing safety. Gold, unlike a bond, does not default. However, buying gold for safety is precisely the reason why the price will go up because investors will pay just about anything for safety.
The Institute for International Finance estimates that financial assets globally now stand at approximately $290 trillion compared to roughly $2.5 trillion is physical gold available to the market in transactable form. The Institute estimates that global debt is at $217 trillion, up $11 trillion during the first nine months of 2016. These are the assets that could compete for ownership of the world’s only asset that cannot default, the only asset that backs itself. What do you think will happen to the gold price in the next financial crisis when the market figures this out?