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Turk:  “The big news here in London, Eric, is that gold slipped into backwardation once again.  The previous backwardation ended here in London on Monday, when the US was closed for a holiday.  It looked like a concerted effort by the central planners to put gold and dollar interest rates back into their normal relationship....

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“But this artificial condition could not hold because the demand for physical metal is just too strong.  So gold's 1-month forward rate against the dollar is once again negative. 

I think some history will be useful to help explain what is happening, starting first with what took place in 1999.  In May of that year,  British Chancellor Gordon Brown announced that Britain would sell one-half of its gold reserves.  That announcement started a selling panic which ended with the so-called ‘Brown bottom’ on July 19 at $253.  In a couple of months, gold had dropped about 10%.

As we now know, that selling climax ended the 19-year bear market in gold.  Importantly, the gold price then began to slowly climb.  At the end of September 1999, central banks announced the Washington Agreement on Gold which limited the weight of gold they would lend to the bullion banks that had been actively borrowing metal. 

This activity was a major reason why the gold price had fallen nearly 40% over the last years of the 1990s.  So it is understandable that the central bank announcement resulted in a big $30 jump in the gold price to over $300, and for a couple of days, gold even went into backwardation -- indicating a shortage of physical metal.  Thereafter, the gold price began what has become a historic multi-year climb.

Now, let's fast forward to 2008.  After the Lehman collapse there was a rush for liquidity, and gold is one of the most liquid assets.  So it was aggressively sold into November of 2008, when the selling pressure ended as gold went into backwardation for a couple of days.  And as proof that the baby was thrown out with the bath water, gold climbed from $717, at its November 2008 low, to $1,000 by February 2009.  And it kept climbing for two more years.

During each of those two previous periods, gold was in backwardation for just a few days.  In contrast, the backwardation that ended Monday prevailed for a totally unprecedented and record breaking 40 trading days.  During that time, gold rose from $1,200 to over $1,430.  It was a spectacular jump in price.  But with gold again below $1,400, the backwardation has re-appeared.

Where are the arbitrageurs?  Why haven't they stepped in to take the easy profits?  All they have to do, Eric, is sell their physical metal and simultaneously buy it back for future delivery at a cheaper price.  Plus, they have use of the proceeds from their sale to invest.  They also avoid storage costs while they own paper gold - a promise to pay gold in the future - instead of physical metal.  For the big gold players it is easy money laying right there on the table, in plain sight for everyone to see.  So why don't the big players take the advantage of the arbitrage?

Is it because they fear the promise to deliver physical gold to them in the future will be broken?  Do they value a tangible asset more highly than a financial asset?  Do they believe the reward for holding physical metal is greater than the potential of a short-term profit?

We of course do not know the answer to these questions, but one thing is clear, this new backwardation illustrates that physical metal remains scarce, or in other words, it is being held in strong hands.  It is therefore going take much higher gold prices to entice these strong hands to part with their metal and instead hold some depreciating national currency.

Most importantly, Eric, if we look at what happened with regards to the persistent rise in the gold price after gold became backwardated in 1999 and again in 2008, we can only conclude from these precedents that gold has much further to rise in the weeks and months ahead.”

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© 2013 by King World News®. All Rights Reserved. This material may not be published, broadcast, rewritten, or redistributed.  However, linking directly to the blog page is permitted and encouraged.

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Eric King

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