A Quick Reprise of the Fundamentals

As we have always said (in good company with Jim Grant), the gold price is a reciprocal (inverse) of public confidence in central banks and financial assets-stocks and bonds. We believe that the fundamentals are telling us that financial assets should be trading at much lower levels and gold should be much higher. The fundamentals are what matter in the long run. But the markets do not currently agree with our interpretation of the fundamentals and, in the short run, the markets are always right. Equities are higher and gold is lower.  

A Quick Reprise of the Fundamentals

The central question, in our opinion, is whether the U.S. economy is in a recovery which can achieve 'escape velocity', enabling the Federal Reserve to take its foot off the monetary gas pedal before inflation becomes a problem. This is the so-called Goldilocks scenario which has driven stocks higher and the gold price lower.

We continue to believe that there is no meaningful recovery in the U.S., that there won't be one anytime soon and that the Federal Reserve is trapped in a cycle of endless easing until markets begin to fear inflation and the bond market says enough. We base our conclusion on measures of the U.S. labor market because that is what matters most and the Federal Reserve agrees.

Of the new jobs created since the start of this year, 77% (731,000) are part-time. The number of part-time workers in the U.S. has just hit a new record while the number of full-time jobs is still 6 million below 2007. Overall, there are still 2 million fewer people working than in 2007. The US economy is adding jobs in bars and restaurants while losing jobs in manufacturing. Real wages for most Americans are falling. One out of every four American workers has a job that pays $10 an hour or less. An astounding 53% of all American workers make less than $30,000 a year. The U.S. has a higher percentage of workers doing low wage work than any other major industrialized nation. The labor participation rate is at a new 40 year low. This is not a recovery. (See Zerohedge.com, July 7, 2013 for data sources).

As the false Goldilocks scenario is exposed, and it becomes clear that the Federal Reserve cannot taper its Quantitative Easing in any serious way, we believe the gold price will rebound. The reaction of the Treasury market following the Fed's May 22, 2013 discussion of tapering is further evidence of the Fed's inability to slow the pace of its money printing. When the mere possibility of near-term tapering was publicized, bonds immediately fell sharply (interest rates rose), putting pressure on mortgage rates, slowing the pace of mortgage applications, depressing the level of sales activity and driving down the shares of homebuilders. Housing is a key element in the recovery story.

As persuasive as these facts are, there is another factor which may prove to be more important for gold in the near-term. The structure of the gold market is showing evidence of extreme positioning by major players and very tight supply for physical bullion, two factors we think may be signaling that gold could soon go higher.

The Structure of the Gold Market

The Bank Participation Report (BPR), published once a month by the CFTC, discloses the positions in the COMEX futures markets held by U.S. and foreign banks. In the report for December 4, 2012, four U.S. banks reported a long position in gold of 37,790 contracts (10% of Net Open Interest) and a  short position of 144,183 contracts (39% of NOI) for a net short position of 106,393 contracts (29% of NOI) while gold was trading at about $1700. The net open interest is the open interest less the number of spreading contacts which are both long and short.

In the most recent BPR for August 6, 2013, the same four U.S. banks held 90,949 long contracts in gold (24% of NOI) and 31,476 shorts (8% of NOI), resulting in a net long position of 59,473 contracts (16% of NOI). This report represents an enormous swing in just eight months of 165,866 contracts, the equivalent of nearly 16.9 million ounces of gold worth more than USD 22 billion at current prices. This position swing occurred (coincidentally?) during a period of rapid decline in the gold price. The entities involved in these positions include some of the world's pre-eminent bullion banks, essentially the market-makers in gold and the biggest and most knowledgeable participants in the gold market. Their huge, well-timed short position, now covered, would have been immensely profitable. Will their newly established long position also prove to be so? We think this is a reasonable assumption.

According to experienced observers, the current long position in gold is the most concentrated in the history of the COMEX. The previous short position of last December was also the most concentrated on record. Concentrations of this magnitude could be considered 'corners' with the potential to generate enormous price movements. Corners are very rare, but we seemingly have had two in gold within a year. Of course, the banks involved in these positions are active in other gold markets and they may have offsetting positions elsewhere but the fact remains that these concentrated positions on COMEX have been reliable predictors of subsequent price direction.

Another important feature of the current structure of the gold market is its increasing tendency towards backwardation, also a very rare event. The spot price of gold should, and almost always does, trade below its future price as expressed in futures markets such as COMEX. Because gold is not consumed and almost all the gold ever mined is still available, gold sold in the futures market should always trade at a premium to the spot price (the contango) to reflect the cost of holding (financing and storing) the gold. When gold is in backwardation, there should be traders willing to sell gold now and immediately buy the futures for a risk-free profit until gold has been arbitraged back into contango. But this is not happening.

Persistent backwardation, even if small and only in the near months, is significant, indicating that there is tight supply of gold for immediate delivery, or a perception of counter-party risk in the futures market, or both. What is curious is that backwardation is working its way further back along the forward curve and getting deeper, as time goes on. Here are the dates when this year's COMEX contracts first went into backwardation (see monetary-metals.com, August 1, 2013):

• The April contract first backwardated on February 15, 30 trading days before its first notice day
• The June contract first backwardated on April 4, 42 trading days before its first notice day
• The August contract first backwardated on May 16, 55 trading days before its first notice day
• The October contract first backwardated on July 8, 61 trading days before its first notice day
• The December contact first backwardated on July 31, 67 trading days before its first notice day

Some commentators have dismissed this backwardation as unimportant. Certainly it is not too surprising to see backwardation occur briefly in gold when the front contract is near to expiry but when it happens so far in advance of this event, when it extends into the next three successive months, and when it continues week after week, it is difficult to argue how this is normal; it has never been seen before.

The physical market in London has also moved into backwardation. GOFO, the Gold Forward Offering Rate at which gold is swapped for dollars, started going negative on July 8, 2013 for only the third time in 14 years. Essentially, this means that gold is commanding a higher interest rate than U.S. dollars which is the same thing as saying that demand for immediate delivery and soon-to-be-delivered gold is high enough to pay a premium for gold today. GOFO has now been negative for an unprecedented 28 consecutive trading days, the rate is steadily becoming more negative and the backwardation is reaching into longer maturities. Notice the consistent steepening and the fact that the six month swap rate has now moved into negative territory (see tfmetalsreport.com, August 8, 2013):

The one month rate at -0.12167% is the lowest it has been since rates went negative in early July and the two and three month rates are also at their lows.

For comparison, there were three days in 2008, at the height of the financial crisis, when GOFO was negative:

There were also two days in 1999, immediately after the announcement of the original Washington Agreement limiting Central Bank sales and leasing of gold, when GOFO also went negative and the gold market nearly collapsed as the price soared (until the Bank of England and others stepped in to pacify the market).

Clearly, there is growing reluctance to trade physical gold for paper gold even when backwardation guarantees an arbitrage profit. We believe that backwardation reflects unprecedented stress in the gold market generated by the decline in the gold price to unsustainable levels and a resulting enormous increase in the demand for physical gold. Perhaps central banks have also decided not to roll over the gold loans they have made to bullion banks, leaving them to scramble for metal to meet their obligations.

In summary, the structure of the gold market is, in our view, sending us a signal. The world's most powerful bullion banks have forcefully positioned themselves for a turn in a market which is trading as if bullion is in short supply. It is worth noting that most bullion is held in unallocated accounts and that bullion banking has always practiced fractional reserve banking just the way dollar banking does. A perceived shortage of physical gold could lead to a gold bank run which would greatly exacerbate the current tightness in the gold market. Unlike dollars, gold cannot be created to meet demand. The leverage in the gold market is unknowable but there is no reason to believe that the opaque nature of the market has encouraged conservative behavior.

Patience May Now Be Rewarded

Year after year, Seabridge has continued to improve the underlying value of its assets but market conditions in the past two years have prevented much evidence of this success from showing up in the share price. We think this frustrating period may be coming to an end. The news at KSM could hardly be better and the gold market is beginning to suggest to us that it could now move higher. Thank you for being patient. We are doing our best to ensure that patience is not just its own reward but also a means to increased wealth as well.

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