As Gold Rebounds Over $1600, Some Thoughts On Why The Liquidation Snapback Is Here

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Yesterday when gold was trading in the $1570 we suggested that based on the very volatile shifts in the funding environment for gold, whereby the gold lease rate had moved from record negative to borderline flat, the plunge in the yellow metal is likely coming to an end. Less than 24 hours later, gold has just passed $1600 yet again. And as the following note from Sandeep Jaitly of First International Group (whose interview with Max Keiser exposing economics for fraud back in June was quite the hit) observes, by analyzing the continued funding unwind pressure, the recent liquidation move in gold is one that has to be taken advantage of. To wit: "The movements in the bases confirm that the recent downward move in gold against Dollars was as a result of Dollar funding pressures. Gold was lent on the swap against United States Dollars. This swap must be unwound and where a bid for gold was sought to raise Dollar liquidity, an offer of gold will be sought to unwind the swaps. The co-bases for Feb-12 and Apr-12 gold contracts are starting to advance – an exceptionally bullish signal following the selloff and a sign that physical buying is being prompted by these lower prices. It would be very prudent to accumulate gold against United States Dollars aggressively over the next fortnight."

From First International Group, Gold Basis Service

LONDON, Thursday 15th December, 13:43 HRS BST. Spot gold is currently $1,584.25/45, and the gold/silver ratio is currently 54.56/54.63. The conclusion from the last missive sent on 23rd November read:

“The movements in the December gold bases are still pointing to further upside for the gold price in fiat currencies – especially the Dollar, Euro and Pound Sterling (note the drop of just referring to the United States Dollar.) The ratio of the December gold/silver bases is pointing to downside for the gold/silver ratio.”

Gold was $1,687.15 bid at the time. Subsequent to that, it rallied to a high of $1,763.01 on 2nd December, before falling back to its current $1,584. The movements of the basis and co-basis during this time told all.

The chart to the left displays the normalised co-bases for The Dec-11, Feb-12 and Apr-12 COMEX gold contracts (left hand scale), as well as the gold price on the right hand scale.

Point 1 on the chart shows the December contract going into backwardation (a high of +0.7% was reached on 30th November), just as the price of gold began to escalate. Point 2 shows the backwardation in the December contract starting to decrease and fall rapidly – a few days ahead of the contraction in the price from 2nd December’s high. Point 3 shows the co-bases for Feb-12 and Apr-12 advancing higher towards a possible backwardation (likely to occur by the beginning of January by historical standards.)

A lot of reasons have been given for the correction in the gold price – futures liquidation being a prime candidate. However, this is not the case as movements in the bases tell otherwise. There has been continued Dollar-based funding pressure in the money markets of late (witness the escalation in LIBOR which has doubled over the past few months.) The escalation in the gold lease rates – that prompted gold to go into backwardation – was caused by gold being borrowed with the intention of providing Dollar liquidity (by selling the gold in a ‘sale and repurchase’ transaction.) The fall in the gold price being accompanied by a fall in the co-basis points to signs of physical gold being liquidated not futures. Massive futures’ liquidation would see the co-basis rise and basis fall – the complete opposite of what actually occurred.

The salient points to remember here are: that the borrowing of gold caused lease rates to escalate above money market rates and that gold was borrowed ‘on the swap.’ The former point can only be explained by the fact that the physical gold market is very tight (in terms of both supply, and loanable gold.) With the latter point, one must remember that swapped (and sold) gold must be returned (and therefore bought.)

The Feb-12 and Apr-12 COMEX gold contracts are already advancing towards backwardation with the co-bases for each having bottomed on 9th December (Point 3 on the chart above.) This is an exceptionally bullish sign for gold priced against fiat currencies. As the gold price has been correcting, physical interest is dominating the gold market.

The amount of gold stored at COMEX warehouses remained static over the past quarter as can be seen in the chart to the left. However, there was an important mix shift at the end of November into December: around 1m ounces of gold (around 10% of total inventory) was shifted from the ‘eligible’ category to the ‘registered’ category. That is ‘registration’ for sale. This again points to gold on the swap being the cause of the price decline.

The gold/silver ratio has remained range bound, currently at 54.56 bid v. 53.16 bid at the last missive. There is insufficient data for 2012 contracts to provide a change in this stance.

The fourth quarter’s Course of The Exchange will be published soon. As patrons of this service have known since the beginning of the year, the Dollar’s resurgence against other fiat currencies was expected. We will be reiterating the (unchanged) reasons for the continuance of this trend going forward. Issues surrounding the Eurozone will be covered from a multi-century historical perspective. United States equities, bonds or both for 2012? This will be a central issue to be discussed as well.

CONCLUSION…The movements in the bases confirm that the recent downward move in gold against Dollars was as a result of Dollar funding pressures. Gold was lent on the swap against United States Dollars. This swap must be unwound and where a bid for gold was sought to raise Dollar liquidity, an offer of gold will be sought to unwind the swaps. The co-bases for Feb-12 and Apr-12 gold contracts are starting to advance – an exceptionally bullish signal following the selloff and a sign that physical buying is being prompted by these lower prices. It would be very prudent to accumulate gold against United States Dollars aggressively over the next fortnight.