Gold and Silver

Silver alert: Unusual development could cause a repeat of last year's explosive rally

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From The Daily Capitalist:

March silver has been flirting with backwardation since the end of 2011, and today it has moved more firmly into backwardated territory. This is extremely bullish for silver, and let me explain why.

Backwardation means (and I am oversimplifying a bit here) that a futures contract is cheaper than buying the physical good in the cash market. To understand the meaning of this, the first question is this: Is it possible to warehouse the good? If not, then the futures market is simply the market's opinion of what the price is likely to be on the contract expiration.

Silver, unlike interest rate futures for example, can be warehoused. This means it is possible to simultaneously buy physical silver in the spot market and sell a future in the futures market. One has no net exposure to the price. One is exposed only to the spread. This is a simple arbitrage. One can "carry" a good (buy spot, sell future).

The possibility of this and other arbitrages in a good that can be warehoused changes the whole structure of the futures market. One cannot look at the price of March silver as a prediction of the March price. Absent a shortage or other anomaly, the March price should be close to the spot price plus the cost of carry (interest rate and storage). March silver should be at a slight premium to spot silver. This condition is normal, and it is called "contango."

But that is not the case...

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