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Monday, 23rd January 2017

Signs of a Turn in Gold?  

There are growing signs of a turn in the gold market. The correction may be over.

The Commitment of Traders (COT) weekly reports from the CME are painting a more bullish picture for gold although GLD has not been adding gold the way it typically would in a rising gold market. And for the first time in many months, there has been a hint of backwardation on COMEX, in the front month (February) contract. Unlike GLD, this indicator suggests that demand is rising and that holding physical gold may now be slightly preferred to holding U.S. dollars.

First, the COTs. Gold has rebounded $100/oz from the December low but the net speculative position as a percentage of Open Interest has actually declined to 26%. Lat week, despite a stronger gold market, the net speculative position only increased from 118,000 to 123,000 contracts. By comparison, it was 345,000 contracts at gold's summer peak. In other words, the net position of speculators in Comex gold futures is roughly the same now, with the gold price in the low $1200s, as it was when the gold price was bottoming in the $1120s last month. This is unusual and clearly bullish because it means that the gold price has managed to gain about $80/ounce without speculative buying.

Now, let's look at backwardation. Here's how it works. The usual state of affairs for gold is called contango. If you buy gold now in the spot market and you can sell the same amount in the futures market and make a small profit, gold is in contango. This is also referred to as a positive basis. Contango means that physical gold is in good supply so it is easy to buy. It also means that the buyer of gold expects to get a higher price in the future to offset the cost of temporarily giving up the dollars used for the purchase. The implication is that dollars are in greater demand than gold.

The opposite of contango is backwardation. In backwardation, you make a small profit by selling gold now in the spot market and buying it back at a lower price in the futures market. Backwardation means that physical gold is not in good supply; the market is willing to pay up for current delivery. This is referred to a positive co-basis. The implication is that holding gold is preferable to holding dollars. It may suggest that buyers see a risk in future delivery and want the metal now. So backwardation is obviously bullish for the gold price, especially if it continues as the price rises.

Last week, the level of backwardation in the near term (February) gold contract was minor and it is probably temporary. However, the rising price of gold did not made gold more available and the backwardation persisted. This tells us something. Some investors are switching their preference to gold, in spite of the higher yield on dollars now available in the market. This preference, unlike speculators buying futures with leverage, is likely not about betting on price. It is about probably choosing safety. Gold, unlike a bond, does not default. However, buying gold for safety is precisely the reason why the price will go up because investors will pay just about anything for safety.

The Institute for International Finance estimates that financial assets globally now stand at approximately $290 trillion compared to roughly $2.5 trillion is physical gold available to the market in transactable form. The Institute estimates that global debt is at $217 trillion, up $11 trillion during the first nine months of 2016. These are the assets that could compete for ownership of the world's only asset that cannot default, the only asset that backs itself. What do you think will happen to the gold price in the next financial crisis when the market figures this out?