Why does the “Paper Gold” Price Track the Physical Gold Price?

It’s curious, isn’t it? So-called “paper gold” (a futures contract) has a price that is not only very close to physical gold, but it remains locked to it. This is despite the fact that “paper gold” is reviled in the gold community.

I am writing this on Sunday evening with little liquidity in the market, and yet spot gold (XAU) is 1665.80 and the December future (GC Z3) is 1674.40. There is a small positive spread, about 0.5%, between spot and future. This spread is remarkably consistent from day to day. If spot gold goes down 1.2% then the December future,and the other months as well, go down by almost exactly 1.2%.

It’s worth underscoring that these are different prices for different things in different markets. “Paper gold” is not physical metal! If there weren’t some force that kept their prices locked together, they would detach and one could rise while the other falls, or vice versa. This is not, in fact, how they behave. They remain locked (at least for the time being). Why? What is this mysterious force that binds them tightly together?

Let’s take a step back for a moment. The futures market exists to serve the needs of producers and consumers. Producers—miners in this case—need to have predictable and consistent cash flow so they sell some of their production forward. Consumers, such as electronics manufacturers, and jewelers, have the same need so they buy some of their raw materials forward. Both can sign a contract now that locks in a price at some date in the future.

Of course, in the gold standard, there would be no such thing as a gold futures market. Futures for all other goods would be priced in terms of gold. Gold itself would not be available at a discount, nor would one ever need to pay a premium to get it. One could borrow it at interest, but that is in the bond market not in the futures market.

Once a futures market is established, speculators come in to bet on the direction of the price. They do not produce the good—gold in this case—nor use it. They cannot deliver gold to a buyer, nor do they wish to be delivered gold. They want to profit from a change in the price. They believe they have superior knowledge compared to the other market participants, and so use the futures market as an easier and more convenient way to bet than the physical metal market. And besides, the futures market offers leverage.

This is the basic theory of the futures markets, in a nutshell. Producers and consumers are trying to reduce risk. Speculators are making bets, pushing prices around, sometimes annoying the producers and sometimes annoying the consumers.

We still have not explained the fact that the price of “paper gold” tracks the price of gold metal. To do that, we need to introduce a third type of actor in the futures markets. The arbitrageur does not care about price; he is focused on spread. The arbitrageur can buy physical metal and at the same time sell a futures contract. This will earn him a little over $8 per ounce based on the prices I quoted at the top, or a bit more than 0.5% annualized. Compared to the yield on a 1-year Treasury, about 0.15%, this isn’t bad.

So long as the price of the futures contract is higher than the price of the physical metal, then the arbitrageur can buy metal and sell a contract to pocket this spread. This will obviously lift the price of the metal and depress the price of the paper, compressing the spread. The arbitrageur will stop when the spread becomes too small to be worth his time, effort, and risk.

If the futures contract ever became cheaper than the physical metal (called “backwardation”) then anyone who owns a gold bar can sell it and simultaneously buy a future with the intent to stand for delivery. In this case, the arbitrageur sells physical metal and buys a future, thus depressing the price of metal and lifting the price of the future. As in the previous case, the spread is compressed.

This is not merely academic theory. Analysis of this spread (called the “basis”) can shed light on what’s really happening in the markets. Sometimes (as now) there is a simple trade that is obvious, but only to someone looking at this spread.

In Part II of this article (free enrollment required for full access), we walk through the analysis and propose a contrarian precious metals trade.

Source: Zerohedge

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Belkin – We’re Facing A 1987 Selloff & Eventual Hyperinflation

Today the man who counsels prominent hedge funds, investment banks, institutional money managers, mutual funds, pension funds, and high net worth individuals across the globe, told King World News that he believes we are facing a 1987 type scenario where the markets will get badly shaken.  Belkin, President of Belkin Limited, also believes we are eventually headed for a destructive hyperinflation where gold will have an extended upside move.

Here is what Michael Belkin had to say in this powerful interview:  “Back in 2009, in the spring, I was extremely bullish.  Back in late 2002 when the stock market bottomed I was bullish on the economy and on markets.  The time to buy is when blood is in the streets.  We are so far from that.”

Michael Belkin continues:

“The markets are so overextended.  The markets have been going up since 2009, for almost 4 years now.  We need to have a selloff, that’s a healthy thing for the market.  The other thing I would like to say is sell rallies.  When the market is going up you buy the dips and the trend bails you out.

When the market is going down you sell aggressively into these brief, two to three day rallies that we’ve had, and that’s what I’m telling my institutional investors to do.”

Belkin also discussed government counterfeiting of money:  “I used to work for a top three government securities dealer, Salomon Brothers, back in the 80s and 90s….

“How this works is the Treasury issues debt, the government securities dealers buy the debt at auction, and then the Fed comes in and buys the debt from the government securities dealers. That’s what debt monetization is.

So when Salomon Brothers bought $5 billion of the 2-Year Notes at the auction, and then the Fed came in and did a coupon pass and bought $2 billion of that, they credited Salomon’s account with $2 billion.  That’s counterfeited money.  That’s brand new, high-powered money.  I had some mentors that were former Fed officials so I have a pretty cynical view on this whole process.

…I think we’re in a 1987 scenario where interest rates go up, the bonds fell off, and the market gets shaken.  And then at some point there is a real turning point, I don’t want to use the word ‘crash,’ but a high volatility selloff in the stock market.  At that point, I think there will be a flight back into bonds and gold and gold stocks could have a huge rally … First you have to have a deflation in asset values, and then you have to have a policy response that’s really pedal to the metal.

John Exter was a former Fed official.  He was my mentor.  He’s now passed away, but he quit in disgust.  He managed the Fed’s gold reserves in the  William McChesney Martin (Former Chairman of the Fed) years.  When they started printing money and he had to deliver gold over to the Bank of France and the Bank of Japan because we were on the gold standard, he just quit the Fed in disgust.  But what we have now is so far beyond that.

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