I mentioned earlier that I wanted to revisit the current GOFO rate situation and also the huge anomaly which occurred on the COMEX not once, but two days in a row to end last week. I have written several times regarding “GOFO” which is the lease rate for London gold. The last time I did this was back in May of this year, rather than writing another explanation I will copy and paste what was written then. I will comment further after the May missive below:
COMEX backwardation and inverted GOFO rates should never ever happen in a normal world for any reason ever, but they have. Why or how could this happen? First let me explain “what” has happened, later I will explain “why.”
GOFO rates had gone negative for 29 of the last 30 days before turning positive for the last two. GOFO stands for “gold forward” rates. In other words, when gold gets leased out there is interest paid by the borrower and received by the owner. When these rates go negative it means that there is more interest payable (higher rates) to the holder of gold than to the holder of dollars. You can look at this from several vantage points. First and most obvious is that gold “supply” may be tight, in other words there may be difficulty in sourcing gold. From another perspective, it can be viewed as too many are trying to exchange dollars into gold or that interest rates on dollars are too low (or could be too high for gold?).
The thing is this, you have always heard the saying, “but gold doesn’t pay any interest or dividends” which is true… unless you are willing to lend it out for interest. The easy way to understand this is that there are simply not enough lenders willing to lend their gold out into the market place which is another way of saying that supply is tight. The risk to the borrower is that they might have to deliver higher priced gold while the risk to the lender is that they may never see their gold again.
OK, now let’s look at the COMEX and the futures market. Since you can lend gold out and receive interest for it, it then follows that “gold in hand” could (should) be worth more say six months down the line because it can be lent out and returned with an added 6 months interest attached to it. This is why “futures” prices are almost always above the spot price for gold and silver. This should ALWAYS be no matter what …because they are “money” that are not subject to droughts, floods or whatever that can affect the supply greatly. This is the case EXCEPT for couple of “mega sigma” events happening. In one instance, it is possible that traders become fearful that they will not get delivered their contracted gold in the future which would make “gold in hand” worth more to them than the promise of future gold. They may be fearful because they feel that the current supply is tight and are not sure that future supply will arrive or they may even be fearful that a system wide crash or default will occur before their contracted delivery which might leave them high and dry. The big point here is that “gold in hand” can never ever be worth more than gold in the future (IF you know for sure that it will be delivered) because you can earn interest on it.
I have gone back and forth with several theorists as to whether or not we have already seen backwardation or not. To their credit, we have not seen it yet in the out months but they are very flat. So “flat” that we are only talking .50 cents or less for 6 months out. But, here is where it gets interesting. I spoke with a Chicago floor trader this morning who told me that he has actually executed 3 separate “back warded” gold trades since last June. Normally for example you would buy a June contract and sell in August for a $1 credit, thus buying today and selling later at a $1 profit. On 3 separate occasions, this trader tells me that the spot month has gone to a premium over the future month in the delivery process. This past February it went as high as a $3.50 premium.
So how could this possibly be? How could gold have gone to any premium at all? How or why could it ever be worth more today than in the future? Does the old “bird in the hand versus two in the bush” come to mind here? The only way that the delivery month (for gold because it is money rather than a commodity) can trade at a premium is if it gets bid up in price or the future month sold down in price, one or the other and as simple as that. The delivery month will only get bid to a premium if enough buyers either question the available current supply to deliver or question the availability of future delivery. There can be no other reason than this, does or will the supply exist for delivery? Yes I know, it will be said that “short sellers” may have gotten spooked and bid the spot month to cover a position but why would you do this if supply was not a question and could “buy” your gold in a future month for less if you were 100% sure that you were going to get it?
The above was written after GOFO rates had finally turned positive after a negative run of 29 out of 30 days. As I wrote then, this should never ever happen for even a single day unless one of two conditions are present. 1. Gold may be very difficult to source and borrowers of gold have a difficult time finding the metal to lease or 2. Owners of gold begin to refuse to lend because they fear not receiving their gold back in the future. This is very simplified but the bottom line is that a negative lease rate shows “tightness” in the physical market either because too many want to borrow gold or too few are willing to lend it.
Fast forward to this past week and we see the GOFO rates more negative than any time since 2001! Too many searching for metal? Too few willing to lend? I don’t have the answer to this but I do know the lease rates are far more difficult to “fudge” than is “price.” What do I mean by this? “Price” can and is suppressed by the sale of more futures than there is real supply. The perceived supply is simply “watered down” by posting margin and selling “gold” which does not exist. Lease rates on the other hand involve actual and real weights of metal. This “real metal” cannot be faked or substituted by the financial machinations of posted margin. I am sure someone will point out the concept of “re hypothecation” which certainly does exist and very well may be a reason for the tightness …the “chain” may have grown too long? This is a topic for another day.
OK, so the GOFO rates are now more negative than any time in the last 13 years, we saw something else on Thursday and Friday which may also be connected. As of Thursday, there were only 33 Nov. Gold contracts still open and awaiting the delivery process. Scotia was served 920 contracts Thursday and another 462 on Friday. Please understand this was done “interbank” between Scotia by and large as the stopper, and JP Morgan the issuer. We are talking about 138,200 ounces of gold of which delivery is being demanded …NOW! We don’t know if it is Scotia who has a desperate need for the metal or one of their clients but we do know it is someone, otherwise these transactions would not have occurred.
We also know this “need” for gold has been done in a public fashion. Do you see where I am headed here? Why would Scotia do this in a fashion where the COMEX has to report it? Why not source it from the LBMA? Why not buy shares in GLD and then withdraw the metal? Why not go to a refiner or a producer privately as a source? Why do this in a public manner where “conspiratorial knuckleheads” like us can see it? Could they have done this elsewhere? Or couldn’t they? As I mentioned before, this has only happened a handful of times that I can remember in the last 20 years but now happened two days in a row, back to back! Also, whenever this did happen, it was generally during a large delivery month rather than an off month like November …and with much smaller amounts of gold. This is highly unusual to say the least. (After scratching my head a little, I can only guess that this came about as a settlement to some sort of OTC derivative trigger?)
This of course leads me to a question that a 3rd grader might ask, “Daddy, if the price of gold went down because so much of it was sold then why isn’t it available?” I would ask where did it all go? Why are there ANY signs of stress or tightness when theoretically you should be able to just walk the streets and pick it up like placer gold? What happened to the 40 tons of gold that was sold a week and a half back at 12:30 in the morning? Or was this just “paper?” Of course if you were German you might ask why you could only get 5 tons last year and if you might get a little more this year since it’s so “plentiful”? Oh, I forgot, this is now considered called a “diplomatic snafu” and has nothing to do with supply.
Folks, this is really big news and a huge “tell” as to the state of supply in the gold market. Just add these two pieces together, negative GOFO rates and notices instantly being served in a very small delivery month… you get a picture of severe supply tightness. This in no way is compatible with weak pricing! Something has to give and since “delivery” in the gold market is a major part of the equation, the sale of derivatives will not cut it much longer. Just as machinery will not run on COMEX diesel futures, Eastern vaults will not be filled with derivative contracts!