Why Keith Weiner’s Blog is Wrong.

Why Keith Weiner’s Monetary Metals Blog is Wrong.

 

If you’re a gold investor or gold trader, it’s hard not to run across the ideas of Keith Weiner.

His Monetary Metals Supply & Demand blog is reprinted on many popular investing websites, such as Acting Man, Gold Eagle, Silver Doctors, Financial Sense, and even Forbes. And his theory on what determines the price of gold is well-researched and well-argued.

But does Weiner’s Monetary Metals Supply & Demand blog actually describe the way the gold market functions?

I used to answer this question with a resounding “yes”. It seemed obvious to me that Weiner’s “basis theory” did describe movements in the gold market. However, I no longer believe that.

Below, I will explain why I think his theory is wrong.

But first, let me say in advance that none of what I am about to say here is a criticism of the Monetary Metals business. I think Keith Weiner’s various investment products are great. And I think many accredited investors would benefit from investing in his products.

This criticism is only directed at the Monetary Metals Supply & Demand blog, which in my opinion has nothing to do with the investment products offered by the company itself.

In addition, this criticism has nothing to do with Keith Weiner’s Theory of Interest And Prices in Paper Currency, a theory he developed to explain how the global economy works when the gold standard has been dispensed with.

In my opinion, this latter theory has some problems. But it’s mostly true. And I have no desire to criticize it right now.

So this article is only in reference to the “basis theory” that forms the foundation of the Monetary Metals blog.

Keith Weiner’s Monetary Metals theory explained.

Before criticizing any idea for how a particular market functions, it’s important to first make sure we understand what the idea is saying. So here is an explanation of the basis theory as I understand it.

The best explanation of Keith Weiner’s theory is his January, 2013 post, Permanent Gold Backwardation: The Crack Up Boom”.

In this article, Keith Weiner explains that most commodities trade in contango. In other words, their prices for future delivery are higher than their prices for immediate delivery. This is because it costs money to store commodities and because a person who stores a commodity forgoes interest that he would make if he deposited the cash instead.

However, sometimes commodities go into backwardation. In other words, sometimes their prices for future delivery are less than their prices for immediate delivery. This is because commodities sometimes are in short supply and there is not enough inventory to fulfill demand.

“But what if backwardation happens to gold?” Weiner asks. What would it mean if gold was in a shortage? It cannot mean the same thing that it would mean for wheat, oil, or other commodities. These things are used up by human beings. But gold lasts forever. There are plenty of stockpiles of gold in the world. So it cannot be in shortage the way that wheat and other commodities are.

So what does it mean?

Keith Weiner explains that the only thing it could mean is that investors have come to disbelieve Comex participants will deliver gold in the future as required by their contracts.

Otherwise, if investors/savers had trust in the ability of Comex to deliver gold, why would they not sell their gold into the spot market and buy it back for future delivery? If they did so, they would get a risk-free profit. So why wouldn’t they do it?

Of course, Keith Weiner admits that sometimes there may be temporary backwardation. Sometimes, it may take time for gold savers to realize that there is a risk-free arbitrage available. So if backwardation occurs over a short period of time, it doesn’t necessarily mean that investors are losing confidence in Comex.

However, Weiner argues that any long-term backwardation must be caused by a loss of trust in Comex and in the wholesale gold market in general. Otherwise, investors would want the risk-free profits associated with selling spot and buying future during backwardation.

How the price of gold is explained by Keith Weiner’s basis theory.

Keith Weiner applies his basis theory each week in his blog.

In each post, he shows a chart of the gold basis (the immediate delivery bid price minus future delivery ask price of gold) and co-basis (the immediate delivery ask price minus the future delivery bid price of gold).

He also includes the price of a dollar in milligrams of gold as part of the chart.

The are four possibilities that can occur in these charts, each with its own interpretation as to the meaning for the future price of gold:

  1. When the price of the dollar goes up in gold terms and the co-basis rises at the same time, this means that speculators are pushing down the price of gold artificially. Therefore, the price will probably go up again soon.
  2. When the price of the dollar goes up and the cobasis stays the same or declines, this means that long-term hoarders of gold want to sell. This implies that the move down in the gold price is likely to be long-lasting.
  3. When the price of the dollar goes down and the basis rises at the same time, this means that speculators are pushing up the price of gold artificially. This implies that gold will likely fall soon.
  4. When the price of the dollar goes down and the basis stays the same or decreases, this means that long-term gold hoarders want more gold. This implies that the rise in gold is likely to last for a while.

The central premise behind these four interpretations is that a rising basis and falling co-basis indicate “abundance” of physical gold in the market, whereas a falling basis and rising co-basis indicate “scarcity” of physical gold in the market.

What’s wrong with the basis theory.

In order to understand why this theory is wrong, let’s look at a typical currency and how it trades in the futures market.

Here is a current screen-shot of RUB/USD (Russian ruble measured in U.S. dollars) prices for spot and future delivery, extending out into June of 2019.

Click to enlarge.

As you can see, the price of a Russian ruble for spot delivery is higher than the price for future delivery. And the further out into the future one wants delivery, the lower the price. The ruble is trading in backwardation to the U.S. dollar.

Why is this? Does this mean that Russian rubles are “scarce” and that investors don’t trust Comex participants to deliver the rubles in the future as promised?

Here’s another example. This is the British pound priced in U.S. dollars, for spot and future delivery.

Click to enlarge.

As you can see, the price of a British pound for future delivery is higher than the price for spot delivery. And the further out into the future one wants to take delivery, the more expensive the pound is.

Why is this? Is it because the pound is “abundant”? Is it because there is an enormous amount of trust among sterling traders that Comex will deliver their pounds in the future?

What accounts for contango and backwardation in the currency markets?

The theory of interest-rate parity.

I would submit to you that it has nothing to do with abundance or scarcity at all. Instead, it’s simply a function of the interest rate differential. The pound has a lower interest rate than the USD. And the ruble has a higher interest rate than the USD. This is why the pound trades in contango and the ruble trades in backwardation. There’s nothing more to it than that.

This is what the economic “theory of interest rate parity” predicts. And the confirmation of that theory can be seen here in these prices.

You can find an explanation of interest rate parity here.

What really drives the gold basis?

If the basis for currencies is usually driven by interest-rate parity, you might wonder how this would apply to gold. After all, we are usually told that “gold has no yield”.

However, this is not really true.

The gold-lease rate.

It’s true that gold has no yield for most investors. This is because very few investors are able or willing to buy and hold gold in the 400-ounce increments required to take part in the bullion banking system. However, large institutions like bullion banks and central banks do loan out gold at a rate of interest.

This rate of interest is called the “gold lease rate”. And Weiner actually has charts on his website that attempt to derive what this rate might have been over time. Unfortunately though, these charts do not play a role in his basis theory or his weekly blog posts.

Once we understand that gold has an interest-rate called the gold-lease rate, however, we can understand what drives the gold basis. Like any other currency, the basis is simply the difference between the USD interest rate and the gold-lease rate. That’s it.

Deriving the theoretical gold-lease rate.

So how do we know what the gold-lease rate is? The LBMA does not publicly disclose any data as to what central banks and bullion banks are charging to loan out their gold. But we can approximate what it is by subtracting the basis from the USD interest rate (USD LIBOR).

This should be what the gold-lease rate is, theoretically. In other words, it is the rate that should apply to gold loans in order for interest rate parity to be achieved. During times of extreme stress, the actual gold-lease rate may diverge from this theoretical rate. But over the long-run, it should be stable most of the time.

So what is the gold-lease rate?

Keith Weiner’s own research indicates that it has only been around 50 basis points for most of the time since the bull-market began in the early 2000’s. This document from Barrick gold also claims that the rate was very low through most of the 1990’s, around 1%.

So we can say that in most cases, the actual gold-lease rate is very low.

Why gold usually trades in contango.

This explains why gold usually trades in contango. It isn’t because gold is “abundant”. It’s because gold has a low interest rate.

However, when the U.S. dollar interest rate fell to zero after the financial crises, gold did go into backwardation multiple times and for long periods of time. And the next time the FED lowers rates to zero, we can expect that this will happen again.

There may even be a time in the future when the FED imposes negative interest rates. When it does so, we can expect that gold will go into permanent backwardation. But contrary to Keith Weiner’s contention that this will be caused by distrust of Comex, it will simply be the normal behavior of a currency whose interest rate is higher than the currency it is being priced in.

There is nothing unusual about backwardation of currencies, whether it be in U.S. dollars, pounds, rubles, gold, or silver. It’s perfectly normal.

What can the basis tell us about the future price of gold?

So what can the basis tell us about the future price of gold?

Not much.

Here are the four possibilities from Keith Weiner’s blog revisited. But with the correct interpretations.

  1. When the price of the dollar goes up in gold terms and the co-basis rises (or the basis falls) at the same time, it means either:
    1. The USD LIBOR fell and the gold-lease rate stayed the same. So the basis fell. Meanwhile, the spot price of gold went down.
    2. The gold-lease rate increased and USD LIBOR stayed the same. So the basis fell. Meanwhile, the spot price of gold went down.
    3. There was some shock to the system that caused the basis to decline even though the interest-rate differentials did not warrant it. Because of this, a temporary, risk-free arbitrage developed between the gold-lease rate, the gold/USD basis, and USD LIBOR. This arbitrage opportunity will soon close either because the gold/USD basis will rise back to where it was before, the USD LIBOR will fall, or the gold-lease rate will rise. Meanwhile, the spot price of gold went down.
  2. When the price of the dollar goes up in gold terms and the co-basis stays the same or falls (or the basis stays the same or rises), it means either:
    1. The USD LIBOR rose and the gold-lease rate stayed the same. So the basis rose. Meanwhile, the spot price of gold went down.
    2. The gold-lease rate fell and USD LIBOR stayed the same. So the basis rose. Meanwhile, the spot price of gold went down.
    3. There was some shock to the system that caused the basis to rise even though the interest-rate differentials did not warrant it. Because of this, a temporary, risk-free arbitrage developed between the gold-lease rate, the gold/USD basis, and USD LIBOR. This arbitrage opportunity will soon close either because the gold/USD basis will fall back to where it was before, the USD LIBOR will rise, or the gold-lease rate will fall. Meanwhile, the spot price of gold went down.
  3. When the price of the dollar goes down in gold terms and the basis rises (or the co-basis declines) at the same time, it means either:
    1. The USD LIBOR rose and the gold-lease rate stayed the same. So the basis rose. Meanwhile, the spot price of gold went up.
    2. The gold-lease rate fell and USD LIBOR stayed the same. So the basis rose. Meanwhile, the spot price of gold went up.
    3. There was some shock to the system that caused the basis to rise even though the interest-rate differentials did not warrant it. Because of this, a temporary, risk-free arbitrage developed between the gold-lease rate, the gold/USD basis, and USD LIBOR. This arbitrage opportunity will soon close either because the gold/USD basis will fall back to where it was before, the USD LIBOR will rise, or the gold-lease rate will fall. Meanwhile, the spot price of gold went up.
  4. When the price of the dollar goes down in gold terms and the basis falls (or the co-basis rises) at the same time, it means either:
    1. The USD LIBOR fell and the gold-lease rate stayed the same. So the basis fell. Meanwhile, the spot price of gold went up.
    2. The gold-lease rate increased and USD LIBOR stayed the same. So the basis fell. Meanwhile, the spot price of gold went up.
    3. There was some shock to the system that caused the basis to decline even though the interest-rate differentials did not warrant it. Because of this, a temporary, risk-free arbitrage developed between the gold-lease rate, the gold/USD basis, and USD LIBOR. This arbitrage opportunity will soon close either because the gold/USD basis will rise back to where it was before, the USD LIBOR will fall, or the gold-lease rate will rise. Meanwhile, the spot price of gold went up.

In other words, fluctuations in the basis tell us nothing about the price. There is no connection between the future moves in the spot price of gold and the basis.

Interest-rates vs. exchange rates.

The basis tells us what the spread is between the time-preferences of gold-holders and the time-preferences of dollar-holders. It tells us how much more or less dollar-holders charge to lend out their dollars vs. what gold-holders charge to lend out their gold.

But the spot price of gold is something completely different. The spot price of gold is how much a gold-holder charges to permanently relinquish ownership of gold in exchange for Federal Reserve Notes.

Conversely, the spot price of the dollar in terms of gold is how much a dollar-holder charges to permanently relinquish ownership of Federal Reserve Notes in exchange for gold.

Interest rates and exchange rates for currencies are two different things. And they have very little to do with each other.

A rising interest-rate differential at the same time that the exchange-rate is rising doesn’t necessarily mean that one causes the other.

Nor does it mean that one is not the cause of the other.

Exchange rates are affected by many different forces, among which interest-rate differentials are only one. So we can’t just look at a rising or falling interest-rate differential and conclude that “speculators” are doing one thing while “hoarders” are doing another.

It just doesn’t work that way.

Does this mean we can’t understand the price of gold?

So does this mean that we can’t understand the determinants of the price of gold? Not at all.

Once we know that the basis theory does not accurately describe the gold market, we can search for an alternative answer. I have proposed one such answer here.

But regardless of whether you agree with my answer or not, the important point is to keep trying. The failure of one theory shouldn’t be used as an excuse to give up. Nor should the desire to understand the gold market leads us to accept theories that are clearly not true just because we don’t know what else to use.

Conclusion.

If you’re a gold investor or gold trader, you’ve probably run across the Monetary Metals Supply & Demand blog of Keith Weiner. He claims to have figured out what determines the spot price of gold and to have developed a way to trade it effectively.

While I have great respect for him, his investment products, and some of his economic theories, this article shows that his basis theory is wrong. Gold investors and traders should spend their time looking for an alternative theory instead of continuing to try to apply the one he has presented in his supply & demand blog.