Futures Markets Signal Gold Ready to Erupt

Friday, August 9, 2013
By Paul Martin

By Dickson Buchanan, Precious Metals Specialist at Euro Pacific Precious Metals
Friday, 9 August 2013

With gold recouping some losses in its most recent trading sessions, many are asking whether or not the bottom has finally formed for the yellow metal. Most of these gains have been simply chalked up to short-covering and dovish remarks by Bernanke during the recent Federal Open Market Committee meetings; however, there are some key indicators for gold which are overshadowed by the media hubbub. Two of them in particular are important to understand, because they reveal a renewed investment demand for physical gold over paper gold or fiat currencies.

Gold Backwardation

The first indicator to note is called “gold backwardation,” which occurs “when the price of a futures contract is lower than the price in the spot market.”1 This means that traders are willing to pay more for gold that is available for delivery today, rather than lock in a futures contract at a discount for gold that is delivered months later.

Taking this one step further, if gold stays in backwardation for some time, it means that no one is taking advantage of a risk-free arbitrage opportunity by simultaneously selling physical gold at spot and buying a futures contract. In such a scenario, traders can keep not only the spread between the spot rate and the futures rate, but also their original position in gold. This is known as “de-carrying gold.” Now, if enough traders were to take advantage of this risk-free profit, gold would be pushed out of backwardation into its normal trading state (i.e., “contango,” when the price of a futures contract is higher than the physical spot price). The fact that this is not occurring, and that gold remains in backwardation, implies that gold is more and more decoupling from the dollar – a trend that, if continued, could raise the dollar price of gold and other assets significantly.1

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