I wrote the following in response to a comment I received on my perpetualisation of debt post earlier on FT Alphaville.
The guy I was responding to didn’t get the analogy. But perhaps readers of this Tumblr will understand (have expanded a little):
Gold in many ways is a completely false market. Gold is more abundant than any other commodity because you can’t eat it or consume it. It’s purpose is to be financialised. To be pledged as collateral and hedged. The price of gold is dictated by a tiny freefloat of the gold that’s not encumbered in vaults. In reality the gold market represents the biggest con in the world in my view…
You dig something out of the ground that cannot be consumed.. and when its supply becomes too plentiful because it cannot be consumed, you effectively buy it back at a lower price and rebury it in the ground.
The process allows you to capture carry.
Extract => sell at market price => buy back at lower price => Rebury to support the price => sell at higher price
As long as the difference in price covers your extraction and burying (vaulting costs) you’ve captured a carry.
The price is almost designed to stay stagnant and deliver carry.
And that’s how contango/backwardation works.
The only difference is that rather than being reburied commodities are warehoused or vaulted, and the interim price exposure (between you sell it and buy it back) is immediately hedged with a future.
Delivery of additional supply to the market is incentivised by backwardation — the knowledge that your sale should bring down prices to where the future is trading…
The “rebury” trade is incentivised by contango — the knowledge that your sale should help to support prices.
And this is why aluminium and metals markets are now the new financiialsed competition to gold.
The ONLY reason we saw a lift in the clearing price of gold in 2008 is because people were reburying the gold more quickly than they were extracting/unburying it. And that led to a loss of contango carry… because if everyone reburies at the same time — guess what, the price dampening effect of the original sale (and the carry) disappears.
The mechanics of the market inverted.
The flattening of the curve finally made the rebury trade totally non-sensical.
You went from:
Extract => sell at market price => buy back at lower price => Rebury to support the price and sell at higher price
extract => sell at far too high price => find yourself unable to buy back at a low enough cost to cover costs and to incentivise the carry rebury trade.
Suddenly from a financial standpoint vaulting gold becomes unattractive.
No coincidence this is happening:
FT: Swiss Banks Raise Gold Storage Fees
Including the key line:
If investors hold their gold in “unallocated” accounts, as they traditionally have, the gold counts as part of banks’ balance sheets, which means the banks have to hold reserves against them, the Financial Times reports.
The gold is no longer positive yielding but negative yielding and thus a balance sheet burden — irrespective of whether reserves need to be set aside or not.
Hence the incentive to “Goldify” other commodities like aluminium etc.. where the rebury rate was not being over crowded as it was in gold and where a positive yield could still be found.
At this time, to get any positive yield out of gold at all you need to conduct opposite trade entirely (a.k.a the backwardation trade).
Sell the inventory you have into an overpriced spot market, wait for the market to fall, buy it back at the cheaper rate.
And on and on, until the curve flips again.
Or until somebody starts destocking more quickly than someone else is reburying.
As far as I can see, the banks are currently destocking, while the central banks — if anything — are reburying to counteract to try to dampen the rate of destocking which would otherwise impact the clearing price of gold.
Why do they bother? Possibly because a market that’s massively incentivised to liquidate into backwardation is a de facto negative rate market.
It implies that there’s a market expectation for the price of gold to drop. And more so that you can capture that trade here and now because the forward curve is no longer compensating for a positive cost of money.
Since gold is the ultimate manufactured market price on account of its long term and historical over-abundance, this is a real hallmark of deflation.
Which by the way is exactly why gold fell during the peak of the crisis in 2008.