As I look back at the gold and silver market signals we recently published and our 2013 silver forecast, which predicted a price well above $50 per ounce (the high reached in April 2011), I can't help but to wonder what fundamental factors will spark this "hyperbolic" move?
Several major fundamental factors are developing that could send precious metal prices soaring.
Free Money, Inflation and the Increasing Cost of Debt
The Federal Reserve sets short term rates and prints "free" money (since it is not backed by gold, silver or any other inherently valuable commodity) and purchases bonds to infuse cash into the economy. Such tactics have been employed for almost a decade in an attempt to jump-start the economy. The economy appears to be slowly recovering, but the market determines longer term rates. After recently reaching historically low rates on the 10-year notes, long-term rates are beginning to move higher, raising fears of inflation and, possibly, hyperinflation, with too much money chasing too few goods.
One area already showing inflationary signs is commodities; prices are rising. Oil hit 147 in 2008, only to rally even higher in 2011. It appears to be only a matter of time before commodities in general are ready for another move higher, especially if inflation takes off. The stock market is also inflating with the Dow Jones closing above 14,000 on February 1, 2013 for the first time since 2007 as more dollars chase fewer opportunities.
Steve Roy, Chief Technical Analyst for the Equity Management Academy, whose mission is to preserve wealth through education, said, "The Fed thinks they can control it (inflation), but they are always behind the curve. By the time they do anything about it, it will be too late." Over time, the dollar has been devalued by the markets (a certain sign of hidden inflation), with the dollar index slowly declining since a high of about 120 in 2000/2001, and a record high of 165 in 1984. Since 2002, when the dollar index was at about 122, it has fallen now into the 70s. As the dollar index fell, gold really started to take off as a hedge against inflation. If the dollar index moves another leg down, which Mr. Roy expects, it should push gold and silver much higher.
As sovereign debts based on paper currencies appear more and more risky, some are turning to gold as a less risky investment. Governments classify sovereign debt as riskless but, Mr. Roy argued, "We all know now that sovereign debt isn't worth the paper it's printed on. They print money based on thin air, and as long as people buy the story, that money will have value, but once people start questioning whether the governments behind that money have the ability to pay, then it becomes valueless." He mentioned the Euro crisis as a possible first sign of lack of faith in paper or fiat money.
Various groups around the world are talking about alternatives to the U.S. dollar as a global currency, and gold is likely to play a role in such a change in the international financial system. The Bank of International Settlements recently started using gold as a tier one asset; meaning it is seen as risk free. With more and more people becoming skeptical of sovereign debt as a risk free investment, gold is becoming part of more investor's and country's investments.
How Long Can it Continue?
How long can the bond market maintain negative interest rates and the attendant loss of purchasing power caused by the declining real value of the dollar? If I knew the answer to that one, I'd be more famous than Ben Bernanke, said Roy. "What I can say, however, is that the Fed will TRY to keep interest rates low to attempt to convince investors to continue to pour money into the economy in more and more risky investments like stocks and bonds." Such low rates, however, just encourage borrowing and greater debt, which imposes a greater strain on the economy.
The Congressional Budget Office (CBO) projects that under current law debt held by the public will exceed $16 trillion by 2020, reaching nearly 70 percent of GDP. The CBO also projects that interest rates will increase. The combination of rising debt and rising interest rates is projected to cause net interest payments to balloon to nearly $800 billion, or 3.4 percent of GDP, by 2020.
Many other outcomes are possible, however; far worse outcomes. If, for example, the tax reductions enacted earlier in the decade continue, the alternative minimum tax is indexed for inflation, and future annual appropriations remain at the same share of GDP as they were in 2010, debt held by the public would total not a mere 70% of GDP, but nearly 100 percent of GDP by 2020. Interest costs would be correspondingly higher.
In the CBO's most recent projections, which assume that current laws remain the same, annual deficits decline from the $1.3 trillion recorded in 2010, but the cumulative deficit from 2011 through 2020 exceeds $6.2 trillion. Borrowing to finance that deficit-in combination with an expected rise in interest rates-would lead to a fourfold increase in net interest payments over the next 10 years, from $197 billion in 2010 to $778 billion in 2020. As a percentage of GDP, net interest outlays would more than double during that period, rising from 1.4 percent to 3.4 percent. Already the U.S. federal government spends more on interest payments than on education, transportation and veterans.
Currency Wars and the U.S. Dollar
Will an increase in rates support the U.S. dollar?
Generally speaking, money flows to where it is treated best; so one would think that raising rates will support a currency. However, another major factor to consider is the size of a country's debt. At some point, when debt gets too big, people stop lending. Who lends to someone who already owes more than they'll make in a year?
The silver lining is that the U.S. dollar is uniquely the world's "Reserve Currency." This means that other countries mostly rely on U.S. dollars to transact international business and to trade. However, the use of the U.S. dollar is still a choice. In the 19th Century and early 20th Century the British pound sterling was the world's reserve currency; it did not last forever. After its dominance of the 19th Century, by the 1950s, about 55% of the world's currency reserves were in pound sterling. By the 1970s, that percentage had fallen to about 45% and it continued to gradually decline. Today, the US dollar only accounts for about 62% of global currency reserves, with the Euro accounting for another 25%, and The Euro's share has been increasing, while the US dollar's share has been declining. As US debt continues to grow, many other countries are beginning to lose faith in the US dollar.
How will inflation affect the U.S. dollar as the world's reserve currency?
The key to this question is how our inflation rate compares to the inflation rates in other countries. If our rate is lower, it should not have much effect, but if it is higher, the differential between rates may be a significant concern. A thoughtful analyst should be able to roughly predict how interest rates will move based on economic factors. However, the problem with analyzing any of markets now is that they are no longer free. Most markets and interest rates are now manipulated by governments all over the world, which gravely marginalizes conventional analysis. You just can't measure things the way we used to.
Given the gradual decline of the British pound sterling as a global reserve currency and the difficulty of swiftly changing from US dollars to another currency, it seems unlikely that there will be a swift dumping of the dollar. If China, for example, which holds just over a trillion dollars worth of U.S. bonds, suddenly dumped them all to buy euros or European bonds, the price China would receive for the bonds would fall precipitously as they sold off. The loss to China would be massive. Furthermore, given the size of the U.S. economy in relation to the rest of the world, about a quarter of the world's economy, the United States has the ability to provide enough currency to allow the global economy to function. A reserve currency must provide enough currency for the rest of the world to hold it as a reserve. Therefore, reserve currencies tend to be based on the world's largest economy, Britain and then, more recently, the United States. Gradually, as China and India surpass the United States economically, one or the other, or a combination may take over as the reserve currency, but it should be a gradual change if history is any guide.
Who will devalue their debt levels and obligations first when all else fails?
Japan has already started to devalue their debt. The yen has been the borrow side of the carry trade for years. This created a huge increase in the value of the yen, because of the demand for Yen. The high value of the yen choked off Japan's export market and caused massive deflation, which greatly devalued their debt. The United States and the EU have followed suit, but keeping interest rates extremely low, which makes debt less costly.
I believe that the United States will start to see inflation imported as a currency war unfolds and other sovereign nations become protectionist in their monetary policies like Japan in order to generate economic growth after many years of a deep recession. It is already happening as the value of the dollar falls and prices increase.
I had a chance recently to spend some time with Steve Roy from the Equity Management Academy. Here is his technical forecast for where Gold may by heading in 2013. His analysis uses Fibonacci, Gann, Wave analysis (not necessarily Elliott), Moving Averages, as well as their own Proprietary techniques.
Gold hit its all-time high in September of 2011 at $1923.70, as seen using the monthly continuation chart, and has since, been consolidating. So let's see if we can get some idea of where we are now, and my opinion of where we are going this year and beyond.
First let's see where we have been.
I am using the low in 1976 at $100.00 to the high in 1980 at $873.00 as my WAVE 1 of 5. Using the Fibonacci expansion tool, you can see that we are currently around the 2.00 level at $1646.00, which is the minimum for a WAVE 3 completion. We will see, however, that it appears to me that we are not finished this wave yet. I believe that we have completed the 3rd wave of 5 in WAVE 3, and are in the beginning stages of wave 5 of the larger WAVE 3. The next level up is the 2.618 expansion level at $2123.70, and the 3.236 level is at $2601.40, so keep those prices in mind. I have also added the 41 month cycle, which is from the low to the high of WAVE 1. This cycle comes in again in March of 2014. The market corrected this wave 1 until it bottomed at $253.20 in July of 1999. That's about 19 years. So, using that time period as a guide, the next impulse wave should complete around 2018.
So we will start our WAVE 3 analysis from the 1999 low.
We are looking at the Fibonacci retracement of wave 1. Note that the price corrected down to the .382 retracement level. That was the wave 2 correction. I have also added the 104 month cycle, which covers the low to the high of wave 1. This cycle ends in November of 2016. I have added the Fibonacci expansion to Wave 1 of WAVE 3.
Note that so far, wave 3 which began in October of 2008, has also hit the Fibonacci 2.00 expansion of wave 1 at $1814.60, again, the MINIMUM objective to complete a wave 3. The 2.618 expansion comes in at $2297.10, and the 3.236 expansion is at $2779.50. Keep those prices in mind.
I know that at this point there is probably a lot of discussion of how I am determining the waves, so I'll take a few minutes to show you.
Here, I have added our moving averages to the weekly chart of WAVE 3 starting in 1999. This gives you a better view of the action. In my wave analysis, a corrective wave is not confirmed until the PRICE, as well as ALL THREE of the moving averages turn down, and confirmation of next wave beginning when the price and moving averages are moving higher again. So, wave 1 ended in March of 2008 and wave 3 began in October of 2008. We also see similar action up here, but here's an interesting point to note!!!
We have not even hit the .382 Fib retracement yet. If you drop down to a daily chart, you will see that we have met my criterion that the correction is over and the next leg up has begun. The fact that we did not get down to the .382 retracement indicates to me that the next leg up could be explosive!!
In this chart, we are looking at the Gann fan from the beginning of wave 3 of WAVE 3 to the current high of that wave at $1923.70.
The 1x1 line intersects with the 1.618 expansion during the week of June 21st of 2013.
OK, we're now in the home stretch. I have now added a Gann fan from the low in 1999 to the end of wave 1 of WAVE3 in 2008.
We have since broken above the 1x1 line and should head up to the 2x1 line for the next target. That line is above the 1.618 Fib expansion line of wave 3 of WAVE 3 at $2691.70 all year long.
In this chart, I have both Gann fans together.
You can see that they intersect above the 1.618 expansion line during the week of August 16th. So based on this analysis, my forecast for gold prices in 2013 is that we will see AT LEAST $2692.00, on its way up to much higher prices in 2014 and beyond.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: The information in the Market Commentaries was obtained from sources believed to be reliable, but we do not guarantee its accuracy. Neither the information nor any opinion expressed therein constitutes a solicitation of the purchase or sale of any futures or options contracts.