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Dr. Keith Weiner: Temporary Backwardation, Negative GOFO and The Indication
12 Aug 2013
1. A brief introduction about yourself. How did you start investing in gold?
I started and built a software company, DiamondWare. I sold it to Nortel Networks in August, 2008. Then the markets began to crash. I started to study economics to protect myself, and ended with a PhD in economics focusing on monetary science. After you have seen the long term trend of falling paper currencies, after you have proven that gold still behaves as money even today when governments refuse to acknowledge it, after you understand exactly how and why they debase their paper currencies, how could you not turn to gold?
2.      Why is it so important, in your view, for investors to invest in gold, especially physical gold today?
Every government in the world is borrowing to pay for more programs than they can afford. And they are borrowing to pay the interest on previous borrowing. One by one, they will go the way of Greece. This happens when investors no longer want to buy their bonds. The paper currencies are backed by government bonds, so when the bond collapses so does the currency (Greece is a special case because they use a joint currency, the euro). Governments can keep the game going a long time, but the fates of the paper currencies are sealed.
Right now, people think of this government debt as “money”. But when governments default, people will remember, too late, that “money is gold and nothing else”. This is what JP Morgan said to the U.S. Congress in 1912. I corresponded with a gold dealer in Cyprus, and he told me he tried to warn people that they should take money out of the banks and buy gold. No one listened, but now many regret their decision. All government promises to pay will eventually be dishonored, but gold will always be accepted.
3.      There are a lot of talks about a disconnection between “paper gold” price and physical demand. Could you briefly explain your view on the relationship? Does future market reflect the true supply and demand picture of gold and silver?
Most of what is published on the Internet on this topic is misleading. Some writers would have you think that only “paper gold” is $1300, but the real price of physical metal is much higher. There is nowhere you can sell real metal for $1900 an ounce, $1600 an ounce, or whatever price they feel is the “true” price. These writers would have you think that the banks are “naked” shorting gold and silver futures. I have written many articles and shown the data to prove this is not true.
There is indeed a difference, at the moment, between the price of gold in the futures market vs. the price of physical gold. But it is around $0.70 per ounce. This is significant, but not because there it is perceived by the gold buyer. Nor does the price of a gold futures contract represent a prediction of where the gold price will move.
4. What are basis and cobasis? Why is it critical to analyze basis and cobasis?
Basis = Future price – Spot price
Cobasis = Spot price – Future price
These are sensitive indicators. They tend to remain consistent even as the gold price moves up or down. A positive basis (called “contango”) means that it is profitable to carry gold: to buy gold and simultaneously sell a future, holding it in the warehouse in the meantime. If the basis is positive, it means gold is readily available to the market.
A positive cobasis (called “backwardation”) means it is profitable to decarry gold: to sell physical metal and buy a future. A positive cobasis should be interpreted as scarcity.
5.      How long have you tracked basis and cobasis? What are the most important findings from your research?
I have been tracking it since 2009. There should never be gold backwardation. It is a sign of cracks in the monetary system. But it has been occurring more and more, and is now recurrent on every gold future before it expires. At the moment, the August, October, and December contracts are backwardated. This has not occurred prior to now. I think it is a sign of something serious that may occur soon, and the gold price is more likely to rise sharply than to fall.
6.      You have been talking about “temporary backwardation” in gold market. What does it mean? How often do we see it post-financial crisis 2008 vs. before? Why is it significant?
We never saw backwardation before the end of 2008 (when the global financial system was collapsing). I coined the term “temporary backwardation” to refer to the behavior of a futures contract going into backwardation (its price falls below spot) shortly before it expires. Since 2009, it was intermittent. Now it is every contract, and as mentioned above it is three contracts simultaneously with gold (only one in silver at the moment). Because the monetary metals (gold, silver) have such high inventories, there should never be a condition of scarcity and hence backwardation. But it is happening, which is like decay or a cancer in the monetary system. Fissures are opening up.
7.      How do you define “permanent backwardation”? What does it mean? Why is it different from “temporary backwardation”? What signs do you think we should pay attention before “permanent backwardation” happens?
Permanent backwardation is when all futures contracts go into backwardation, and no matter what happens with the gold price (probably rising quickly), the backwardation increases. This is the first step of gold becoming unavailable to the market. Why should people who own good gold bid on bad paper, once it is obvious that the paper is being dishonored? But those who hold paper will still want gold. Increasingly, they will trust only gold metal. So in the gold futures market, the bid is falling and in the physical gold market, the ask is rising. The destruction will come when people discover that so long as they can use their paper money to buy commodities like oil. This will give them a back door to gold. Gold will still bid on commodities, even when it does not bid on paper money. This commodity arbitrage (paper for oil, oil for gold) will drive the price of oil to rise exponentially when measured in paper, and down nearly to zero when measured in gold. And the same will occur for every commodity. People will call this “hyperinflation” but it will have nothing to do with the quantity of money, nor will it be driven by consumers competing with one another to buy bread with wheelbarrows full of paper money. It will be the last chance to trade paper for a little gold, and the end of the paper currencies (the dollar will be last).
We should look for the following signs. The interest rate on the long-term bond approaches zero (which means the Net Present Value of the debt approaches infinity). The gold price is rising exponentially, especially if the cobasis is rising across all contracts. The duration of government bonds held by the public is approaching zero (people are unwilling to take the risk of holding long-term debt). All net new issuance of government debt must be purchased by the central bank. The central bank’s balance sheet becomes filled with illiquid, long-term assets at overstated values, and people call it into question and judge it insolvent (when people withdraw their trust of the bond, they will not jump out of the frying pan and into the fire by trusting the paper currency backed by the bond). And real capital is being destroyed, with rising bankruptcies, many of which are unexpected (like Bear Sterns).
8.      There are a lot of talks about negative GOFO recently. Why is it such a significant event?
GOFO = LIBOR – Gold Lease Rate
The gold lease rate, which is like an interest rate in gold, has risen above LIBOR (the benchmark interest rate in dollars). This means the same thing as backwardation (indeed, although GOFO is different from the basis, it is highly correlated). Gold has become scarce. I think the premium paid in Asia above the price in London is pulling gold from west to east. Bullion banks want to make the most money on the gold bars they can get their hands on. The profit from shipping the gold east is greater than the profit from decarrying the gold. At the moment this looks a liquidity issue. If the backwardation moves out across all futures contracts, then it is a sign of impending monetary system collapse.
9.      Where do you see the gold and silver prices from here? What do you think it’s the best way to invest in gold?
While anything could happen to the gold price, I think it is more likely to rise than fall from here. Perhaps it may rise sharply and substantially. I am more ambivalent about silver. I never recommend anyone take a naked short position on either monetary metal. I would recommend an arbitrage: long gold and short silver. The gold:silver ratio is likely to go higher (it is currently around 66).
Gold is not, in itself, an investment. I define investment as something you buy with the expectation of a yield. Gold has no yield. It is either a way out of the falling paper currencies, or a speculation that its price will rise. Over a long enough period of time, the gold price is rising. In shorter periods (e.g. April 12 and 15) the price can go down sharply. Anyone using leverage took big losses and may have been forced to sell. Anyone who is accumulating gold and keeping his long-term savings in gold could buy more when the price dropped. At the end of the day, what will matter is how many grams you own, not how many dollars or pounds or yuan those ounces were worth.
10.      Please talk a little bit about your fund. Why did you start this fund? What’s the philosophy and strategy? How is the performance?
The Monetary Metals Fund turns gold into an investment. It owns physical gold and silver, without using (or giving) credit, options, derivatives, etc. It avoids all counterparty risk. It trades between gold and silver, holding whichever metal is outperforming according to proprietary indicators first developed during my doctoral work, and refined since then. Since the start of this year, we have held gold as we expected gold to outperform silver. And indeed the gold:silver ratio has risen 20%. This means we could buy 20% more silver now with the same gold as we could have in January. When silver has bottomed, we will buy silver and let silver rise. Then we will buy gold again, but we will have more. For example, let’s say the fund starts with 100 kg of gold. The gold:silver ratio rises to 75. Then we trade 100 kg of gold for 7500 kg of silver. Then the ratio falls back to 50. We trade the silver for 150 kg of gold. We will succeed so long as we know the direction of the ratio (which our model accurately predicts). So far, we have been right.
The philosophy is to be as conservative as possible. Our investors would have bought gold coins or bars, which has no risk. The problem with this is that there is a negative yield, because one must pay storage and insurance. We want the same security and safety, but will own silver at opportune times to generate a gold yield.
Dr. Keith Weiner’s Monetary Metals Fund website: www.monetary-metals.com
Disclaimer: The above views are the opinions of the author or his/her company and do not represent the views of Quamnet.
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Dr. Keith Weiner: Temporary Backwardation, Negative GOFO and The Indication 12 Aug 2013
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