I believe the metals may have seen lows for the year. The action in the gold silver ratio is telling us silver is signalling the vertical rise in interest rates or tightening by the Feral Reserve may be coming to an end. This is not to say the Federal Reserve may stop raising interest rates, however, the pace of rate hikes is slowing or closer to pausing.
The effects of the Federal Reserve’s policy to arrest inflation in the short term may exacerbate inflation in the longer term. Making the cost of capital more expensive will dissuade companies from moving forward with building and capital expenditure projects. This will not solve supply constraints. The demand destruction, the Federal Reserve is wanting to bring prices down will increase unemployment and force more demand for fiscal stimulus, not less. This will force the Fed to support more US government spending which in turn will be stimulative to inflation. The public will be unwilling to take the medicine for correct policy change, and frankly why should they? The Federal Reserve has flooded capital markets with money for 40 years and created one the greatest periods of income inequality in the history of mankind.
WHAT DOES THIS MEAN TO INVESTORS?
It is important to note that a slow down or pause in rate hikes does not mean all things go up. Maybe in the short term we will see a bounce in the financial markets on greater hopes the Federal Reserve will even begin reducing interest rates sooner than expected. However, the stock and bond markets may sell off after this rally. The reasoning is that historically, the only time the Federal Reserve has lowered rates was during a financial crisis. This would mean the financial markets would have to show more weakness before the Federal Reserve starts to lower rates and increase liquidity. We may be entering a time where governments act like race car drivers overcorrecting on every turn, creating more instability for the structure or outlook for capital markets.
However, when watching gold and silver, the focus is more on the US Dollar and rate in change of monetary conditions (tight or loose policy). In addition, longer term inflation expectations are another factor. In essence, how much higher inflation expectations will the government and Federal Reserve tolerate? Remember the markets focus on rate of change and if the Federal Reserve begins to reprice their allowed inflation expectations from 2% to possibly 3% or 4%, this will have reverberations in the US Dollar and Commodity prices. Remember quantitative easing or tightening does not have to mean changes in money supply, it could also mean the propensity to allow the velocity of money to rise to generate more economic activity. This is where tax revenue becomes a bigger focus in order to maintain debt servicing and government spending.
Why would inflation expectations change? Simply, to get back to 2%, the Federal Reserve is realising they may crater asset prices at a much faster rate than inflation is being affected. By allowing higher expectations, the hope would be to not drain as much future liquidity from the system and attempt to stabilise investor portfolios such as pensions, passive strategies, real estate markets, etc from having an outsized negative wealth effect. Social instability is one outcome if the policy errors result in a collapse of most investor’s portfolios.
Commodities have certainly been impacted by the strong dollar. Therefore, commodities have priced in some degree of economic weakness as well as the tighter monetary policy. However, the supply side has not been fixed. In addition, global governments are reacting to inflation and economic conditions with tighter or looser monetary/economic policy based on their countries’ needs. Case in point; China has had a severe lockdown policy for multiple months while the US has been selling off its strategic petroleum reserve (SPR) to get oil prices down ahead of the election. What do these two things have in common? Inflation and supply constraints. I find it odd that the election is upon us and the SPR reduction is about to stop, and the US government is about to buy oil again. At the same time, China was one of the biggest buyers of oil from the SPR drawdown. Could it be that China is about to reopen its economy now that they have a larger supply of oil to ease any demand/price shock which would come from this reopening? In addition, with the USA on the verge of a recession going into 2023, the price pressure from increased commodity demand in China would not be as severe globally as western economies would be slowing down demand. The Federal Reserve could attempt to thread a needle by allowing a higher inflation rate to stave off much lower financial markets.
How do gold and silver fit into this picture? The one factor that has not been talked about in the media or Wall Street is a question of confidence if the US economy falls into a recession. Silver is showing encouraging strength these last two months versus gold. Silver has held its price lows while gold had made slightly lower lows. The gold-silver ratio is a good indicator to follow in this relationship. This is telling me inflation continues to be a theme, however, as a recession looms, the world may be recognising the attractive price of silver as a monetary asset again, versus an industrial commodity. The demand for silver has been incredibly strong.
INTERNATIONAL DEMAND FOR METALS
This has been evident in the backwardation of silver relative to the future paper price of the metal (in green). The following chart shows an unusually long period of physical spot prices higher than the Comex futures price represented by future delivery. When the spot price is higher than the future price, it tells of elevated and increased demand for the physical product today.
1. The following chart shows the massive drawdown of physical silver backing all the Comex Futures contracts. We are now below 35 million ounces in this category. The time frame between 2008 and 2011 saw a significant drawdown as well. During this time silver moved from $9 per ounce to nearly $50 per ounce.
2. India’s demand for Silver has also been incredibly high. It seems Asia is viewing silver under $21 an ounce as a bargain. The following chart shows not only pent-up demand but a recognition that confidence in their countries’ paper currency is in question. In September (not shown on chart), demand for silver reached 1,700 tons. The Indian Rupee has hit new lows against the US Dollar this year.
3. The drawdowns in the London vaults have also been telling. The backwardation story has confirmed that demand for the actual physical metal is real. Over 200,000 tons have left London this year. The gold and silver chart from the LBMA confirms the demand surge. Gold is in yellow, and Silver is in grey. This supply drawdown has ramifications with ETFs and other paper securities that need the metal to create new shares and meet investor’s demand for paper representation for these structured investments. In essence, a supply squeeze is unfolding as we speak.
4. At the same time, gold has had an unusual demand from Central Banks in the 3rd quarter with demand hitting a 55 year high. Nearly 400 tons of gold bought during the 3rd quarter of 2022.
5. Why the big rush to own physical gold and silver? Could it be that gold and silver are universally recognised as a store of value and more importantly, a store of energy? As the US Dollar impacts the world, the rest of the world needs something of value for trade purposes that can be generally accepted and is neutral to all countries. Gold and silver offer this alternative and may become part of a basket of commodities to affect and support trade. Remember, the US Dollar may begin to fall in value as the concerns of recession and slow down grow. To transact business across the globe, you must have money that people can agree on in principle like Gold. Volatile swings in the value of paper currencies as well as political sanctions or constraints, make it more difficult to swap services or goods for sovereign currencies. Therefore, each side needs to understand they have what the other side values to continue to trade. EG