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Fekete's Open Letter To Paul Volcker

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This article appeared in today's FT Alphaville which was based around's Fekete's open letter to Paul Volcker.

His premise is that there needs to be a link between gold and currencies - essentially he's been against the floating currency exchange rates since Nixon's gold standard rebuttal in 1971 - fair enough.

One thing that strikes me as odd is his premise that gold is going to backwardation. I can't see it. The current futures market is in contango, and looking historically at gold prices over the past 5 years, this doesn't seem to have changed.

Can someone explain this backwardation theory in terms of fundamentals (without reference to worthless fiat etc)?

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Can someone explain this backwardation theory in terms of fundamentals (without reference to worthless fiat etc)?

2 explanations.........

The gold backwardation theory

Posted by Izabella Kaminska on Dec 09 15:22.

Apparently there is much speculation among gold bugs around the world on the topic of gold backwardation.

Spot gold prices versus front-month gold future Comex prices are currently in backwardation, in otherwords the price of gold is descending into future as opposed to ascending. The usual state of the market is slight contango, due to the cost of carry and general theory that the longer time frame of investment the bigger the warranted premium in price.

Backwardation, meanwhile, is supposedly unheard of in the gold markets - leading to all sorts of theories relating to supply tightness on the physical front-end.

Fuelling much furore is an article by Antal E. Fekete in particular. Fekete is professor of mathematics and statistics at the Memorial University of Newfoundland and a self-declared advocate of the gold standard. Note his Wikipedia entry.

Fekete highlights the momentous moment gold went into backwardation as follows:

December 2, 2008, was a landmark in the saga of the collapsing international monetary system, yet it did not deserve to be reported in the press: gold went to backwardation for the first time ever in history. The facts are as follows: on December 2nd, at the Comex in New York, December gold futures (last delivery: December 31) were quoted at 1.98% discount to spot, while February gold futures (last delivery: February 27, 2009) were quoted at 0.14% discount to spot. (All percentages annualized.) The condition got worse on December 3rd, when the corresponding figures were 2% and 0.29%. This means that the gold basis has turned negative, and the condition of backwardation persisted for at least 48 hours. I am writing this in the wee hours of December 4th, when trading of gold futures has not yet started in New York.

Checking in today and backwardation is still in place. At 1430 GMT Tuesday spot gold was trading at some $768 while Comex futures were at 766.40.

According to Fekete this is hugely significant (our emphasis):

As those who attended my seminar on the gold basis in Canberra last month know, the gold basis is a pristine, incorruptible measure of trust, or the lack of it in case it turns negative, in paper money. Of course, it is too early to say whether gold has gone to permanent backwardation, or whether the condition will rectify itself (it probably will). Be that as it may, it does not matter. The fact that it has happened is the coup de grâce for the regime of irredeemable 2 currency. It will bleed to death, maybe rather slowly, even if no other hits, blows, or shocks are dealt to the system. Very few people realize what is going on and, of course, official sources and the news media won’t be helpful to them to explain the significance of all this. I am trying to be helpful to the discriminating reader.

No small call, Fekete is essentially calling the end of the fiat-dollar system - just as the US Treasury sells 3-month bills at the lowest level since 1929, and CDS spreads on sovereign debt continue to wander - hmmm does he have a point?

He explains as follows:

Gold going to permanent backwardation means that gold is no longer for sale at any price, whether it is quoted in dollars, yens, euros, or Swiss francs. The situation is exactly the same as it has been for years: gold is not for sale at any price quoted in Zimbabwe currency, however high the quote is. To put it differently, all offers to sell gold are being withdrawn, whether it concerns newly mined gold, scrap gold, bullion gold or coined gold.

I dubbed this event that has cast its long shadow forward for many a year, the last contango in Washington ― contango being the name for the condition opposite to backwardation (namely, that of a positive basis), and Washington being the city where the Paper-mill of the Potomac, the Federal Reserve Board, is located. This is a tongue-in-cheek way of saying that the jig in Washington is up. The music has stopped on the players of ‘musical chairs’. Those who have no gold in hand are out of luck. They won’t get it now through the regular channels. If they want it, they will have to go to the black market.

It certainly sounds like the talk of conspiracy theorists. Could it really be as bad as all that? As an interesting aside, even Osborne Rachman writes in the FT today about how, for the first time in his life, he sees as plausible the formation of some sort of world government.

But before you rush out to stock up on tinned goods, there is, of course, a more muted explanation for gold backwardation out there too. The gold bugs have misinterpreted all says Dennis Gartman, of the Gartman Letter:

Normally, we would join them in their enthusiasm for the backwardation if we were talking about soybeans, or cotton, or sugar or crude; but in the case of gold, we are far less given to this sort of enthusiasm, for the “Bugs†are misinterpreting what is happening there.

Simply put, o/n funding rates are so low, with the o/n fed funds rate as effectively near zero as it can get, that there are strange distortions taking place in gold lending operations. The “Bugs†want very badly to see collusion and manipulation and intervention and all sorts of mischief taking place in the gold market. Instead, we see rather boring, inordinately prosaic interest rate arbitrage taking place and little else. Yes, there are shortages of gold coins in the market, and yes the spot/1st and even to the 2nd future gold future is backwardated, but this is hardly the stuff of manipulation and central bank intervention. We would counsel everyone to take a deep breath; to sit down and count to ten. The “Bugs†won’t, however, for the air is ripe with visions of manipulation rather than sugar plums and St. Nick!

So there you go, no need to panic at all.

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