Gold Should Always Be In Backwardation

This post was missing the point.  The February and April gold futures contracts are in backwardation.  The futures price is less than the spot price.  If you have a gold bar, you can sell it and buy a future.  This locks in a sure profit PROVIDED THE FUTURES MARKET DOES NOT DEFAULT.

As Jon Corzine and MF Global taught us, the “provided the futures market does not default” clause is not an absolute guarantee.  WIth 0% interest rates, the amount of backwardation should equal the default rate.  (The Fed Funds Rate is currently 0%-0.25%.  That is the rate that applies to large financial institutions, who set prices in the futures market.)

MF Global was approximately 40% of all futures market contracts, and MF Global customers lost approximately 40% of their investment.  Approximately 16% of all assets invested in the futures markets were lost.  If the “new normal” is that an MF Global event happens once every 10-20 years, then there should be a default risk of 0.5-1% priced into the futures market.

30-50 years ago, if there was an MF Global default, the other financial institutions would have covered the loss or arranged for a bailout of the customers.  They would be more interested in protecting the integrity of the futures market, than robbing customers.  Knowing that the end is coming, it’s all about maximizing short-term profit, ripping off whoever you can.

Longer-dated futures contracts have more default risk, due to a greater time period until settlement.  Therefore, longer-dated futures contracts should have lower prices than shorter ones.  The “default risk” that should be priced into futures markets is greater than interest rates (0%).

If all traders are rational, futures markets for gold should always be in backwardation.  You’d be an idiot to trade your gold bar for a future, due to the risk of getting Corzined out of your gold.  The arbitrage argument that says “Gold should never be in backwardation!” is false, because the futures market has default risk.

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