Backwardation

Now that the Rare Earth bubble has come and gone (and may well come back again depending on how much China wants to stretch its political muscle), the Rice bubble is in progress, and may see prices going back to the $24 range we saw last in 2008 when net CBOT non-commercial spec contracts were approaching the 8k levels, the last R-bubble prediction is coming true. Back in October, Zero Hedge said the next bubble are the 3Rs -Rare earths, Rice and Rubber. Lo and behold, rubber just hit an all time high on the Tocom, after returning 30% YTD. And far more importantly to those who care about such things, the rubber forward curve is in backwardation. No need to explain what that means.

Silver backwardation continues and while spot silver is at $30.09/oz, the March 2011 contract is at $30.07/oz and April at $30.01/oz. Incredibly, the July 2012 contract is trading at $29.93/oz and the December 2013 contract at $29.91/oz. Backwardation is when the market quotes a lower price for spot delivery or a more nearby delivery date, and a higher price for a distant delivery date in the futures market. It indicates that buyers are concerned about securing supply in the future and are willing to pay a premium for spot delivery. It suggests that silver bullion in volume is difficult to buy and that the physical market is stressed and becoming less liquid. Backwardation starts when the difference between the forward price in the futures market and the spot price for physical delivery is less than the cost of carry, or when there can be no delivery arbitrage. This is generally because the asset is not currently available for purchase or is increasingly illiquid. It can end in default, failure to make delivery, and in sharply higher prices.

JP Morgan announced today that from now on they will accept physical gold bullion as collateral. This is a sign of gold’s further remonetisation in the global financial and monetary system. It may signal that JP Morgan is having difficulty in securing gold bullion in volume. JP Morgan is the custodian for many of the gold and silver exchange traded funds. They will not accept ETF trust gold as collateral. In October, the clearing house of global exchange CME Group – CME Clearing – announced it will now accept gold as collateral for trades on the exchange. Gold bullion can be used for margins for CME trades, ranging from crude oil, gold, grains, equity indexes and Treasury bonds. Given the current monetary, macroeconomic and geopolitical risk gold is an attractive alternative to debt, equities or other paper assets as collateral. JP Morgans’s move shows how gold bullion’s fungiblity and tangibility as an asset makes it attractive and shows gold’s increasing importance in the financial system. Interestingly, the CME is storing their collateral gold at JP Morgan Chase Bank in London. The exchange said it hoped to add additional depositories in the future but there has been no announcement of developments in this regard.

The ES futures curve is now at inverted term levels that have been unseen for months. For all who claim that by next summer the economy will be coasting well on its way to 3.5% growth or whatever imaginary number the crowd of lemming sell-side analysts pulls out of their pocket in their imitation of Goldman's upgrade, there sure is no actual conviction in this call. The differential between the Dec and the June ES contracts is a notable 10 points: December is at 1,246 while June is at 1,236. This is reminiscent of the curve last December, when those who bet that the market would be substantially lower half a year forward ended up being right on the money. For those who still believe in logic, a compression trade where one sells the Dec and buys the Jun contract may make sense, although with the only variable these days being what side of the bed Brian Sack wakes up on, we would be very cautious. As a reminder, the last time the VIX curve had a normal contango curve structure, was back in 2008, when the Bernanke Put was still being digested.

A few days ago FOFOA drew quite a bit of attention with his post "Red Alert: Gold Backwardation", in which the topic of the GOFO rate receives prominent attention (GOFO is basically the difference between a currency lease rate, in this case dollar Libor, and the GLR, or the Gold Lease Rate, as per the LBMA). FOFOA draws several correlation between the GOFO and an implied backwardation, and asks the question: “Is the dollar bidding for gold, or maybe gold is bidding for dollars?” Indeed, while one read of the underlying material does substantiate the presented hypothesis, another is merely that there has been too much turbulence in the currency market, with Libor, not just USD, but especially EUR, surging recently, on very valid liquidity concerns out of Europe. As a result of the massive squeeze first in the dollar and then in euros, a topic much discussed here previously, one could reach a point where the GOFO is in fact negative, merely due to vol in interbank and money market, which in turn is driven by ever faster liquidations in the shadow banking system, another topic much discussed on Zero Hedge. Certainly, when both of these are in flux, it would be expected that GLR would also do some very peculiar things. Either way, FOFOA has conceived an interesting theory, and gold fans will appreciate the thought experiment of gold being in backwardation. We present Professor Antal Fekete's response to FOFOA's analysis. Both are an interesting read. (The FOFOA post can be found here).

The move in gold to new 18 month highs has not been confirmed by backwardation in the gold basis. Caution is warranted for leveraged traders.

The recent run up in oil prices has resulted in some dramatic shifts along the crude curve. When we first discussed the contango effect (and some amusing risk free ideas as a result), the 12 month spread was roughly $25.