Backwardation is a phenomenon seen in the futures market, which futures traders need to monitor. A forward curve is said to be in backwardation when futures are traded at a discount in comparison with spot. Gold backwardation means that traders could potentially gain capital (versus simply buying gold right away) when holding gold futures until the contract expires.
The same is true when a far month delivery is priced lower in comparison with a near term delivery. Or technically, downward slope of forward curve represents backwardation. Backwardation in commodity markets (including backwardation in gold) originates from the supply demand balance, to an extent; in fact, supply demand determines the shape of the forward curve. Near-month futures of a perishable commodity generally trade at a lower price in comparison with spot. Commodities do not follow contango/backwardation strictly; they are highly prone to shifting from contango to backwardation and vice versa depending on the market fundamentals.
The reverse condition where futures trade at a premium over spot is termed as contango.
Let’s detail the situation using an example. Look at the chart below. At t=0 (today) if the futures are priced below spot, the condition is backwardation On the other hand, if the futures trade at a premium over spot, then it is referred as contango. Ideally, both forwards and expected spot are anticipated to merge at maturity.
For more detailed analysis of the backwardation in gold market, we encourage you to read this article.
Does Backwardation in Gold Have Any Predictive Power?
Generally speaking, a normal situation for durable and easily storable commodities which have a cost of carry, such as gold, is contango. This is due to the carry costs - higher futures price is a way of paying for these costs.
Indeed, gold spends most of the time in contango, as it's reflected by the positive gold offered forward rate. The opposite of contango is backwardation, which is much rarer in the gold market. It's enough to say that until 2009, gold was in backwardation just for a total of eight days. Hence, investors can watch the backwardation in the gold market, as it may signal the imbalance between supply and demand for the yellow metal. The aftermath of the Central Bank Gold Agreement (called also Washington Agreement on Gold) may be the example. In September 29-30, 1999, there was a 2-day backwardation in the gold market. It probably resulted from the announcement of the agreement, which led to a price surge and a mad rush for physical gold to cover short positions.
However, the ZIRP introduced by the Fed caused serious disruptions in the market interest rates and the gold market. Backwardation lost its predicting power. In the environment of low interest rates, investors shouldn't consider it as a bullish indicator of supply shortages.