The price of a commodity futures contract is not the market’s forecast of what the spot price will be in the future. For example, the fact that at the time of writing the price of the December-2016 WTI Crude Oil futures contract is $64.44 does not imply that ‘the market’ expects the price of oil to rise from around $59 (the current spot price) to around $64 by the end of next year. Moreover, the true message of the difference between the futures price and the spot (cash) price can be the opposite of the superficial message, in that the lower the futures price relative to the spot price the more bullish the price implication. If you understand why this is so then you understand more than former Fed chief and present-day blogger Ben Bernanke about how the commodity futures markets work, which, admittedly, is not saying very much.

Part of the reason that the price of a commodity futures contract is not a prediction of the future price of the commodity is that many of the largest participants in the futures markets do not buy/sell futures contracts based on a forecast of what’s going to happen to the price. Instead, they use the futures market to hedge their exposure in the cash market. For example, when an oil producer sells oil futures it is probably doing so because it wants to lock-in a cash flow, not because it expects the price to go down.

The main reason, however, is that the difference between the futures price and the spot price is driven by arbitrage and, in all commodity markets except the gold market, the extent to which current production is able to satisfy current demand (in the gold market there can never be a supply shortage because almost all of the gold mined in world history is still available to meet current demand). In effect, regardless of what people think the price of the commodity will be in the future, arbitrage trading will prevent the futures price from deviating from the spot price after taking into account the cost of credit (the interest rate) and the cost/availability of storage.

Considering the case of the oil market, I mentioned above that the spot price is currently about $59 and the price for delivery in December-2016 is about $64. This $5 difference does not imply that ‘the market’ expects the price of oil to be $5/barrel higher in December-2016 than it is today; it implies that the cost of storing oil for the next 18 months plus the interest income that would be foregone (or the interest that would have to be paid) equates to about $5/barrel. If not, there would be a risk-free arbitrage profit to be had.

For example, if a large speculator who was very bullish on oil bid-up the price of the December-2016 oil contract from $64 to $70, it would create an opportunity for other traders to lock-in a profit by purchasing physical oil and selling the December-2016 futures with the aim of delivering the oil into the contracts late next year. This trade (selling the December-2016 futures and buying the physical) would continue until the difference between the spot and futures prices had fallen by enough to eliminate the profit potential.

For another example, if a large speculator who was very bearish on oil aggressively short-sold the December-2016 oil contract, driving its price down from $64 to $60, it would create an opportunity for other traders to lock-in a profit by selling physical oil and buying the December-2016 futures with the aim of eventually replacing what they had sold by exercising the futures contracts. Even though in this example the December-2016 futures contract is still $1 above the spot price, there is a profit to be had because the cost of storage plus the time value of money amounts to significantly more than the $1/barrel futures premium.

I also mentioned above that the true message of the difference between the futures price and the spot (cash) price can be the opposite of the superficial message, in that the lower the futures price relative to the spot price the more bullish the price implication. I’ll use the same oil example to explain why.

As I pointed out, if the futures price falls by enough relative to the spot price it will lead to a situation where there is an essentially risk-free arbitrage profit to be made by selling the physical and buying the futures. However, this trade is only possible if the physical market is well supplied. If this isn’t the case and all the oil being produced is needed for current consumption, then the price of oil for future delivery can drop to an unusually low level relative to the spot price and stay there. If the current supply situation is tight enough then the futures price could even drop below the spot price. That’s why a sustained situation involving an unusually-low futures price relative to the spot price has bullish, not bearish, price implications.

My final point is that one of the most important influences on the difference between spot and futures prices for many commodities is the prevailing interest rate. In the gold market it is the most important influence by a country mile. The lower the interest rate the smaller the difference will tend to be between the spot price and the prices for future delivery, so in a world dominated by ZIRP (Zero Interest Rate Policy) the differences between spot and futures prices will generally be smaller than usual.

In conclusion, anyone who views an unusually-large premium in the commodity futures price as bullish and an unusually-low (or negative) premium in the commodity futures price as bearish is looking at the market bass-ackwardly.

There’s a line of thinking to the effect that Quantitative Easing (QE) is not inflationary because it involves the exchange of one cash-like instrument for another. Taking the case of the US, the Fed’s QE supposedly adds X$ of money to the economy and simultaneously removes X$ of “cash-like” securities, leaving the total quantity of “cash-like” instruments unchanged. However, even putting aside the fact that many of the securities purchased as part the Fed’s QE programs are not remotely “cash-like” (nobody with a modicum of economics knowledge would claim that a Mortgage-Backed Security was cash-like), this line of thinking is patently wrong.

The simplest way for me to explain why it is patently wrong is via a hypothetical example that accurately reflects the situation in the real world. In my example, Jack is a securities dealer who deals directly with the Fed.

As part of a QE program the Fed wants to buy $1B of 2-year T-Notes with newly-created cash. Jack has $1B of T-Notes to sell, so a transaction occurs. If the Fed and Jack had simply swapped securities then there would be nothing inflationary about this transaction. Instead of holding the $1B of T-Notes yielding, say, 0.6%, Jack would be left with $1B of some other income-producing asset. However, what Jack is actually left with is a bank deposit containing 1 billion dollars of money earning 0%. Moreover, whereas he previously had no risk of suffering a nominal loss (assuming that he was prepared to hold the Notes to maturity), he now bears a low-probability risk of suffering a large nominal loss since only a tiny fraction of his $1B deposit is government guaranteed. Consequently, Jack will be quick to spend the money received from the Fed, most likely by purchasing some other bonds or perhaps by purchasing some equities.

Let’s assume that Jack uses half of the money received from the Fed to buy bonds from Bill and the other half to buy bonds from Ted. Bill and Ted are hedge fund managers. Following this transaction, Bill and Ted now each have the ‘problem’ of finding something to do with $500M of cash, because, like Jack, they can’t just leave such a large sum in a zero-interest bank deposit. They therefore quickly turn around and buy other assets, shifting the ‘problem’ of what to do with the cash to the sellers of those assets.

Get the picture? When the Fed injects money via its QE programs it is, in effect, passing a hot potato to securities dealers. The hot potato quickly gets handed off to other dealers and speculators, giving the demand for various financial assets an artificial boost along the way. Eventually the money will leak out of the bank accounts of large-scale speculators and begin to boost prices outside the financial markets, but, as we’ve seen, that process can take a long time.

The Bloomberg article posted HERE reports that after a decade-long 5-times increase, the worldwide stash of foreign currency reserves held by central banks has begun to shrink. Is this good, bad, or irrelevant?

The answer is no — it’s not good, it’s not bad, and it’s not irrelevant. To be more accurate, it would be good if it indicated a new long-term trend, but it almost certainly doesn’t indicate this. Instead, it is just part and parcel of the way the current monetary system works.

The key to understanding the implications of global reserve changes is knowing that these changes are mostly driven by attempts to manipulate exchange rates.

During the first stage of a two-stage cycle, many central banks and governments perceive that their economies can gain an advantage by weakening their currency on the foreign exchange market. Although it is based on bad theory, this perception is a real-world fact and often guides the actions of policy-makers. It prompts central bankers to buy-up the main international trading currency (the US$) using newly-printed local currency, resulting in the build-up of foreign currency reserves, growth in the local currency supply, and an unsustainable monetary-inflation-fueled boom in the local economy.

The build-up of foreign currency reserves during the first part of the cycle is therefore not a sign of strength; it is a sign of a future “price inflation” problem and a warning that the superficial economic strength is a smokescreen hiding widespread malinvestment.

During the second stage of the cycle the bad effects of creating a flood of new money to purchase foreign currency reserves and manipulate the exchange rate become apparent. These bad effects include economic weakness as investing mistakes become apparent, as well as uncomfortably-rapid “price inflation”. Pretty soon, policy-makers in the ‘reserve-rich’ country find themselves in the position of having to sell reserves in an effort to arrest a downward trend in their currency’s exchange rate — a downward trend that is exacerbating the local “price inflation” problem. This is the situation in which many high-profile “emerging” economies have found themselves over the past two years, with Brazil being one of the best examples.

In other words, the world is now immersed in the stage of the global inflation cycle — a cycle that’s a natural consequence of today’s monetary system — in which reserves get disgorged by central banks as part of efforts to address blatant “inflation” problems. This would be a good thing if it indicated that the right lessons had been learned from past mistakes, leading to a permanent change in strategy. However, that’s almost certainly NOT what it indicates.

The disturbing reality is that at some point — perhaps as soon as this year — a large new injection of money will be seen as the solution, because bad theory still dominates. As evidence, I cite two comments from the above-linked article. The first is by the author of the piece, who implies in the third paragraph that emerging-market countries need to boost their money supplies to shore-up faltering economic growth. The second is from a former International Monetary Fund economist and current hedge-fund manager, who claims via a quote in the fourth paragraph that emerging markets now need more stimulus.

So, emerging-market economies have severe problems that can be traced back to earlier monetary stimulus, but the solution supposedly involves a new bout of monetary stimulus. Let the idiocy continue.

At TSI over the past year and at the TSI Blog two months ago I’ve made the point that the Fed gave itself the ability to pay interest on bank reserves so that the Fed Funds Rate (FFR) could be raised without the need to shrink bank reserves and the economy-wide money supply. I explained that the driver of this change in the Fed’s toolbox was the fact that the massive quantity of reserves injected into the banking system by QE (Quantitative Easing) meant that it would no longer be possible for the Fed to hike the FFR in the traditional way, that is, via the sort of small-scale shrinkage of bank reserves that was used in the past. Instead, the quantity of reserves has become so much larger than would be required to maintain a Funds Rate of only 0.25% that even a tiny increase to 0.50% would necessitate a $1 trillion+ reduction in reserves and money supply, which would crash the stock and bond markets. The purpose of this post is to point out that while the payment of interest on bank reserves is now the Fed’s primary tool for implementing rate hikes, there are two other tools that the Fed will use over the years ahead in its efforts to manipulate short-term US interest rates and distort the economy.

Before going any further I’ll note that it isn’t just logical deduction that led to my conclusion regarding the purpose of interest-rate payments on bank reserves. It happens to be the only conclusion that makes sense, but it’s also the case that the Fed, itself, has never made a secret of why it started paying interest on reserves. The Fed’s reasoning was reiterated in a 27th February speech by Vice Chairman Stanley Fischer. A hat-tip to John Mauldin and Woody Brock for bringing this speech to my attention.

The two other tools that will be used by the Fed to raise the official overnight interest rate are Reverse Repurchase agreements (RRPs) and the Term Deposit Facility (TDF). The RRP isn’t a new tool, but its importance has increased and will continue to do so. The TDF is a relatively new tool, having been introduced on a small scale in 2010 and having been expanded in 2014.

The RRP is used by the Fed to borrow reserves and money for short periods, with securities (bonds, notes or bills) from the Fed’s stash being used as collateral for these borrowings. Now, an institution that has the unlimited ability to create new money can never run short of money and will therefore never need to borrow money to fund its operations, but the Fed sometimes borrows money via RRPs as part of its efforts to manipulate interest rates. Specifically, by offering to pay financial institutions a certain interest rate to borrow reserves and money, the Fed pressures the effective interest rate towards its target.

The TDF is similar to a normal money-market account, except that it is provided by the Fed and can only be used by depository institutions. The term of the deposit is currently up to 21 days and the interest rate paid is slightly above the rate paid on bank reserves.

Further to the above, when the Fed eventually decides to hike the Fed Funds Rate it will not do so by reducing the quantity of bank reserves. The quantity of bank reserves will probably decline as part of the rate-hiking process, but the quantity of reserves in the banking system is now so far above what it needs to be that it is no longer practical for reserve reduction to be the driver of a higher Fed Funds Rate. Instead, when the Fed makes its first rate hike — something that probably won’t happen until at least September-2015 — it will do so by 1) raising the interest rate paid on bank reserves, 2) increasing the amount that it pays to borrow money via Reverse Repurchase agreements, and 3) boosting the rate that it offers to financial institutions for term deposits.

A recent Mineweb article warrants a brief discussion. The article contains several illogical statements, which is not surprising considering the author. For example, this is from the second paragraph: “…the fact remains that any entity with sufficient capital behind it can usually move any market in the direction that suits it…” Large financial institutions and hedge funds undoubtedly wish that this were true, but in the real world these entities ‘come a cropper’ when they take big positions that aren’t fundamentally justified. However, I’ll ignore the other flaws and zoom in on the Ted Butler assertion that constitutes the core of the article. I’m referring to the assertion that banking behemoth JP Morgan (JPM) has managed to accumulate a 350M-oz hoard of physical silver while simultaneously causing the silver price to trend downward via the selling of futures contracts. It’s analysis like this that gives gold and silver bulls a bad name, because anyone with knowledge of how markets work will immediately see that it is complete nonsense.

Selling commodity futures and simultaneously buying the physical commodity cannot cause a downward trend in the commodity price, assuming that the amount sold via the futures market is equivalent to the amount bought in the spot market. Price-wise, the only effect would be to boost the spot price of the commodity relative to the price for delivery at some future time. Selling more via the futures market than is bought in the spot market could temporarily push the price downward, but the operative word here is “temporarily” since every short-sale must subsequently be closed out with a purchase. In any case, I get the impression from the above-linked article that JPM has supposedly managed to bring about a downward trend in the silver price while remaining net ‘flat’. This is not possible.

I don’t know how much physical silver is owned by JPM or what JPM’s net exposure to silver is*, and I couldn’t care less. I certainly see no good reason to comb through documents trying to find the answer because the answer is totally irrelevant to the investment case for silver. The investment case for silver is determined partly by silver’s market value relative to the market values of gold and the industrial metals, and partly by the same macro-economic fundamentals that are important for gold. Right now, silver has reasonable relative value and neutral fundamentals, with the fundamentals looking set to improve during the second half of this year.

I’m ‘long’ physical silver, despite, not because of, the ‘analyses’ of some of the most outspoken silver bulls.

*Neither does Ted Butler nor anyone else who isn’t a senior manager at JPM

At the beginning of last week I wrote that gold and the HUI were coiling, the implication being that a sharp 1-3 week move in one direction or the other would soon begin. There was no way of knowing the direction of the move, although the performance of the HUI/gold ratio relative to its 40-day moving average (MA) suggested that the direction would be up.

There were multiple head fakes last week, with a) gold bullion almost breaking out to the downside last Friday, b) the HUI chopping around near its 50-day MA, and c) the HUI/gold ratio being the only consistent indicator by sustaining its upside breakout. At this stage it looks like the HUI/gold ratio was sending the correct message, because both gold bullion and the HUI closed above the tops of their recent trading ranges on Tuesday 28th April.

The minor upside breakouts in gold-related stuff happened on the day before the Fed is scheduled to issue its next policy statement, which is out of character considering how gold has traded over the past 9 months. As noted in a commentary posted at TSI a few days ago, gold had closed lower over the course of the 5 trading days leading up to each of the past 6 FOMC meetings and would have stretched the negative pre-FOMC sequence to 7 if it had closed below $1201.80 on 28th April. Instead, it rebounded strongly and closed at $1211.50.

My thinking was that if the gold price had fallen over the first 2 trading days of this week it would have set the stage for a significant post-FOMC rebound, because the most likely outcome of this week’s FOMC meeting is a statement with almost no wording changes. No meaningful change to the wording of the Fed’s statement would mean that a June rate hike had effectively been taken off the table, which short-term speculators would undoubtedly view as gold-bullish (it’s actually irrelevant, but short-term moves are being driven by sentiment).

However, it seems that speculators have jumped the gun. As a result, buying in advance of Wednesday’s FOMC statement is now riskier. My guess is that gold and the gold-mining stocks will extend their gains if the Fed signals “no rate hike in June”, but there is now more downside risk associated with an unexpectedly ‘hawkish’ Fed statement.

One of the criticisms of the current monetary system is that the money isn’t backed by anything. However, while there are some big problems with the current system, this criticism isn’t valid. The reason is that money is never backed by anything.

Taking the specific case of the US dollar, the view that the US$ should be backed by something and the related view that the absence of backing implies a major flaw is a hangover from the Gold Standard. Under the Gold Standard that existed in the US prior to the early-1930s, a US dollar represented and was exchangeable into a fixed amount of gold.

The critical point is that under the Gold Standard the US$ wasn’t money; gold was money. The US dollars in circulation were receipts or IOUs that entitled the bearer to a certain amount of gold (money). The dollar itself wasn’t money. At most, it was a “money substitute”.

Today’s paper dollars are not IOUs or receipts. They are not “money substitutes”, they are money proper. Consequently, they do not need to be backed by anything. In fact, if they were backed by something then whatever was doing the backing would be money and the dollar itself would be a money substitute rather than actual money.

The situation isn’t as clear with regard to dollars in bank deposits as it is with regard to paper dollars, as the dollars in bank deposits are backed by the promise of the banking system to convert from electronic to paper on demand. It could therefore be argued that electronic dollars in bank deposits are money substitutes rather than money, although it is reasonable to count them in the money supply because the central bank has the ability to meet any demand for the conversion of electronic dollars into paper dollars.

The fact that today’s money isn’t backed by anything is therefore not the problem. If gold were money then the money also wouldn’t be backed by anything. That’s the nature of money. The problem, instead, is that for something to be GOOD money its supply should be fairly stable and it should be widely perceived to have value outside its role as a medium of exchange. The US dollar and all of today’s official monies fail to meet either of these requirements, whereas cryptocurrencies such as Bitcoin fail to meet the second requirement.

A hedging program can make sense for a gold producer, but hedging is something that — with a small number of exceptions — gold producers should never do. This is not because there will always be a direct cost or an opportunity cost associated with any hedging program, it’s because gold producers are so damn bad at it.

In order to optimise cash flow and make short-term financial performance more predictable, it will generally make sense for a gold producer to forward-sell some of its future production, either via a bullion bank or the futures market, after a run-up in the gold price to near a 6-month high. Provided that the total amount forward sold never exceeds more than half of the next 12 months of production, this type of hedging program would always smooth cash flows and would often increase cash flows. It would create an opportunity cost in a very strong gold market, but the cost would not be substantial because all production beyond the coming 12 months would remain unhedged.

However, gold-mining executives have proved over and over again that when it comes to the timing of their hedging moves, they are the proverbial dumb money. They get scared and put hedges in place following a large price decline and then get pressured into removing the hedges at great cost following a large price rise.

In other words, rather than locking-in relatively high prices for a portion of future production by hedging when the market is ‘overbought’, if they hedge at all it is usually when the market is ‘oversold’. Consequently, their hedges tend to lock-in relatively low prices for a portion of future production.

And it’s not just the hedging of future sales that gold-mining executives routinely make a mess of. They are usually just as bad when it comes to hedging their costs. For one example, Barrick Gold chose to mitigate the risk of future gains in the oil price by purchasing some oil production, the idea being that what its gold-mining business lost due to a higher oil price would be partially offset by increased profits from the oil business. The problem is that it made the purchase in mid-2008 — right at the secular peak for the oil price. For another example, the senior management of Gold Fields (GFI) implemented a hedging program covering the bulk of the company’s oil exposure through to the end of 2015. The problem is that the program was put into place just prior to last year’s oil price crash and therefore prevents GFI shareholders from obtaining any benefit from the lower oil price this year.

When trading or investing it is of vital importance to acknowledge your own weaknesses. For example, there is no shame in being a poor short-term trader provided that in recognition of this reality you risk very little money on short-term trades. Gold mining executives should acknowledge that they are hopeless at hedging and should stop trying to do it.

I have never been in the camp that exclaims “buy gold because the US is headed for hyperinflation!”. Instead, at every step along the way since the inauguration of the TSI web site in 2000 my view has been that the probability of the US experiencing hyperinflation within the next 2 years — on matters such as this there is no point trying to look ahead more than 2 years — is close to zero. That is still my view. In other words, I think that the US has a roughly 0% probability of experiencing hyperinflation within the next 2 years. Furthermore, at no time over the past 15 years have I suggested being ‘long’ gold due to the prospect of a rapid rise in the CPI. This is partly because at no time during this period, including the present, has a rapid rise in the CPI seemed like a high-probability intermediate-term outcome, but it is mainly because gold has never been and is never likely to be a play on “CPI inflation”.

Gold is a play on the economic weakness caused by bad policy and on declining confidence in the banking establishment (led by the Fed in the US). That’s why cyclical gold bull markets are invariably born of banking/financial crisis and/or recession, and why a cyclical gold bull market is more likely to begin amidst rising deflation fear than rising inflation fear.

There are times when the declining economic/monetary confidence that boosts the investment demand for gold is linked to expectations of a rapid increase in “price inflation”, but it certainly doesn’t have to be. For example, the entire run-up in the gold price from its 2001 bottom to its 2011 peak had nothing to do with the CPI. Also, an increase in the rate of “CPI inflation” would only ever be bullish for gold to the extent that it brought about declining confidence in the economy or the banking establishment, as indicated by credit spreads, real interest rates, the BKX/SPX ratio and the yield curve. Since it’s possible for the CPI to accelerate upward without a significant decline in confidence, it’s possible that an upward acceleration in the CPI would not be bullish for gold.

The bottom line is that as far as the gold market is concerned, the CPI is more of a distraction than a driver. 

The US$ gold price has essentially gone nowhere in a boring way over the past 2 weeks, which probably means that a sharp 1-3 week move is about to start. The question is: In which direction?

Obviously, no one knows the answer to this question. The most we can do is look for clues in the price action.

On the minus side, gold closed below its 20-day moving average (MA) on Monday 20th April. This was the first daily close below this MA since mid-March and in isolation would be a sign that the price was rolling over to the downside. On the plus side, however, the price managed to hold at the 50-day MA on Monday. More importantly, the gold-stock indices made small gains despite an $8 decline in the gold price. This small bullish divergence between the bullion and the mining stocks tilts the odds in favour of the next $30+ move being to the upside.

Here are the relevant charts:

1. The first chart shows that gold has near-term resistance at $1210. A daily close above $1210 would suggest that the price was headed to at least $1230 and possibly as high as the $1280s.

2. The next chart shows that the HUI has managed to hold last week’s minor upside breakout, but has more resistance at 180. There is near-term (1-3 week) upside potential to 195.

3. The final chart paints the most bullish picture.

Gold’s true fundamentals (the fundamentals that many gold bulls studiously ignore as they instead choose to fixate on irrelevancies such as the amount of gold being imported by China) are neutral and gold/euro does not yet appear to be close to completing the intermediate-term correction from its January-2015 ‘overbought’ extreme, so the start of a major gold rally is probably not imminent. In other words, if the recent choppy price action leads to a quick advance over the next couple of weeks it probably won’t mean that we’ve seen the last opportunity to buy gold below $1200.