Why does the “Paper Gold” Price Track the Physical Gold Price?

Monetary Metals's picture

It’s curious, isn’t it? So-called “paper gold” (a futures contract) has a price that is not only very close to physical gold, but it remains locked to it. This is despite the fact that “paper gold” is reviled in the gold community.

I am writing this on Sunday evening with little liquidity in the market, and yet spot gold (XAU) is 1665.80 and the December future (GC Z3) is 1674.40. There is a small positive spread, about 0.5%, between spot and future. This spread is remarkably consistent from day to day. If spot gold goes down 1.2% then the December future,and the other months as well, go down by almost exactly 1.2%.

It’s worth underscoring that these are different prices for different things in different markets. “Paper gold” is not physical metal! If there weren’t some force that kept their prices locked together, they would detach and one could rise while the other falls, or vice versa. This is not, in fact, how they behave. They remain locked (at least for the time being). Why? What is this mysterious force that binds them tightly together?

Let’s take a step back for a moment. The futures market exists to serve the needs of producers and consumers. Producers—miners in this case—need to have predictable and consistent cash flow so they sell some of their production forward. Consumers, such as electronics manufacturers, and jewelers, have the same need so they buy some of their raw materials forward. Both can sign a contract now that locks in a price at some date in the future.

Of course, in the gold standard, there would be no such thing as a gold futures market. Futures for all other goods would be priced in terms of gold. Gold itself would not be available at a discount, nor would one ever need to pay a premium to get it. One could borrow it at interest, but that is in the bond market not in the futures market.

Once a futures market is established, speculators come in to bet on the direction of the price. They do not produce the good—gold in this case—nor use it. They cannot deliver gold to a buyer, nor do they wish to be delivered gold. They want to profit from a change in the price. They believe they have superior knowledge compared to the other market participants, and so use the futures market as an easier and more convenient way to bet than the physical metal market. And besides, the futures market offers leverage.

This is the basic theory of the futures markets, in a nutshell. Producers and consumers are trying to reduce risk. Speculators are making bets, pushing prices around, sometimes annoying the producers and sometimes annoying the consumers.

We still have not explained the fact that the price of “paper gold” tracks the price of gold metal. To do that, we need to introduce a third type of actor in the futures markets. The arbitrageur does not care about price; he is focused on spread. The arbitrageur can buy physical metal and at the same time sell a futures contract. This will earn him a little over $8 per ounce based on the prices I quoted at the top, or a bit more than 0.5% annualized. Compared to the yield on a 1-year Treasury, about 0.15%, this isn’t bad.

So long as the price of the futures contract is higher than the price of the physical metal, then the arbitrageur can buy metal and sell a contract to pocket this spread. This will obviously lift the price of the metal and depress the price of the paper, compressing the spread. The arbitrageur will stop when the spread becomes too small to be worth his time, effort, and risk.

If the futures contract ever became cheaper than the physical metal (called “backwardation”) then anyone who owns a gold bar can sell it and simultaneously buy a future with the intent to stand for delivery. In this case, the arbitrageur sells physical metal and buys a future, thus depressing the price of metal and lifting the price of the future. As in the previous case, the spread is compressed.

This is not merely academic theory. Analysis of this spread (called the “basis”) can shed light on what’s really happening in the markets. Sometimes (as now) there is a simple trade that is obvious, but only to someone looking at this spread.

In Part II of this article (free enrollment required for full access), we walk through the analysis and propose a contrarian precious metals trade.

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Bansters-in-my- feces's picture

"Let’s take a step back for a moment. The futures market exists to serve the needs of producers and consumers."

So which one is JPM&Co


And HSBC...?

Barbaric relic's picture

Seems to me that the physical market obviously trails the paper in this manipulated market -- ie, price smackdowns of paper gold on the crimex and London affect the physical price.  Am I wrong, if so tell me how?

Thisson's picture

You're wrong.  Despite all the claims that there is a conspiracy to keep the gold price down, the actual evidence (Central Banker Behavior) is to the contrary.  For example, if bankers wanted to push the price of gold lower, why would they sigh the Washington Agreement, which is an agreement to limit gold sales by Central Banks?

DowTheorist's picture

Just in case, I'd rather settle with physical....


More about the cost of storing physical here:




tradewithdave's picture

Paper gold tracks physical gold until it doesn't.

mark mchugh's picture

Next up on ZH:

A first grader will tell us how cars work.

donsluck's picture

Oh, me, me, choose me! The car based transportation system (almost exclusively USA) "works" because of constant, generous taxpayer support.

Fuh Querada's picture

" The futures market exists to serve the needs of producers and consumers. "
You really are terminally deluded, my friend. Did you by any chance have an account with MF global? Do you have oil futures perhaps?
Gimme a break.

Sean7k's picture

The author provides a nice, vanilla explanation of future markets. Gold and silver markets are different from other future markets. Gold and silver markets have the ability to affect the value of currency- especially currency being wildly inflated through massive supply. 

As the purveyors of said currency, it behooves Treasury and the FED (a collection of private banks), to work within the futures market to manipulate the price in coordination with all large holders of gold and silver to insure profits for these traders and confidence in the currency.

There is money to be made in trading futures, GLD and SLV, UNTIL THE RULING PARADIGM changes. It may never change in our lifetimes. However, as the Zimbabwe, Argentina and Hungary's of the world attest, it is possible. 

Still, wealth is about security. Do you feel secure in the current FED manipulated system? Good traders know when to get out, when to jump in and how to manage their exposure. If you do not know this, a website will not provide the knowledge you need to protect yourself. 

I find that an understanding of inflation in all its' forms, as well as its' effects, is the more useful tool in regards to gold and silver.

Thisson's picture

The central banks already make plenty of profits by printing currency, leasing out gold, and making loans.  They're not manipulating the gold market to reduce prices.  Gold is an asset on their balance sheet, that they loan out (through bullion banks, which they undoubtedly have financial interests in as well).  They make more profits when gold prices are higher (because they get more value for the gold they loan out)/

Sean7k's picture

I never said they were manipulating to reduce prices. They are manipulating to control possession. However, at the rates they loan to the bullion banks and taking into account inflation ( you should read for comprehension), they are losing money. 

MrBoompi's picture

Isn't there a fourth actor? JP Morgan, who's only actions in the physical and futures markets are intended to suppress the price, regardless of the profit or loss?

donsluck's picture

regardless of the profit or loss doesn't make sense.

Voice_Of_Unreason's picture

Paper gold can go up in smoke. Real gold can't.

Almost Solvent's picture

I heard real gold floats so it's easy to recover after a boating accident.

Voice_Of_Unreason's picture

They sound like gold turds to me ...

Deo vindice's picture

That is the best news gold owners have had in a long time. Now everyone is heading back to the spot where their canoes capsized.

EyesWise Shut's picture

XAU is NOT equal to physical gold. XAU= (Reuters) is more like scriptural gold, debited or credited to your account. Physical Gold is when you take delivery or deliver. But still, I agree that it's strange that scriptural gold price still equals physical gold price.

Downtoolong's picture

anyone..can .. buy a future with the intent to stand for delivery.

Go ahead, try it and see what happens. This is where the theory breaks down in practice.

I think you left out one other type of player in the market too. That's the TBTF banks using the futures markets to hedge their Opaque OTC positions. That's the primary reason futures markets exist, and why there will never be position limits in the futures markets, even though the banks always claim their net positions are near zero in size.

agent default's picture

That's al good until you get a delivery failure and backwardation skyrockets signaling the end of the paper market. Futures will be worthless after that, either you own it or you don't.

donsluck's picture

True, eventually, but storing a year of food for that "eventuality" of system collapse leads to you either spending way too much on food or eating year-old food constantly. A little balance is called for.

Quinvarius's picture

You just explained that the paper market does not track the physical market with your futures example.  The cost to store 400 oz of gold is zero.  Anyone can do it.  So why would the market put a premium of $3200 per bar per month on storing gold?

Aside from that, confusing paper promises to give you something irreplaceable, that was borrowed from someone else, with that product in hand is probably a bad idea. 

Tango in the Blight's picture

It's zero if you stuff your 400 oz Good Delivery bar under your mattress or keep it in your breadbin.

But yes, why would anyone pay more for paper than for the real stuff?

Parabox's picture

Access.  Most people are not traders.  Most people do not have excess money to invest.  Most people can only invest what is in their 401(k).  And 401(k)s do not give access to physical, only paper.  That I know of.  And if I am wrong, boy howdy would I like to know.

Panafrican Funktron Robot's picture

You can roll it into an IRA, but yeah, even though it's "physical", it's still required to be stored by a company, ie., you cannot physically possess it, ergo, counterparty risk.

That said, regardless of tax arguments/retail price premiums, all excess earnings from productive activity really should be going to gold (or silver) physical purchases, as they represent real money and a real store of wealth.  401K (and probably IRA) money is very much under the control of the federal government.

"Most people do not have excess money to invest.  Most people can only invest what is in their 401(k)."

This was a bit contradictory, because if you have money to put in your 401K, that's excess money.  If you have 401K money, you really should be cashing out presently (even with the penalty) and buying physical gold and silver.  Again, 401K money is not in your control.  The government is preparing to "voluntarily manage" your accounts (ie., convert it to a federal pension); that is just step one, it doesn't take a rocket scientist to figure out that step two is making "volutary management" the condition for continuing tax-free status of those accounts, which is de-facto confiscation.

Parabox's picture

I can't get my hands on it.  Government rules lock 401(k) money away until I terminate employment or turn age 59.5.  If I could cash it out without quitting my job, I would.


New World Chaos's picture

Look into a self-directed IRA.  You can roll over to an LLC company which can invest in all sorts of stuff.  You can even  take delivery.

Solon the Destroyer's picture

I was going to post the same link.

The author of this teaser article wants us to pay for more information that is out there for free.  And done far better.

Fekete rocks.  For those new to his writings, start with the earliest articles and work your way up to the most recent.

Mi Naem's picture

Karl, I believe you are referring in particular to the article at http://www.professorfekete.com/articles\AEFAmericanBasesGermanyGoldBasis.pdf            ?

Thank you for the link to this chillingly informative paper. 

For example:

"Germany is the natural choice to feed the gold futures markets in an effort to protect the
dollar against the last assault that is shaping up."

Karl von Bahnhof's picture

Fekete is especially interesting reading, going back to history and explaining forgotten reasons for some key points in financial history (end of bimetalism, real bills, what real gold standard means etc...)

Definitively worth to read.

If he is (will be right) then it will be really nasty.

fourchan's picture

just buy the real stuff and end your worries and tribulations. all paper is bunk.

donsluck's picture

True Fourchan, eventually the structure (futures market) will collapse because of fraud. However, due to low overhead and ease of use, it's strill useful to dabble in the futures market. Because of the risk introduced by the lack of investigation in Corzine and his failed futures brokerage, I would recommend 15% of your PM exposure be to futures, with 85% physical.

razorthin's picture

And the earth still rotates on its axis on its current plane about the sun.  Until the big rock strikes and it doesn't.  Try getting even the nominal dollar value out of your bank or brokerage when the shit hits the fan.

Pinto Currency's picture

You can obtain retail amounts of metal at spot.

Try to obtain silver or gold in size and you will see that the paper price is not the physical price.

CIABS's picture

That's what I was wondering.

"The arbitrageur can buy physical metal and at the same time sell a futures contract."

"buy physical metal" ?

Not really.