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Actually, I think backwardation and contango cause inventory to go down and up, because of the cash and carry trade. First, the situation how contango increases inventory: when there is a steep enough contango futures curve all prices in the future are significantly higher than spot. An arbitrage opportunity arises where traders can borrow USD funds, buy spot gold and store it (in a COMEX vault) to sell through a futures contract at a higher price. If the difference between the spot and the future price over period X is higher than the interest to be paid plus the cost of storage over period X, it becomes profitable to cash and carry.
For example, simplified: the spot gold price is 1,000 USD per ounce, the one-year gold futures price is 1,050 USD per ounce, the cost to store 100 ounces of gold for one year is 900 USD and the USD interest rate (LIBOR) is 0.5 %. Paul borrows 100,000 USD at 0.5 % and buys 100 ounces of gold to store at the COMEX. At the same time he sells short a 100 ounce futures contract at 1,050 USD per ounce. Paul’s total costs are, 500 USD interest and 900 USD storage costs, equals 1,400 USD. His revenue is 5,000 USD, as he will receive 105,000 USD for the gold in one year that he bought for 100,000 USD. 5,000 minus 1,400 USD, is 3,600 USD in profit.
Contango can cause inventory to increase, whereas a lack of contango unwinds inventory. Also, during backwardation a reversed cash and carry trade arises: borrow gold to sell for USD and buy long a futures contract to settle the debt when the gold loan matures. The price of the futures contract would be lower than that of the gold borrowed. Whenever demand to borrow gold increases, the gold lease rate (GLR) goes up, which is exactly what happened recently.
Now we can see how GLR and LIBOR are related and how LIBOR can affect the gold futures curve. If LIBOR is lower than GLR there is gold backwardation, if LIBOR is higher than GLR there is contango. Hence…
LIBOR – GLR = Gold Forward Offered Rate (GOFO)
We could say, negative GOFO signals scarcity in the gold market. Unfortunately the LBMA ceased publishing GOFO rates with effect from 30 January 2015 “following discussions between the LBMA and … Market Makers”. Ironically, GOFO rates went dark right after dipping into negative territory in 2013 and 2014.
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