Here is a detailed instructional article from one of our favorite Gold bloggers. We have been getting a lot of questions on the Gold spread market, contango and what to look for in terms of a delivery squeeze. This guy explains it best. Courtesy http://fofoa.blogspot.com/
The Gold Backwardation Story
Do any of you check the GOFO rate from time to time just to see if it is getting close to zero? GOFO is a relatively good proxy for the gold contango because it represents the cost basis a dealer calculates to take either side of a 'gold for currency swap' over a fixed length of time. It is also a good proxy for liquidity in the gold market. It should never turn negative because that would mean it costs more to borrow gold than to borrow dollars. (GOFO = $ interest rate - gold lease interest rate) In other words, if GOFO goes negative, the message is that gold is more precious than dollars.
As long as the GOFO rate is positive, the borrowing of dollars will cost you more "elbow grease" (debt service) than borrowing gold. So it can be said that there is a bid from gold for dollars as long as the GOFO is positive! When it turns negative, it can be said there is NO bid from gold for dollars.
Dollar forward mechanism – LBMA
I check the GOFO rate every few days, but more for amusement than analysis lately as it has been rising!
(A side note: Last week when I clicked my GOFO bookmark that I have been using for years, for the first time ever it asked me to log in, which apparently costs "an application fee of £1,000 (which is not refundable if the application is rejected for whatever reason) and an annual levy of £2,500." I'm sure this was just a normal LBMA site improvement though, because they put the new URL for free GOFO data in the small print down at the bottom. And they also improved the actual GOFO data by reducing the font size to tiny, compressing the columns, and reducing the contrast to light-gray on white background making it much easier on these tired old eyes.)
LBMA "website improvements" - Click image to view actual size
Looking at the 3 month GOFO rate for the calendar years of 2005, 2006 and 2007 (here) we see a steady gradual rise at an average annual clip of 34%, with a maximum of 79% in 2005 and a minimum of 1% in 2007. Yet so far this year we have a 221% rise from Jan. 29 through July 23 alone.
That 221% rate change in 6 months is pretty high volatility for this normally stable metric except in the remote instances of impending doom. But surprisingly, the rapid rate change this year has been in the direction of "nothing to see here, folks."
So here is the basic story of gold backwardation. On September 29, 1999 gold went into backwardation for the first time in modern history. The cause is commonly cited as the Washington Agreement on Gold that happened three days earlier in Washington, DC. This backwardation manifested itself in three common metrics. First, the price of gold shot up.
Second, the gold lease rate spiked. And third, the GOFO rate went negative in all five durations, from 1 month to 12 months.
What is important here is both the meaning of these anomalies and the message they send to the marketplace. The GOFO rate is basically a measure of unencumbered physical gold's desire to bid for dollars. And the lease rate is the banks' bid to borrow your gold so they can sell it and then do whatever it is that banks do with your money.
So the message of a high lease rate is "lease us your gold, PLEASE, and we'll pay you handsomely for it." Remember, a lease is where you "rent out" an asset to derive an income stream. And a swap (like GOFO) is where you need a loan, so you offer an asset as collateral and then YOU pay the income stream to someone else. Only with a negative GOFO rate, you retain control of the gold PLUS you receive the income stream coming in, so why would anyone LEASE their gold in this backwardation scenario?
For the full story continue here.
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