Back in February we published Gold Outlook 2021, our annual analysis of the gold and silver markets from CEO Keith Weiner.
In it, Keith explained the market players, dynamics, fallacies, and drivers. He also made a call on gold and silver prices for the year.
In this week’s episode of the podcast, we focus on just a few concepts from the article:
John: Hello again and welcome to the Gold Exchange podcast. I’m John Flaherty and I’m here with Keith Weiner, founder and CEO of Monetary Metals. In today’s episode, we’re going to discuss monetary metals gold outlook for 2021, which was recently published on our website.
Predictions, as you know, for the dollar price of precious metals have a pretty wide range, to say the least. And those who assure us that gold and silver will be dramatically up by the end of the year seem to always point to inflation expectations or the Fed balance sheet as the main drivers. Of course, those people always expect inflation and the Fed’s balance sheet, well, always increases.
As usual, we will try to dig beneath the surface a bit and ground our discussion in some timeless principles about gold and the market forces that affect it.
So, Keith, everyone wants to know what gold is going to do, particularly in this era of massive interventions by governments and central banks. You have written extensively about the concept called basis and its corollary, cobasis. Could you please define these terms for us and explain their critical relevance as indicators for gold markets?
Keith: Yeah, sure. So, basis is the difference between the price in the futures market and the price in the spot market. So if you can buy gold at, let’s say, 1740 in the spot market and sell it for, let’s say, June delivery to 1760 in the futures market, there’s a twenty dollar profit or twenty dollar spread to be earned.
And then if you annualize that, OK, that’s what is that, three months? Twenty dollars….so that’s close to three percent, something like that. And you can compare that to a rate of interest. And that’s critically important because as banks and other major financial players are always looking to compare, can we do this? Can we do that? Where can we make more money? And also they borrow in order to do this trade. They borrow dollars typically at LIBOR, plus some little spread, buy the gold sell at forward, warehouse it in the middle and then make that spread.
So to understand this concept, you’ve really got to think in terms of what is physically going on. I like to use the example of a grain market, especially before global trade and grain can be brought in from other climate zones. In North America, especially the northern part of the US, I understand that the wheat harvest is like in the first week of August. Maybe that’s right, I don’t know, it doesn’t matter.
Suppose you were to drive an empty grain truck up to one of those grain elevator towns in the northern, upper Midwest. And you did that like July 30 and said how much to fill this here grain truck up? Well, they’d be laughing at you. I imagine that they’d be going through the silos, cleaning them. The pops would be flipped open, like a lid and they’d be hosing everything down, anticipating the harvest coming in.
But nobody has any grain at that moment. So if you take out a wad of hundred dollar bills, the only way you’re going to get any grain, is somebody is going to make a phone call and then some truck that’s halfway to a bakery or brewery in Wisconsin is going to be turned around, you’re going to have to pay them more profit to break that contract and sell it to you than they make by simply delivering on it.
And so let’s say you find that the price to buy a bushel of wheat was whatever…seventeen dollars. But if you’re willing to wait for September delivery, another month later, then the price would be seven dollars. So that’s an inversion of what I said earlier. Gold in the spot market being 1740 gold for June delivery…. and these are just made up numbers. It’s not necessarily the case right now. What I just described in wheat is the opposite. That is the price of the spot market is higher than the price in the futures market.
Well, if that’s the case, then all it takes…somebody can make ten dollars per bushel by selling spot and buying futures. There’s just one catch. You have to have the bushel of wheat in order to do that trade. And so when you see contango, which is the first case that I described, it generally means that the market’s in normal conditions and that means that there’s some abundance of the commodity available in the spot market for delivery right now.
And backwardation, what I just described in the grain market means that the commodity isn’t available. The reason why I bring up the wheat example is so people can see the actual physical reality of what shortage means. And why that the day before the harvest comes in, nobody has any wheat lying around. It’s all been consumed and sold, they’re waiting for the harvest the next day. Backwardation shouldn’t be able to occur in gold because virtually all of the gold ever mined in human history is still in human hands.
But it does intermittently occur in gold. And that indicates not a scarcity of the metal, per se, because all that metal mined over 5000 years is somewhere, but rather a scarcity of metal offered to the market. And so that’s a scarcity of trust. And a harbinger of higher, potentially much higher prices when it occurs.
John: Got it. So this trade you referred to is called the carry trade, basically the profit from holding gold and selling a feature against it?
Keith: Right. So if you’re borrowing cash to buy the commodity on the spot market, stick it in a warehouse, and then sell it and some futures contract or some forward, then that’s carrying it. And then inversely, if you are selling something out into the spot market and then buying a future to recover your position, that would be decarry.
John: Gotcha. So the basis then becomes the profit on the carry trade and then the cobasis is basically its inverse? Do I have that right? The profit to decarry?
Keith: A profit on the decline, which is normal in a normal market, should be negative. There should not be a profit to decarry.
John: OK, so what is the normal behavior of basis in the “normal” market?
Keith: Well, one, basis should be above zero. Unless there’s some dislocation, some shortage or whatever.
And number two, price can move around all over the place, kind of like a random number, kind of like clicks on a Geiger counter. But spreads in markets should be much more stable because the spread in this case, in the case of the wheat market, is essentially indicating the cost of interest, plus the cost of storage in a grain elevator, plus the marginal profit for the marginal warehouseman.
That shouldn’t be moving around all that much. And generally it doesn’t. Again, unless there’s some crisis or dislocation or something like that. In the case of gold, the cost of storage is essentially negligible compared to wheat, which is so much more bulky, and has requirements of light and humidity and bugs and so on. And so the basis in gold should be, nominally above LIBOR.
John: Gotcha. So in your article, you define an important concept. You alluded to it earlier in your grain example, this concept of stocks to flows. How is this relevant to the gold and silver markets?
Keith: So in all normal commodities, if there is such a thing as a glut….if the low bid of production comes in, let’s say in the case of wheat, there’s a really great year, just the right exact combination of sun and rain. And the insect population is low that year. And for whatever reason, grain production is up one percent compared to what was expected. That produces a glut. And the price drops, or it can even crash.
So that’s a signal to producers not to produce so much in the next harvest. At the same time, the lower price is an incentive to other marginal consumers of grain to use wheat and substitute wheat for potato or corn or whatever other grain they’re using. But in the case of gold, and to a slightly lesser extent silver, there is no such thing as a glut.
We’ve been accumulating stuff for 5000 years. And so you can measure as a ratio, stocks, which is total accumulated inventory divided by annual production. And if you do that using the official numbers, the World Gold Council works with all the governments and the central banks and Brinks and commercial banks and everybody else to try to add up what they think is all the gold ever produced in human history.
I think that’s prone to being underestimated. But be that as it may, with a number they come up with and you divide that by the amount that the miners are producing in the current year, you end up with decades. And in any other commodity, it’s months.
So in gold it’s like 200,000 tons, you know, 300 tons a year gives you a ratio of something like 66. That’s why you can’t do conventional supply and demand analysis on gold. You can’t say, well, this mine in South Africa is going offline and therefore the supply of gold is going to decrease.
No. The supply of gold is not just what’s coming out of the mines. It’s also all of the extant accumulated hoard over five millennia. That’s all potential supply at the right price and under the right conditions.
John: So in your article, there is a section entitled How We Analyze the Gold Market here at Monetary Metals, and you give a brief description of the five main actors who are driving the market. Why don’t you walk us through those, starting with the buyers and sellers of metal.
Keith: Right. So that’s the core of the market. And everyone else is either feeding off of them or providing a service. So buyers of metal is anybody worldwide – so if the population of the world is, what? Approaching eight billion people now? There’s eight billion people on the planet who potentially are buyers of gold and will buy gold under the right conditions. And what’s the right conditions?
For an American sitting in an air conditioned office staring at a news feed? It could be that Biden says “Oops, you know, remember that 1.9 trillion that we said we were going to spend? Well, let’s make it 2.9 because good measure.” And then standing standing behind him is Bernie and Alexandria Casio-Cortez and Nancy Pelosi.
And maybe that person says, “You know, that son of a gun, I’m going to finally bite the bullet and buy some gold.” So everybody has a different set point. And then also, somebody might own a little bit of gold and then they see that news release and maybe they buy more. So the buyer of metal is anybody who is deciding to opt out, for any reason, from the paper dollar system.
The sellers are people who either feel the price has hit their target, or the price has gone down, so it’s a stop loss. Or it’s people that need the liquidity. Maybe they have a debt they have to pay and their revenues weren’t as good as they expected them to be.
John: Yeah, I think we saw that in Covid panic, as it were. The price of gold, rather than take off, it retreated briefly. I think that was one of the explanations: more people just need liquidity, they’re covering stop losses or whatever and gold served its purpose. It was liquid and able to come to the rescue, in that sense. Do you buy into that?
Keith: It’s liquid versus, say, if you owned real estate in New York City. That might be worth a lot of money, but it’s not liquid and you’re not going to be able to sell it quickly, even in a good market. So anyway, so sellers are people who either need liquidity, or get sick and tired of it, or their fears are not realized. And they’re like, “Why am I holding this metal? It’s unproductive.”
All of these things are always constantly feeding back with the real economy. And the real economy is feeding back into these factors.
Now, buyers and sellers of paper are speculators. In the case of metal, and there’s certainly speculation in metal, too. But a very large percentage of the people that are buying metal are doing so with very long-term time horizons. If somebody has made a lot of money, he’s in his 50s, and he’s trying to set up a intergenerational wealth plan for his kids. He’s maybe got one or two grandkids already, and he’s anticipating great grandkids and he’s setting up some sort of estate plan.
Gold almost always plays a role in something like that. And the time horizons are decades. In India, when they get married, there’s gold involved in the dowry, as much as they can afford, usually. In the case of paper, it’s a shorter term play because they’re doing it with leverage, which means there’s risk. If the price goes up a little bit with leverage, you’re getting a big gain. So they’re happy. They’re happy with that.
If it goes down, obviously big losses. And there’s also a cost. Essentially, you’re paying interest one way or the other for that trade. So the paper market, there are people that are hedging, which we’re not going to talk about too much today. But just the speculators, who are shorter term traders. Maybe it’s a day trade. Maybe they’re trading for a few weeks. But they don’t have the same horizons and they don’t have the same motivators that the buyers and sellers of metal do.
And then finally, there’s the warehouseman. As we described, even though everyone focuses on him and says “Look at his short position,” he’s long physical metal, which they may or may not see…the metal inventory the warehouseman has. It isn’t necessarily only in a COMEX-approved warehouse. And he’s price indifferent. He’s price agnostic. He doesn’t care about price. He cares about spread.
So what will motivate him to put on more carry trade is a rise in the basis. What will motivate him to take off some carry trade is a fall in the basis, especially if it goes negative and the cobasis goes positive. Now the market is paying him a profit to lift his carry trade.
John: Right, gotcha. Yeah, and you’ve been writing the Supply and Demand Report for years now. And I’ve always appreciated how, as you’re breaking down the chart, you’re putting it into the context of these actors. “Here’s what the paper is doing, here’s what the metal is doing. This is what this means…” as you’re analyzing basis relative to the price chart.
So let’s now move to wrap up here. A lot of gold investors believe that the dollar price of gold will go up because, as we mentioned, inflation. And when the gains don’t materialize, you often see the chorus of those who cry manipulation grow louder and louder. You have a different explanation for what is driving the dollar price of gold. What is that?
Keith: I hinted at it earlier. When I was talking about buyers of metal. It’s interesting to look at the start of Covid as a defining moment for a lot of new people to the gold market. Before Covid, let’s say, January 2020. The interest rate on 10 year Treasury was something like eight percent. Which had been coming down a bit. October the year prior, so 15 months before that, was 3.2 percent, something like that. At 3.2 percent or 1.8 percent, there’s some yield to be had there. There is a case to be made, if you need to hold a cash balance, to hold it there.
And then Covid hit. Two things happened. One, interest rate plunged to 0.5 percent, sucking almost all of the yield out of that investment. Of course, anybody who had bought in January was sitting on a nice, big, fat capital gain and maybe thinking of taking profits as well. But going forward, no yield there.
So at the same time that the reward or the return for taking that investment had gone way down, the risk had gone up dramatically. So the US government before Covid….the 12 months ending March 31, but right before the CARES Act was enacted, I want to say March 29. So let’s just assume that for those 12 months you’re ending March 31, the CARES Act spending had not kicked in yet. The government had increased its debt by 1.7 trillion dollars.
Now, they quote a lower deficit number. There’s some accounting gimmick, and every once in a while when I have a few free minutes I try to research and figure out what’s the gimmick. I haven’t figured it out yet. But on a cash basis, one point seven trillion with the increase in the government’s debt. Then they passed a 2.3 trillion dollar CARES Act, followed almost immediately by another half a trillion. So let’s call the CARES Act all-in at 2.8 trillion dollars.
At the same time, they lock down the economy, which meant that tax revenues were surely going to drop drastically. You add the 2.8 to the 1.7 trillion that was already existing and now you’re looking at…and then add a tax shortfall to it…you’re surely looking at over a five trillion dollar cash shortfall for the government. So the risk of being a lender to this drunken sailor, if I can use that analogy, has gone up dramatically. And as we said, the return for doing so has gone down dramatically.
So what do you do when risk goes up and return goes down? Maybe you look for alternatives. Gold always stands out – and silver also. And at that time, the gold silver ratio was so extremely high that it was it was logical if you’re thinking of precious metals to buy silver. And we saw at that time institutional investors talking about silver, and buying silver.
Whereas normally institutions don’t touch silver – it’s gold gold exclusively as an opt-out choice, as an exit door from being in the chute. The sacrificial animals are all penned in, the pasture is all penned in, and they keep moving the fence in tighter and tighter. Gold is the one way to get out before they push you down the sacrificial chute.
So to really understand changes in the price of gold, you have to understand what is causing the marginal non-gold owner to decide to own gold, or what’s causing the marginal gold owner to decide to cease owning it.
You can kind of think of it as a race condition, a term from computer software, between dollar-holders that are getting sick and tired of the higher risk and the lower returns versus gold owners that are either getting sick and tired of waiting for the magic price of fifty thousand dollars an ounce that never materializes. Or, I don’t think most of them are waiting for that, frankly, or that are forced by other circumstances to liquidate because they need cash.
John: So to conclude with a drum roll, what is Monetary Metals’ call for gold and silver by the end of the year?
Keith: I think in gold we’re going to see $2000+. So, right after Covid we did hit over two thousand dollars and then it came back down. But I think I think the trend is going to be up, and perhaps seeing two thousand for the last time. And then if we had a gold-silver ratio of sixty, which is a little closer to its long term, that’s a reversion-to-the-mean kind of play, then that gives the silver above $33.
John: Two thousand for gold and thirty three for silver. Do you always tie your thoughts about the silver price to the ratio? Or you looking at basis and cobasis with the same level of scrutiny as you do with gold?
Keith: I’m looking at basis and cobasis, but the longer your time horizon, the more that the current basis….basis and cobasis are essentially telling you “What would the market be if you subtract the actions of the speculator?” So the speculators are using leverage, and they can stretch the price either below or above where it would be if just the buyers and sellers of physical metal had to clear, what would that price be? And that’s our Monetary Metals fundamental price.
Unless you start to look at one year and longer time horizons, the current basis conditions could change, probably will change. And so it becomes more of a macro call, than a strict reading confined to just reading the basis.
John: Gotcha. Well, Keith, those numbers certainly aren’t as sexy as some others I’ve seen, but they certainly seem to be grounded in a lot of thoughtful reason. That’s all the time we have today. We thank you for joining us on the gold exchange.