Red Alert Update

(27 February 2012)

In Backwardation in the Case of a Monetary Metal, we have explained how to interpret backwardation in the case of gold or silver. The major difference between gold and silver on the one hand and industrial or agricultural commodities on the other hand is the large stock to flow ratio, i.e. the fact that there are large stocks of gold and silver held for investment purposes which can immediately be on the market for sale should the price rise high enough. Therefore, the gold and silver markets do not exhibit the occasional shortages such as, for example, the markets for wheat or corn. Backwardation therefore has a different cause which we have identified as counterparty risk in gold or silver swaps.

This update adds one further possible cause of backwardation: significant carrying charges for holding US$ deposits or outright negative nominal interest rates.

The title Red Alert Update alludes to Antal Fekete’s article Red Alert (also see his The Last Contango in Washington). In these articles, he explains that persistent backwardation causes gold to leave the public exchanges and trading venues and to disappear into private hands. One way of understanding this is to view the market makers in the same fashion as the warehouse managers of industrial commodities or the operators of grain elevators in the case of wheat or corn. In a backwardation environment, they can no longer afford to maintain their inventory, and so the liquidity of the market dries up. We have touched on this aspect in Section 4 of The Many Values Of Gold.

We are grateful to One Bad Adder at FOFOA’s blog (formerly Topaz) for insisting on the danger of negative (nominal) interest rates and refer to his article The Last Rubicon. Three ideas now fit together:

  • FOFOA’s insistence that the London gold market is in danger not from rising prices and buying pressure of unallocated or even allocated gold, but rather from a sudden extreme risk aversion and deleveraging. We refer to his Todays (quote-unquote) ‘Gold’.
  • One Bad Adder’s insistence that the danger is negative (nominal) interest rates which can indeed be expected in an environment of extreme risk aversion when all investors crowd at the very short end of the yield curve and in demand deposits.
  • A quick review of our Backwardation … article shows that indeed negative nominal interest rates or, alternatively, carrying charges for US$ deposits, can cause backwardation.

Therefore, Antal Fekete’s Red Alert may be triggered when short term nominal interest rates turn consistently negative. What matters is not so much demand deposits for retail customers, but rather the question of whether money in size, say US$ 50 million or more, may have to accept what is effectively a negative nominal interest rate, just for the privilege of a very liquid short-term investment.

There is in fact a recent precedent for carrying charges on large demand deposits (which, at that time, they did not enact, if I remember correctly). On 5 August 2011, the Wall Street Journal reported:

Bank of New York Mellon Corp. on Thursday took the extraordinary step of telling large clients it will charge them to hold cash.
The shift is also emblematic of the strains plaguing the U.S. economy. Fearful corporations and investors have been socking away cash in their bank accounts rather than put it into even the safest investments.
The giant bank, which specializes in handling funds for financial institutions and corporations, will begin assessing a fee next week on customers that have been flooding the bank with dollars, Bank of New York told clients in a note reviewed by The Wall Street Journal.
Bank of New York finds its deposits “suddenly and substantially increasing” as investors are in a mass “de-risk” mode. The bank said the decision was driven by the fact that it cannot invest much of the new deposits because clients have the ability to move the funds out at any moment.

The ultra-low interest rates set by the Federal Reserve in an effort to stimulate the anemic recovery have also neutered banks’ ability to reap profits from investing their deposits.
Bank of New York said that customers that have deposited more than $50 million into their accounts since the end of July will face an annual fee of at least 0.13% of the excess deposits. The fee would rise if the one-month Treasury yield dips below zero, according to the letter sent to customers.

A second indication of difficulties in managing large sums of short-term money is the 13 Week T-Bill Yield which has remained very close to zero during most of the second half of 2011. Investors who have large sums to invest and therefore cannot use demand deposits at a bank, typically choose short term Treasury Bills instead.

13 Week T-Bill Yield Index (^IRX)

Since 13 week T-bills do not carry a coupon, they are auctioned at a price of 100% minus a discount, the 13 Week T-Bill Discount, and at maturity are repaid for 100%. So far, the auctions have been done only at a true discount, and it has not been possible to auction T-bills at a premium which would correspond to a negative nominal interest rate. Several Primary Dealers have apparently asked to make negative nominal interest rates possible in the future. According to the minutes of the Treasury Borrowing Advisory Committee of January 31, 2012:

[…] The question was asked if it made sense for Treasury to permit bids and awards at negative interest rates in marketable Treasury bill auctions. DAS Rutherford noted that there were operational issues associated with such a rule change, but that the hurdles were not insurmountable. It was the unanimous view of the committee that Treasury should modify auction regulations to permit negative rate bidding and awards in Treasury bill auctions as soon as feasible. Rutherford noted that any decision on this policy change would likely be made at the May refunding. […]

Let us now review our article on Backwardation … and reconsider the formula for the interest rate on swaps of gold for US$, i.e. the interest rate paid if one lends gold and borrows US$ for a fixed period. This rate corresponds to the Gold Forward Offered Rate (GOFO) in the case of the LBMA or to the gold base rate in the case of the COMEX:

swap rate paid =

+ nominal risk-free yield of US$

+ risk-premium because you might not return the borrowed US$

+ storage expenses for the gold

– risk-premium because your counterparty might not return the gold

– carrying charges for US$

The last term, the carrying charges for the US$ deposits, was assumed to be zero in our previous article, and we had not anticipated that the nominal risk-free yield of US$ might become negative. If we now take a possible environment of negative nominal interest rates into account, we would have a negative nominal risk-free yield of US$ or, alternatively, zero nominal risk-free yield of US$, but non-zero carrying charges for US$. So even if the two risk premiums cancel or can be ignored, it may happen that the carrying charges of US$ or the negative nominal yield of US$ exceed the storage expenses for the gold. In this case, an efficient market discovers a negative swap rate paid which means backwardation.

Gold! It is the only medium that currencies do not “move thru”. It is the only Money that cannot be valued by currencies. It is gold that denominates currency. It is to say “gold moves thru paper currencies”.

Dollars bidding on MSFT stock set the value of that stock. If dollars are frantically bidding on MSFT (high velocity), the stock skyrockets. If dollars stop bidding for MSFT all at once (low velocity), the price falls to zero. This is true for everything in the world **except gold**.

Gold bids for dollars. If gold stops bidding for dollars (low gold velocity), the price (in gold) of a dollar falls to zero.

The critical situation to watch for is therefore the flight of capital down along Exter’s Pyramid,

Exter's Pyramid

from any riskier and longer term investments into T-bills and demand deposits and perhaps even into tangible cash, into gold, or if gold it not available, then into hoarding any of the necessities of life (also see FOFOA’s All Paper Is Still A Short Position On Gold).

We like to summarize the outcome of the ultimate flight of capital as follows:

  • If physical gold is available at a fixed currency price, the gold will be hoarded while credit collapses. In the absence of bailouts, we get 1929-1933.
  • With bailouts as follows:
    • If physical gold is not available, capital flight will be into the necessities of life instead (hyperinflation).
    • If physical gold is available at a fixed currency price, there will not be enough of it.
    • If physical gold is available at a floating price in terms of credit money, its price may skyrocket, but gold can continue to flow and help avert hyperinflation.

9 Responses to Red Alert Update

  1. Bosco says:

    Hi Victor,

    Another good article.

    My question is on the last scenario. Will the availability of physical gold in a floating price in terms of the credit currency prevent HI? I am doubtful on this. This seems to me builds on the assumption that people want to hold gold ONLY in an uncertain currency. But history shows that’s never the case. Gold can rise (perhaps rise biggest) in a failing currency (and is still available) but there’s no reason to assume people, even in the presence of gold available on the market to buy, NOT to buy up other stuff that they see value in, be it silver, farm land, rices, water or whatever.

    My biggest trouble with the Freegold theory is, gold is SoV par excellence but that does not exclude other stuff to act as SoV as well unless, again, it’s by gov’t decree.

    • Hi Bosco,

      perhaps I shouldn’t try to predict too many details because this is very likely to go wrong. I am not sure it is guaranteed to prevent HI, but I do think it would help. Assume you have about 2 weeks worth of groceries in your fridge or basement and still several months worth of salary in your bank account, you see consumer prices rise, but you are worried they might rise in an unpredictable fashion, and you don’t trust those who issue your currency. Now you can certainly just spend the money and stock up on food and perhaps fuel. But this is seriously inconvenient. It takes a lot of space, and, by the way, I’d prefer to eat fresh.

      Now if there is a liquid market for gold and you don’t trust the paper currency as a store of value even over a few months, you can just buy gold and at least approximately preserve the purchasing power of your savings. But this works only if the gold price is free. I am not saying I would not stock up on food and fuel, too, but having a working market for gold would certainly help.


  2. Michael H says:


    Is there another possibility as to why silver was in backwardation in early 2011, related to the ‘silver bubble’?

    My thoughts are as follows: maybe the miners saw the price of silver doubling and decided to lock in profits. Having sold all their current inventory, they started selling forward as much as they could. The additional forward selling either a) overwhelmed the usual arbitrage channels that kept the term structure in contango or b) tipped off the BBs that the miners were desperate and so the BBs allowed the backwardation so they would be able to pocket the free arbitrage money.

    Just wondering if the backwardation signal ended up being not a ‘buy now because there’s a shortage’ signal, but a ‘sell now because its a bubble’ signal.

    • Very good question. I don’t have the charts here right now, but silver backwardation started in January 2011 and lasted until early April when the price rose beyond $40 (roughly). Therefore, I guess, the increase beyond $40 was most likely driven by paper buying rather than shortage or counterparty-risk. You are therefore asking about the increase from $30 to $40 during which we had backwardation.

      What’s still not obvious to me is why during phase of backwardation, nobody performed the arbitrage and pocketed the free money. A cartel of the bullion banks? Who besides the BBs owned enough silver and could have done it? Everyone in SLV could have done it, lots of investment funds, hedge funds, and so on. Silver is easy to trade – in contrast to oil, for example. With oil, you regularly have backwardation because only very few have access to physical oil infrastructure, tank farms and VLCCs. All the financial firms are limited to the futures market. But everyone can trade physical silver, either through SLV, COMEX, or the BBs.

      I don’t know the answer. Perhaps it was Sprott who upset the market and, not least with his propaganda, made investors cautious and prevented them from selling physical for a while. His funds hold minority stakes in numerous mining companies. Did he talk them into not selling physical at spot, but rather storing the metal and only selling forward? Maybe. Can he influence enough miners? Don’t know. Costata might say the BBs used Sprott in order to rip off the industrial consumers. I think it was Jeff Christian who said that the main risk to the silver market is Sprott and his funds. One day when the market moves against him, he might cut and run and collapse both silver and the miners in the process. We’ll see.


  3. Hi Victor,

    am I right in understanding your summary like this:

    • You are describing there how the “end of the dollar” could look like.
    • There are 4 possibilities what could happen in this situation:

    (1) 1929-1933 because of gold availabe in fixed price and no bailout.
    (2) Hyperinflation because of gold not available although bailout.
    (3) Not enough gold to meet demand because of gold available in fixed price although bailout.
    (4) No hyperinflation because of gold available in floating price; bailout needed.

    Am I right that (4) is describing Freegold?
    Am I right in understanding that (4) is meeting the governmental goals most?
    Therefore (4) will happen because it’s highest probability?

    Are these possibilities true for the $USA only?
    Could they happen equaly for €Europe to?

    • I guess the dollar may have the problem (3), simply because there may not be enough physical gold when the (paper) price of gold collapses.
      (4) is the advantage of the Euro, a freely floating price of gold – assuming the ECB or BIS immediately start to make a market in physical gold once the London market fails.
      The US could theoretically try (4), too, but there are some $10 trillion dollars held abroad that would try to catch some of the physical gold that is for sale for dollars. So the US would need a gold price substantially higher than the Euro zone just in order to survive. That would still make the dolar decline quite a bit – but is’s the right direction and it’s stabilizing.


      • Thanks!
        (4) “… assuming the ECB or BIS immediately start …”:
        Does this mean that from your point of view Freegold will NOT come inevitably but depends on if and what specific people decide or decide not?
        That would stand in quite a contrast to FOFOA’s position, wouldn’t it?
        How would this look like, an Euro zone making a market in physical gold?

        • I don’t think this contradicts FOFOA. Should the London gold market ever close again, at least one of the others (ECB, BIS, China, …) has to restart the gold market, simply because otherwise the oil trade would be disrupted.

          How would it look like? Let’s guess. The ECB selling 100t in an auction. Two days later, the ECB buying 100t in an auction, and so on.


          • Thx, Victor. I am realising again: Oil is the linchpin of the whole story. Sure! Besides consciousness it’s the one still irreplacebale and not free stuff which is making our human world go round in these days! So back to reading the great Another …

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