Backwardation: What Everyone is Missing


Prudent investors make wise markets: this should be the quote above every trading desk. The enemy of the hedged investor is not wild markets, nor bearish markets; it is their own emotions.

With silver prices reeling to highs we haven’t seen since the 1980s, every piece of information has earned some urgency. Immediately, the world attempts to decipher new developments and information as if there is some sort of end of the world scenario looming below.

While we subscribe to the view that the silver market is being manipulated, backwardation cannot be immediately interpreted as a symptom of such manipulation. For that to be the case, we would have to reason that the majority of investors know about the excellent investment that is silver, as well as the market dynamics that make it so greatly undervalued. That simply isn’t the case.

Instead, backwardation is a very clear signal, and it is not inherently a tip of the hat to a shortage in silver. In fact, economics tells us there is shortage in everything, at least as it relates to price. The price of silver is nearing $30 per ounce; thus, there has to be a shortage of silver at $25 per ounce, otherwise $25 would be the market price.

What Backwardation Means

The time value of money may be a theory applied best in finance and one better assigned to paper currency, but it has relevance in the metals market, as well. When backwardation occurs, the markets are telling us that it is willing to pay less for a commodity in the future than it is right now. Essentially, the ratio of supply to demand is greater at the long-end of the curve than it is in the short-end.

That isn’t implicitly market moving, however. It could very well mean what we suspect it to mean: producers are far more interested (temporarily) in locking in prices into the future than investors are buying into the future. Consumers, those who wish to use the metal for production or consumption in manufacturing and jewelry, probably have plenty of forward contracts already…at lower purchasing prices. Those who need silver in the future have it (assuming, of course, that there will be metal for delivery when the time comes – another issue for another time).

Bringing back the time value of money, we know that an item should be worth more in the future than it is right now. Buying a March 2011 January future should be less expensive than a 2015 December future, since the December future should take into consideration the financing costs of borrowing money for four years.

However, what many are missing is that there is no time value of money. Borrowing costs are plummeting, and the risk-free rate is, for all intents and purposes, null and void.

This isn’t to say that investigation into silver backwardation and short-selling isn’t valid. Instead, it is to say that either: A) the markets are functioning properly and the price of silver is simply reflecting the risk-free rate advantage that can be earned elsewhere in combination with miners’ willingness to lock-in prices or B) that the markets are manipulated.

Either way, it doesn’t much matter. Money has no time value, and that isn’t natural. Consumption is as economically advantageous as is investment. Even if all the evidence pointing toward manipulation is found to be untrue, it is certain there is manipulation in currency, and that means silver goes higher.

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