Precious metals bulls had a difficult week. Gold and silver dropped below key support levels, while ETFs tracking the metals followed suit. Gold ETFs like SPDR Gold Shares (GLD) (down 11 percent); silver ETFs like iShares Silver Trust (SLV) followed through in sympathy (down 18 percent), and Freeport McMoRan Copper and Gold (FCX) was down 26 percent. Gold Miner Market Vectors (GDX) and Market Vectors Junior Gold (GDXJ) were down more than 30 percent. What's going on? What have bulls got wrong?
Precious bulls have many things right about QE: it devalues the dollar against foreign currencies; it is a hedge against sovereign debt, and runway inflation. But they got two premises wrong:
The first premise is that central banks around the world will sit around watching American products flooding their markets. As it turn out, they didn't-the launched their own QE, neutralizing, and in some case, reversing the dollar decline.
The second premise is that capacity utilization is negative correlated with interest rates. This means that as several QE rounds is driving interest rates lower, capacity utilization will eventually rise, to the point that will create inflation. A close examination of the historical patterns of the two variables, however, points otherwise. Repeated declines in interest rates have boosted capacity utilization in the short-run, but the overall trend is down. This means that QE is deflationary rather than inflationary! What can explain this behavior?
The traditional trade-of between present and future demand--precipitous interest rate cuts give a temporary boost to capacity utilization, as consumers and businesses rush to take advantage of lower rates. But in the end a dollar spent today cannot be spent tomorrow, which can explain why the trend for capacity utilization has been heading south rather than north.
The bottom line: In the long term QE is bearish, not bullish for precious metals, as it fails to depress the dollar and boost capacity and inflation. That's why I would stay way from them at this point.
Disclosure: I am long FCX.