My answers to FOFOA’s response.
I think an accurate definition of "paper" and "physical" is important to the accuracy of your statement: "I am reasonably confident that paper and physical are bound together."
But what if you could play the arbitrage (closing the gap) game without actually putting any physical at risk of delivery? Would this change the accuracy and credibility of the basis signal?
I assume you are talking here about using unallocated. OK so lets scenario it. Assume a stable supply/demand for both cash and futures so without the actions of an arbitrageur the cash price would remain at $1200 and Dec futures at $1195 for a period of 6 months. Hedge fund notices this and wishes to profit from it but it does not want to (or have) physical gold it wants to risk.
Hedge fund contacts their friendly bullion banker and asks to lend gold. Bullion bank conjures out of thin air some fake unallocated gold, merely recording an asset in its books (loan to hedge fund) and a liability (unallocated owed to hedge fund). Let us assume the amount of ounces is enough to move the price in our otherwise stable market by $3.
Hedge fund’s first step is to buy the Dec futures at $1195 but in doing so its price increases to $1198 (lets say that is the next offer price). Secondly they have to sell spot. Say they find a trusting investor who is willing to accept a transfer of the fake unallocated gold for $1200. Again, this action decreases the spot price to $1997 (next marginal bid price) and the market is now in contango. So far so good.
But what happens in six months? The hedge fund only has two choices – cash settle or physical settle.
If they cash settle then they have to sell back their Dec futures contract, but doing so will cause the price to decrease from its new equilibrium price of $1198 to $1195. Likewise, they have to buy unallocated to repay the loan to the bullion banker, but that will increase the spot price from $1997 to $1200. All that cash settling has done is delay the appearance of backwardation but not eliminated it.
If they physical settle then they get their gold from COMEX and deliver it to the bullion bank to repay their loan. Now this would have no effect on prices. However, the bullion bank now has physical 1:1 backing its unallocated liability to the trusting investor. If that investor asks for delivery, it will have no effect on price because the bullion bank has the physical. In a roundabout way the hedge fund eventually did sell real physical gold to the trusting investor.
Now your retort may be that the fact that the trusting investor was willing to accept fake unallocated allowed the manipulation of the basis to turn backwardation into contango. You would be correct, and that is the point of my scenario. The basis is therefore reflecting reality, the reality that there are idiots prepared to accept paper gold.
The basis IS telling the truth. It is not the hedge fund or the bullion bank who have “manipulated” the basis, it is the trusting investor. But in a sense the basis has not be manipulated, arbitrage is ensuring it reflects reality, that there are idiots who are prepared to bid dollars for paper gold.
If that trusting investor was not so trusting, then the hedge fund would not have been able to execute their arbitrage because there would be no one willing to accept their paper gold. The cash price would have remained at $1200 and the market in backwardation, and the basis would reflect reality, the reality that people were only willing to bid dollars for real gold.
You said “If gold stops bidding for dollars (low gold velocity), the price (in gold) of a dollar falls to zero. This is backwardation!” My reply would be that even if all (real) gold stops bidding for dollars, but there is plenty of paper gold bidding for dollars which are being accepted, then there is no backwardation.
My logic therefore leads me to the conclusion that the basis does not lie, that it cannot be manipulated. Professor Fekete was right all along, long live the basis. However, I don’t feel totally confident in this statement, as I said I’m not an expert in futures so there is probably a flaw in my scenario and logic. If so what is it?
Over time, group 1 will swell and end up holding most of the above-ground physical gold in the world. Group 2 will shrink and end up holding mostly paper gold. Group 3 will be financially sucked dry by the vampires in group 4. And group 4 will ultimately find it has no more markets to churn.
This is the theoretical process that gold backwardation should represent. A healthy and REAL gold contango SHOULD send this process into reverse, perhaps slowly at first, but reverse nonetheless.
So the question I am asking is which direction are we heading right now in this process? How close are we to the end of this process? And why aren't the market signals matching the rest of the picture?
If group 1 already has most of the physical gold and is now a one-way flow, is that not the state-of-the-market that backwardation should signal? And if the state is present but not the signal, what does that say about the signal?
Following from my conclusion that the basis does not lie, then the “signal” must be correct, which means “the state” of group 1 strong hands having most of the physical gold is not correct and we not close to the end of the process you describe. This is consistent with the defence by goldbugs to claims we are in a gold bubble that investment in gold is still a fraction of portfolio allocations and the mass market is not buying gold. Dollars are not being bid for gold, real or paper.
If you don’t like the conclusion, then you must find a flaw in my logic about the basis. I am more than happy to be proven wrong. Well, maybe not just yet, I'd like to pick up some more cheap gold :)