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If There's No Shortage of Silver, Why Are Forward Rates Negative Again?

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Until those calling for a top in silver prices can answer this question, their argument will be far from convincing.

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Silver finished a very volatile week with significant developments on seemingly every front. There were two margin hikes for the futures market within 48 hours of each other. The Central Fund of Canada (CEF) saw its premium to spot prices (both gold and silver;CEF owns about 50% of its assets in each) disappear completely. As of April 29, 2011, CEF is trading at 2.4% discount to its net asset value in US dollars; a 2.7% discount in Canadian dollars. Sprott Physical Silver Trust (PSLV) also saw its premium to spot fall to about 16% from above 20%.

To some, these moves suggest that silver's bubble is getting too frothy to continue, as in the Sunday, May 1 plunge. For others, these moves show continued desperation on the part of the COMEX and bullion dealers to shake out weak long contract holders.

While these data points are important in and of themselves, it's the forward market that is more conclusive. Until those calling for a top in silver prices can explain why silver forward rates (SIFO) are once again negative, their argument will be far from convincing. Essentially, negative SIFO rates mean that some investor (or investors) who's short actual metal is paying physical holders a premium to obtain the metal.

In the opaque world of precious metals, forward rates are the foundation for "leasing." Silver shorts that participate in leasing are actually lending cash to the owners of the physical metal. The silver owners then hand over that metal to the cash owners (the shorts) as collateral for the loan.

When the forward market shows negative rates, it means that the cash owners are, instead of earning an interest rate on their loan, paying someone else to borrow it. This is like going to your local bank and having them pay you interest to borrow the bank's money. The only reason this would occur is if cash owners are being forced to repay or return physical metal that they do not have and are having a lot of difficulty finding the actual metal through other means.

This situation is more common in the repo (repurchase agreements) markets where the same money principles apply. In treasury repos, a specific bond can go "on special" when it has been shorted too far above its actual physical availability. There are even times when special rates go negative – when the shortage is particularly acute and closing out short positions is extremely difficult. This is an exact parallel to what we are seeing in the silver market.

In January and February 2011, leasing rates jumped as the SIFO curve fell all the way into the negative. These moves were in anticipation of a difficult delivery month of March, where approximately 1,800 contracts actually stood for physical delivery. Although it only represented about 9 million ounces, on an exchange that advertised over 100 million ounces in its vaults and 50 million ready for actual delivery, it took the entire month to service all the contracts. It even went all the way down to the last weekend before all the contracts settled. Not coincidentally, silver prices, including the iShares Silver Trust (SLV), shot higher.

I speculated at that time that the leasing activity in January and February obtained just enough actual metal to deliver through March, but not much more than that. I thought that the large shorts were hoping to discourage enough long investors by getting through March without any kind of COMEX default.

That theoretical hope was extinguished as we approached the first notice date for the May delivery month. The open interest "problem" reappeared with an increased vigor above even March. The COMEX data shows almost 2,200 contracts standing for delivery, about 20% more than March.

The negative SIFO rates confirm that silver dealers underestimated the need and resolve on the long side. From April 6 to April 26, one-month SIFO fell from a high of 40 basis points all the way to minus 4.5 basis points. From April 13 to April 26, one-year SIFO dropped from 19.3 basis points to minus 11.7 basis points. SIFO rates are still negative as of April 28, but have moved back closer to zero.

These machinations in the forward rates have led to a messy futures curve. Normally, since it is derived from forward rates, the curve will have a nice, smooth shape regardless of whether the market is in contango or backwardation. This is due to the term structure of money interest rates. Remember, forward rates really represent a collateralized loan.

When the futures curve shape is nothing like a normal curve, it can only mean that money rates are no longer the primary consideration in setting various term levels. Something else has to be driving the curve or it would result in a money-driven shape. The current futures curve is in contango until December 2011, with a light backwardation from then until May 2012, then almost $1 of backwardation out to December 2015. This hybrid curve, in my opinion, is the most powerful evidence that there is a shortage in physical silver. This is not a curve driven by money rates.

How can silver be in a bubble?

The only answer would have to be some kind of short-squeeze story. If there is squeeze on, then prices would rise into a parabolic blow off. Once the squeeze is executed, the squeezer exits its position and the price collapses (see the Hunt brothers in 1980 and Warren Buffet/Phibro in 1998). There have been numerous rumors making the rounds in the past few weeks of a Russian billionaire playing such a part.

This is a possibility, of course, now that it's becoming clear to a much wider audience that the COMEX is now on its fourth consecutive delivery month of ratcheting degrees of trouble. But this squeeze rumor does not account for all of the actions in precious metals over the past couple of years. How does the squeeze rumor explain the lack of available coins at major mints? It does nothing to explicate why silver dealers continue to have trouble maintaining a supply for retail investors.

In my opinion, if there is a major individual running a silver play, it is entirely derivative of the original trend in place. In other words, the squeezer is taking advantage of a different and even more powerful kind of squeeze that has been running for far longer.

That underlying trend is nothing more than Gresham's Law. In the days of hard currency, when both gold and silver (a bi-metallic standard) "backed" paper money, one metal was almost always given more favorable terms than the other. Typically, the national government, under political pressure from one metal constituency or another, was responsible for the imbalance.

Gresham's Law simply accounted for the actions that inevitably followed the bi-metallic interference, and is one of the few economic "laws" that has a basis in empirical reality. To put it simply, whenever one metal was favored (overvalued) versus the other (undervalued), the overvalued metal would circulate while the undervalued metal would get hoarded.

As an example, if the national price of silver was fixed too high in relation to gold, the silver coinage or silver-backed paper would get circulated by the public and businesses while gold coinage or paper would be hoarded. In unofficial "markets" or transactions, the price of the undervalued metal would rise in relation to the overvalued until some kind of parity resulted. Of course, this would create all kinds of economic and market difficulties and distortions.

If we think of this dynamic in terms of monetary actions from 2009 to 2011, we can fill in the terms for Gresham's Law rather easily. Playing the role of the overvalued, government-entangled currency is fiat dollars. The relative "price" of those dollars has been fixed at a high level by continued and active suppression of interest rates. The alternate means of exchange are precious metals. Since Gresham's Law states that the overvalued currency is circulated, is it any wonder that the relative value of the dollar is falling so dramatically? Conversely, Gresham's Law expects the undervalued substitutes, gold and silver, to be hoarded, which the forward, futures and spot markets all suggest is happening. The recent run in gold, including SPDR's Gold Trust (GLD) shares, also backs this proposition.

The massive amount of dollar holdings outside the US and its reserve status necessarily means that Gresham's Law would occur there first. The fall in exchange value of the dollar is the circulation part, while central banks, including persistent rumors of China and India, buy or hoard as much precious metals as they can. At the same time the concerted effort to remove the dollar's reserve status, which precious metal hoarding is an active part, is simply preparation for the eventual withdrawal of artificial constraints on the dollar's price and the likely painful adjustment that will come with it.

If this is indeed what is occurring, then hoarding of gold and silver will mean that physical availability will continue to be a problem for the foreseeable future. The only way to remedy Gresham's Law is to remove the artificial price fixing. The minutes from the last Federal Open Market Committee meeting show that as an extremely remote possibility.

Unfortunately for those on the short side of silver, every piece of relevant data points to a physical shortage. Worse yet, the longer-term demand for silver is directly related to Fed-controlled interest rates fixing the price of soft, fiat currency too high. Until these imbalances are removed, the shortage will grow. Ancillary movements in the physical funds, CEF or PSLV, nor margin increases will change this.

Movements like last night's may shake up the long side speculators, but in the end the real capacity for silver and gold prices to rise is equal to the determination of central banks to control the interest rate structure.

Editor's note: For additional commentary, visit the website of Atlantic Capital Management.

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The author owns long CEF and long SLV & GLD call options positions personally, as well as investments in gold and silver positions, including CEF, in client accounts.

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