Usually, metals’ futures markets trade in contangos. The future price is higher than the spot price to account for the opportunity cost of holding (or financing) the long position in the underlying metal.

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There is also a cost of storage which needs to be incorporated into this calculation. Arbitrageurs keep the prices in line, and whenever the futures price rises too much, they sell the future, buy the spot, finance the position and arrange for storage. On expiry, they deliver into the futures contract, earning their profit. If the future prices are too cheap, then either arbitrageurs unwind, or might even borrow the metal short to sell in the spot market, and cover by receiving deliver for their futures long position. Also natural long buyers who are willing to wait, could buy the forward contract, content to own their metal at a discount to spot later. Assuming there is a properly functioning metals market, the futures price should not deviate too far from the cost of carry.

Which is why today’s action in the palladium market is so interesting. Buyers are willing to pay a large premium for the contracts that expire earlier (which is the exact opposite of what should occur).

Have a look at the prices for the different palladium contracts.

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The volumes are small at the front end of the curve, so I can already hear the complaints - that’s not a real market, someone just got squeezed on delivery.

Yet, if there was simply a problem with the June delivery, then we would see the June contract trading at a big premium, and the rest of the curve would be in contango. Instead, the whole curve has inverted.

Here is the chart of the September 2017 versus December 2017 palladium spread.

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This is a real spread market that you can trade. So right now, you can enter into a contract to sell palladium in September, receive it back in December, and pocket $24 extra dollars for your work. It’s not just a June delivery problem, the whole curve is inverted.

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So what’s going on? Well, let’s take a peek of the spot price of palladium.

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It’s up on a stick and breaking out to new highs. Not only that, it’s doing this as the rest of the precious metals are sucking wind.

I realize palladium is more of an industrial metal than a pure precious metal, but not only is it breaking to new highs for this move, but it is actually pushing up against the highs that were hit during the great precious metals bull market of 2011.

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One of my trading buddies, the always insightful Ari Pine trades a ton of precious metals, and has been encouraging me to watch the platinum/palladium spread for some time now.

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I wish I had listened. Ari was spot on correct that something was happening in the palladium market that deserved our attention (for Ari’s views on gold, click here for his interview on the great Futures Radio Show Podcast).

Palladium has been gaining versus platinum for the past year. Why do we care about this spread? Well, palladium and platinum’s main use is in the fabrication of catalytic converters for automobiles.

And maybe this offers a clue as to why palladium is soaring. I grabbed this palladium FAQ off the web that explains the two metals’ use in cars.

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Palladium is mainly used in gasoline engines, while platinum plays a larger role in diesel cars. The Volkswagen emissions scandal effectively killed diesel’s future in passenger vehicles, so maybe this palladium outperformance can be explained by the dramatic switch from diesel to gasoline.

Combine this extra demand with the fact that palladium is a small market that was already suffering from challenging global supply, you had the recipe for a squeeze.

This slide is from North American Palladium’s website presentation from 2015 (it’s tough to find up to date information about palladium):

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When I was discussing palladium with Ari this morning, he wryly commented, “now that we have noticed the big curve inversion, the move is probably over.” That’s part of the reason I enjoy talking with him. Ari is probably even more cynical than me.

But I told him that this palladium move was a high standard deviation event. And I reminded him of one of my favourite lines. You know the problem with fading a 4 standard deviation move? It’s almost always right, but not before it becomes a 6 or 7 standard deviation move…