Backwardation, negative GOFO and the gold price

July 24, 2013 07:47 AM

The term ‘backwardation’ has suddenly popped up in the mainstream financial media and is being touted as the signal that the price of gold is on its way back up.

What does backwardation even mean?

It means that the spot price rose above the nearest future contract.

Last Friday Reuters reported that ‘Gold went into backwardation in comparison to the three-month futures contract in early January.’


Well it doesn’t stop there, it’s no longer about the nearest future contract but this is likely to stretch out to longer-dated maturities. As Reuters explained this may be ‘cause for alarm.’

This dislocation between the spot and the futures price suggests that physical delivery is vastly outweighing supply.

As Reuters reports this has increased concerns that ‘in the market the change may not be a momentary blip and participants may have become overleveraged.’

If it happened in January why are they only just reporting it now?

This has been going on even longer than that, in April Professor Antal Fekete warned that ‘gold futures markets may have been flirting with backwardation for a year or so.’

When ‘officialdom’ realized this, he writes, then they ‘were forced to act.’ Hence why, on April 12 and 15, the gold price was taken down. Bernanke was concerned about a permanent state of gold backwardation.

However, the mainstream are only just picking up on this because GOFO is negative. The appearance of a negative GOFO rate confirms what backwardation has suggested for some time — that there is a severe physical shortage.

What is GOFO?

In its simplest terms the Gold Offered Forward Rate is a daily LBMA published rate used as the cost of leasing gold, when you use the gold as collateral in order to borrow dollars, it is the rate used for gold/US dollar swap transactions.

Many gold bugs associate negative GOFO with backwardation, when the spot price fetches a higher price than the nearest futures contract. Sandeep Jaitly writes ‘it seems there is unparalleled demand to exchange dollars for physical bullion- so much so that the availability of bullion to settle bullion obligations – whatever their nature is dwindling.’

For the gold bugs, this is when there is a shortage of physical gold, this physical gold is superior to paper gold in the futures markets.

According to Iza Kaminska, ‘objective’ gold analysts merely see the backwardation of gold and the negative GOFO are more likely to be a factor of changing money market interest rates or inflation rates.

Why are they concerned about backwardation?

Because it means individuals want to get their hands on physical gold now, which it turns out isn’t so easy to arrange. Therefore, ‘officialdom’ need to scare out any physical they can in order to meet demand elsewhere.

They hope that by pushing down the gold price as far as they possibly can, gold will appear unattractive.

Of course, the opposite has happened. In China, for one example they still cannot get enough gold through the exchanges and out for delivery quick enough.

The acceleration in backwardation alongside prolonged soaring gold borrowing costs suggests that the disconnect between paper and physical gold is about to get even greater.

Physical gold shortage?

As our very own Ned Naylor Leyland reported earlier last week, this widening of the backwardation ‘indicates that the physical market has tightened up substantially.’

As we have written in the past, much of the gold market is highly leveraged, Naylor-Leyland explains that ‘what we are seeing now is that the absolutely inevitable ‘run’ on the 100:1 leveraged banking system is truly underway.’

Is it bad news that GOFO is negative?

When it is negative it means you will receive more interest when you lease your gold than your dollars, i.e. there is more interest to borrow gold and use dollars as collateral. Gold is perceived as having more value as something to hold, than dollars do.

Early this month, the GOFO rate was negative for up to three months, as you will have read repeatedly, the last time this happened was in November 2008.

What does it mean for gold if it’s negative?

Primarily it means that gold leased out today is worth more than the gold delivered at the end of the three months.

As we explained above, the negative GOFO rate means someone wants to get their hands on gold. The further ahead the negative GOFO rate reaches the larger the shortage of gold in the delivery that needs to be made.

There is speculation that the elevated high levels of demand we’re seeing in Asia has emptied the London Market.

Many also see the negative GOFO rate as a sign that the bottom of gold will soon be a thing of the past, with soaring gold prices to come

Not for those who own physical gold

Negative GOFO and gold futures in backwardation is finally evidence that there is a distinct flight into physical gold.

According to SocGen, the biggest gold backwardation since the start of the millennium prompted a ‘corrective rally’ but the general sentiment on gold is bearish as there is no physical gold supply shortage to worry about.

SocGen’s Robin Bhar attributes the cause of backwardation to a possible range of factors from an overcommitted bullion bank to miners’ hedging strategies.

I think we can safely say that GOFO and long term backwardation suggest there may be an error in their analysis.

What does this mean for the gold price?

The November 2008 negative GOFO rate happened around the same time a bottom in gold came to an end. What proceeded was a doubling of the gold price and it reaching nearly $2,000.

Once again we see negative GOFO just as gold returns from a price collapse. This time it has remained negative for longer, suggesting that the problem with deliverable bullion is this time even greater.

What will this mean going forward?

Given the negative GOFO rate shows stress on the London market when it comes to deliverable bullion, and warehouse stocks in the COMEX futures markets continue to decline, we suspect what lays ahead is a perfect storm for the gold price.

We believe it shows there is a distinct lack of confidence in the paper money system. No longer to investors want to hold paper promises (whether for gold or currencies) instead they prefer to hold real, physical gold and silver.

So, rather than worry about a gold price that is yet to return to $1,920, instead see this as a warning signal that the relationship between spot and future price, physical and paper is growing tired. Hold onto physical gold and ignore the price until it matters.

About the Author

Jan Skoyles is Head of Research at The Real Asset Company, a platform for secure and efficient gold investment. Her work and views are now featured on a range of sites including Kitco, GATA, and The Telegraph. She has appeared on news channels including Russia Today to discuss the gold price and gold investing.