There has been quite a bit of chatter about gold going into backwardation instead of being in its regular state of contango.  These are adjectives for futures contracts on commodities and not types of dances.  Gold has been in backwardation briefly as of late but it will need to remain in that condition for a significant amount of time for things to get particularly interesting.

I received a question from DP "Love your site ... I am sending this email because I am currently trying to figure out all the details regarding gold's recent backwardation.

Is there any way you could perhaps do an article on backwardation, as I have been looking over the internet for explanations but none really do a thorough job explaining it. ... 

I find that most forums or internet sites either explain it in one-liners, or go into more technical jargon like yield curves and such (I find this more difficult as my degree is in engineering and not economics). ... Have a good day."

 I wanted to write an article on backwardation but thought my readers would not want such an esoteric subject but thanks to DP I will attempt to explain this topics as requested.

Backwardation is a situation where the fiat currency price of a commodity is pregnant with a premium the buyer is willing to pay for immediate delivery.  The price of a commodity for future deliver is lower than the spot price.  This is contrasted with contango where the spot price is lower than the futures price.  Backwardation seldom arises in the monetary commodity gold or the quasi-monetary commodity silver.

Most economists and finance professors are completely wrong on this topic.  Why?  Because they start off with a fundamentally flawed premise just like those who thought the sun revolved around the earth were wrong because they started off with a fundamentally flawed premise.  In other words, what is the risk-free rate?

Gold is a currency.  Commodities like gold, wheat and oil are produced because they add value to society.  Wheat is food, oil is for everything and gold for performing mental calculations of value.

 Unlike wheat or oil; gold is hoarded not consumed.  Just like the common fallacy that the sun revolved around the earth was taught in the leading schools of the time; a common fallacy taught in financial management classes at all major business schools is the time value of money with present and future value calculations based on a faulty risk-free rate based on a government treasury bill.

Wealth and purchasing power are distinct.  The concept of having more wealth in the future simply by holding wealth now is an illusion.  This idea is deeply ingrained in most people's psyches; particularly economists and finance professors who feed off the teat of the welfare state funded by the theft derived from confiscation through inflation which is taxation without representation via fiat currency.

 Most commonly think if one has $100 in their savings account today they should have at least $100+x in their savings account a year from now.  Never should they have less than $100 just for storing their capital.  The problem is there is no definition of what a dollar is.  When there is no definition then how can one make accurate calculations?

But the real nature of interest is negative.  Wealth should always atrophy because wealth requires production.  The trick is finding the store of capital with the lowest store of capital expense.  For example, GoldMoney's storage fees are .18% APY which is the lowest store of capital expense I am aware of.

Just set some bananas on the counter for a few days and you will notice they have a much higher atrophy rate.  I estimate the Dollar's store of capital expense has been around 25-30% per year over the past 5 years.  The rate will probably increase over the next 5 years.

Contango is supposed to exist because of gold's inherently negative interest rate.  The future price of gold is generally the spot price plus the future value based on the currency's interest rate and a premium for counter-party risk.  For example, if the interest rate is 12% APY and gold is $100/ounce then gold's futures price for delivery in one month would be $101+CPR=$100+(.12/12*100)+CPR.  As counter-party risk or the perception thereof increases, like an exchange's potential failure to deliver, there is greater demand for present delivery of gold.

Without getting into yield curves the recent lowering of interest rates by central banks are leading to some interesting developments in the monetary arena.  The question becomes:  If I earn no interest on my dollars, euros, yen, etc. and lose purchasing power from inflation then I have a negative real rate of return.  If I have a negative real rate of return then why should I own dollars instead of gold?

As evaporation of the monetary system continues during this deflationary credit contraction capital piles into the national currencies by moving down the liquidty pyramid into the safest and most liquid assets.  

As the national currency interest rates continue to fall they evaporate faster driving them towards a zero-interest rate policy environment.  The WSJ has accurately observed that investors are 'bugging out of gold' but if backwardation is and remains in effect then this situation has changed.  

However, eventually the last currency to evaporate will be the United States Dollar through its continued hyperinflation.  This will happen when negative real rates of return are painful enough that holders of capital decide to own gold instead of dollars.

 The gold for present delivery will carry such a premium over gold for future delivery that it will be in a permanent state of backwardation because the dollar and all its babies, the other fiat currencies, are headed to join their ancestors in the fiat currency graveyard.  In other words, it will be like the gold price in $Z; it is not for sale at any price.

During a credit contraction it goes against economic law for capital, in aggregate, to move up the liquidity pyramid.  That is what happens during a credit expansion.  

Gravity is a useful metaphor; what goes up must come down.  When gold goes into permanent backwardation against the dollar the price of other assets, like homes or stocks, in gold will accelerate their decline.

 For example, based on historical trends like the Case-Shiller index the average American home will fall in price from its high of about 38,000 ounces of silver or about 525 ounces of gold to a much cheaper price of 500-1,000 ounces of silver or about 25 ounces of gold.

We are participating in the collapse (evaporation) of a worldwide monetary system; the largest in history.  No one knows neither how it will play out nor how long it will take.

 I recommend migrating, during these stable times, to a new sound monetary system like GoldMoney for ordinary daily transaction in an effort to reduce the shock to one's businesses and way of life.  I hope that answers your question DP.

Discussion on Al Korelin's Economics Report (mp3)on June 16, 2008 on this topic.