As a follow-up to our recent missive on gold, we want to take a look at the drivers influencing precious metals prices we have identified as relevant.
There are three types of precious metals – gold, silver and platinum group metals (PGM's). There are six different PGM's, namely Platinum, Palladium, Rhodium, Iridium, Osmium and Ruthenium. The first three of these are used extensively in automotive catalysts, but only platinum and palladium sport exchange-listed futures contracts, as the rhodium market is extremely small (annual production is slightly less than 700,000 oz.). Iridium, Osmium and Ruthenium production is even smaller than Rhodium production, however, Rhodium generally tends to be most expensive PGM (it is indispensable in catalytic converters and as only tiny trace amounts of it are needed, demand is relatively price-inelastic). There are ways to invest in Rhodium via so-called pool accounts, but from a practical perspective one can state that investment demand is far more important factor in the Platinum and Palladium markets. In addition to futures and options, coins and bars made of these two metals are available, and there are nowadays also ETF's that are backed by physical Platinum and Palladium held in storage, similar to the Gold and Silver ETF's (GLD, SLV and similar products).
In terms of importance to the overall supply-demand picture, investment demand is the by far most important factor for the gold market, a major factor in the silver market and a minor factor in the PGM market.
Fundamental Drivers of the Gold Market
Given that industrial demand is only a minor factor in gold's overall supply-demand picture, one can basically ignore it when analyzing the gold market's fundamentals. The same holds for jewelry demand (a portion of which actually constitutes investment demand. For example in India, most jewelry is bought for investment purposes). Similarly, the supply from mine production and scrap is a negligible factor in the gold market and can be safely ignored.
It should however be noted that mine production has historically tended to be negatively correlated with the price of gold, which is the exact opposite of what one would normally expect. There are two reasons for this superficially strange behavior.
Firstly, gold producers tend to react to a higher gold price by increasingly mining lower grade reserves of their deposits that could not be mined economically at lower prices. In this manner mine life can be extended and although production costs will tend to increase with the mining of lower grade portions of gold deposits, this method still the best way of maximizing the long term return of what are after all wasting assets.
Secondly, there are long leads and lags in the mining business generally, and they are even more pronounced in the gold mining business. An increase in the gold price does of course attract more funds toward exploration for gold deposits and the development of new mines. However, it nowadays takes up to 10 years or longer from the discovery of an economically viable deposit to bringing it to production. This is partly due to the fact that the large capital investment necessary to build a mine requires a reasonable degree of certainty regarding the likely future price range of the metal. Futhermore, obtaining the permits needed for mining is today an extremely complex and time-consuming process. Lastly, economically viable gold deposits are rare and their geographical distribution is not uniform. Many of the most enticing prospects are in areas where political risk is high. As an example, the Republic of Congo (DRC, formerly Zaire) is extremely well endowed with natural resources, including gold. However, the current government of the DRC has shown by various actions that it has little respect for property rights and as a consequence many mining companies deem the risk of investing in the country too high.
The result of the foregoing is that additional mining capacity usually tends to come online with such a big time lag that by the time it results in an increase in annual mine production the price trend of the metal is likely to already have reversed. In addition, a trend of falling prices will then provoke "high grading" by producers, which tends to increase production while shortening mine lives.
However, the fact remains that this is a fairly unimportant factor for the price of gold. We will now look at the various drivers of the gold price in more detail to see where things currently stand.
1. Real Interest Rates
Real interest rates are very important for the value of gold relative to competing currencies. Gold pays no interest – there is a negligible lease rate that can be obtained by lending out gold, but it is as a rule far lower than the interest rate paid on fiat monies. Moreover, the gold lending market is not accessible to individual investors. Since no central bank can "print" gold, the yearly increase in the gold supply is fairly stable (in fact, it tends to slowly trend down relative to the overall supply of above ground gold over time as that cumulative supply increases). For fiat monies to successfully compete with gold, they need to offer the inducement of a positive real interest rate, which raises the opportunity cost of holding gold vs. holding fiat currency.
The question then becomes how to determine the real interest rate. One simple method would be to compare the nominal interest rate to the yearly rate of increase in a price index such as CPI. However, this is not really satisfactory, as the CPI is a snapshot of the past. Furthermore, it is not a reliable measure of the loss of a currency's purchasing power. As previously noted, it attempts to measure something than can not truly be measured. In addition, the government's statistical methodologies are highly suspect and many observers allege that they significantly understate the loss of the currency's purchasing power.
The best method (still not a perfect method to be sure) to determine real interest rates is to compare nominal interest rates to so-called "inflation expectations." Inflation expectations in this context are "expectations of the likely future loss of money's purchasing power as expressed by the market prices of debt securities." The relevant price ratios are so-called "inflation breakevens," which are comparing the yields of government bonds with the yields on "inflation protected" government bonds. The flaw of this method is that the inflation protected debt securities in turn use prices indexes such as CPI as their reference point, so one can not truly escape the flaw in CPI calculation methodologies. However, it is all we have to work with.
A recent article by Jim Bianco that appeared at Big Picture discusses the current state of inflation expectations derived in this manner. The most important statement Bianco makes in this article is the following (our emphasis):
Since August, both of these tables [different methods of measuring inflation expectations, ed.] show the 5-year inflation break-even rate is up more than nominal yields. This means all of the rise in nominal interest rates since last summer can be attributed to higher inflation expectations. This is exactly the opposite of Bernanke’s contention that "the bulk of the increase in interest rates has been in the real side". In fact, none of the rise in yields since August has come from higher real rates."
Below is a chart of five year U.S. inflation breakevens as calculated by Bloomberg.
(Click to enlarge)
Five year U.S. inflation break-evens, according to Bloomberg (per Bianco: "Bond traders use a better duration-matched Treasury note, the 2.50% of April 2015. Bloomberg uses this Treasury note in constructing its inflation break-even series [USGGBE05]"). Five- year inflation break-evens are at 2.77% while by contrast the yield to maturity of the five- year U.S. Treasury note is currently at 2.17%.
(Click to enlarge) The 5 year Treasury note yields 2.17% nominal.
Another way of proving Bianco's contention that the rise in nominal yields we have observed in recent months is not a reflection of rising real yields is by comparing the TIP-TLT ratio to the 30 year bond yield. TIP and TLT are ETF's holding long bonds (TIP holds inflation protected securities, TLT "normal" bonds) with an average maturity of 20 years or longer. A rise in the ratio signifies that inflation expectations are rising while the opposite holds for a falling ratio. As can be seen below, the rise in nominal bond yields has closely tracked inflation expectations.
(Click to enlarge) The TIP-TLT ratio vs. the 30 year bond yield – changes in inflation expectations mirror the corresponding moves in nominal bond yields very closely.
Since the yield curve is currently very steep, the negative real rate becomes more pronounced the shorter the debt maturities one looks at. For instance, the one year Treasury note yield is currently only at 27 basis points, a mere 2 basis points above the upper bound of the Federal Funds target rate of 0 – 25 basis points. Anyone who believes prices will rise by less than 27 basis points over the coming year may want to inspect a certain bridge in Brooklyn that is for sale.
(Click to enlarge) The one year Treasury note yield – at 27 basis points it can not possibly compensate for the loss of purchasing power likely to occur over the coming year.
We can conclude from the above that the real interest rate backdrop remains positive for gold.
2. The U.S. Dollar's exchange rate
In recent years the dollar's exchange rate has had less influence on the gold price than in the period 2001-2008, as inflationary policies have been pursued everywhere in the world – this has helped the dollar index to stabilize in a trading range which it by and large inhabits since early 2008.
(Click to enlarge) Since the March 2008 low, the US dollar has settled into a trading range.
This factor is therefore neutral – since April 2010 the beginning of the euro area's sovereign debt crisis has provided support to the gold price even in the face of a stable or rising US dollar.
3. Money Supply Growth
Below are two charts depicting the growth of the money supply TMS-2 for the U.S. and the euro area ("true money supply" as per the Rothbard-Salerno definition, via Michael Pollaro. For definitions, sources and references on the calculation of money TMS see here).
(Click to enlarge) U.S. money supply TMS-2 ("broad Austrian money supply") – vigorous growth has been in evidence since … well, forever actually, but it has increased markedly since 2000. Between 2000 (when the gold bull market began) and today, U.S. TMS-2 has grown by 142%.
(Click to enlarge) Euro Area money supply TMS-2 – while money supply growth in the euro area has been a bit slower than in the US, is growth still amounted to 125% in terms of euro area TMS since early 2000.
Since there are as of yet no indications that money supply growth is about to slow down, this factor remains strongly supportive to the gold price.
4. The Steepness of the Yield Curve
The yield curve can steepen for two reasons. Firstly, easy monetary policy – since the Fed influences mostly the very short end of the yield curve with its Federal Funds target rate setting, an easy monetary policy will bring short rates down relative to long rates - and secondly an increase in inflation expectations, which tends to raise longer term rates relative to shorter term rates (the longer the maturity of a debt instrument, the more harm rising inflation will inflict on its price. Also, the Fed has comparatively much less control over the direction of long term rates).
Sometimes both events can happen concurrently – which seems to be the case at present.
Therefore, a steep yield curve is generally considered bullish for gold, while a flattening yield curve (which can be the result of either tighter monetary policy, falling inflation expectations or both) is considered bearish.
(Click to enlarge) The spread (ratio) between the 10 year and one year Treasury yield. This ratio is not far from its recent highs and remains in a well-defined uptrend.
Currently the yield curve is very steep, which is bullish for the price of gold.
5. Credit Spreads
Generally, credit spreads (i.e., the yield differential between low and high rated debt) are considered bullish for gold when they are widening and bearish when they are narrowing. Gold's price itself can be used to create indicators of waxing and waning economic confidence, by measuring the ratio of the gold price to other prices (the gold-commodities ratio or the famous Dow-gold-ratio are examples for this).
A simple way of determining credit spreads is to compare the ratio of high yield ETF's to TLT or other ETF's holding government debt. Below we show the ratio of JNK (the Barclay's high yield bond ETF) to TLT.
Since this is a price ratio with TLT as the denominator, a rising ratio indicates narrowing credit spreads and a falling ratio indicates widening credit spreads. Currently it would appear that credit spreads are bearish for gold, as they have tended to narrow markedly since the late 2008 extreme in spread widening in the wake of the financial crisis. We would however caution that when spreads become extremely narrow, one should actually consider such a state of affairs to be potentially long term bullish for gold. The reason is that extremely narrow credit spreads reveal that there is probably too much economic confidence, i.e., they become a contrary indicator by virtue of being at such an extreme level (what constitutes an extreme level can be gleaned via historical prices).
(Click to enlarge) The ratio of JNK to TLT has risen to new highs for the move this year, which shows that economic confidence is at a post crisis high point. This confidence may turn out not to be justified.
6. The Desire to Increase Savings
In a true free market economy not subject to inflationary boom-bust cycles, society-wide savings would have a tendency to increase over time with growing affluence, as more and more wants would be satisfied and the sacrifice involved in saving would become less onerous – i.e. peoples' time preference would tend to fall as their wealth increases.
In today's practice, we often observe that the desire to increase savings is related to growing uncertainty about the economy's future.
In societies that lack the safety nets provided by the welfare state, there is also a strong incentive for individuals to save in order to provide for emergencies and retirement. The welfare state has the perverse effect of increasing peoples' time preference, as provision for emergencies and retirement has been largely usurped by the state.
In the context of growing uncertainty about the future there is also a problem that is a unique characteristic of the pure fiat money system. Since this system tends to produce ever bigger booms and busts and is inherently unstable, there is a growing incentive to insure oneself against the possibility of its collapse.
Most of the time such a collapse may appear highly unlikely, but the longer the system lasts, the more likely a collapse actually becomes. Consider in this context the "parabolic" charts of money supply and government debt growth, which vastly exceed the growth in economic output.
The system can actually be likened to a pile of sand. One can keep adding grains of sand to a growing sand pile and it will appear stable for a long time. Eventually though, one grain too many will induce the sand pile to collapse in an avalanche. Physicists studying the behavior of sand piles refer to this phenomenon as the "self-organized criticality paradigm." One such model is presented here.
The swift change from an illusion of stability to a state of chaos also marks financial crises and the breakdown of monetary systems, i.e., there is an interesting parallel to the "criticality paradigm" of sand piles.
As one might expect, periods of recession are associated with both an increase in savings and growing worries about systemic stability. Given that gold can not be devalued by statist central planners, while a devaluation of the currency is practically a given due to the alleged need to fight economic downturns by printing money, gold represents an excellent alternative for savers and those wishing to obtain insurance against inflationary policies and a potential systemic breakdown down the road. One important attribute of "gold as money" (even though it is not currently used as a medium of exchange, and thus is strictly speaking not money at present) is that it is no-one's liability. A fiat currency is a liability of the central bank issuing it, and central banks need not offer anything in exchange for it but other, similar money tokens.
As this essential feature of gold is known all over the world, holders of gold can be certain that gold will be accepted everywhere, i.e. it is the "ultimate liquid asset," as one can easily exchange it for whichever money is used locally anywhere in the world.
(Click to enlarge) The U.S. personal savings rate. After being in a long term downtrend since the early 1980's for the duration of the secular boom, it has set two low points in the 2000ds and has since begun to rise.
(Click to enlarge) Total U.S. Credit Market Debt vs. GDP. This chart illustrates that debt has accumulated very fast compared to the increase in economic output (even though GDP is a very flawed measure , this chart still serves to make the point). The growth of debt as such is nothing to be concerned about if credit is fully backed by savings. It is obviously quite different when most of the credit is inflationary in nature, i.e. based on the creation of fiduciary media from thin air.
7. Confidence in Government, the Monetary Authority and the Financial Establishment
The events of the past decade have obviously chipped away at peoples' confidence in government and its institutions involved in central economic planning. The crisis of 2008 has delivered a further blow to confidence in the financial system more generally, including the central bank, as well as the commercial banking system and investment banks (in short, the financial establishment as a whole).
This is obviously true of both the U.S. and Europe, while in Japan confidence in the government's ability to manage the economy has been in decline for about two decades already. There are differences in the details, but what all these governments have in common is a vast increase in their indebtedness. In the euro area, the large and growing debts of the peripheral nations colloquially known as the PIIGS have already led to a crisis situation as these nations can no longer print money independently to devalue their debts, which makes outright defaults a very real possibility. The supranational ECB is theoretically not allowed to monetize the debt of euro area member nation governments, but as we know, in practice this rule has recently been suspended.
U.S. Treasury debt is at present widely regarded as "safer" precisely because the central bank can in extremis monetize the debt, i.e. it can avert a national bankruptcy by simply printing more money. However, as noted before, a default via inflation is still a default by other means – and it is a far more insidious and in the end a far more dangerous course than outright default, since it risks a breakdown of the underlying currency system at some point.
(Click to enlarge) Going "parabolic" – the debt of the U.S. federal government. Clearly this is unsustainable and harbors growing systemic risks.
Waning confidence in the government and the financial establishment must be considered as strongly bullish for gold.
(Click to enlarge) A monthly chart of gold since 2002 (the month of February is not yet included). The price of gold mirrors the inflationary policy since 2000 and the waning confidence in the economy and government's ability to manage it.
The Silver Market
Silver is a true "hybrid" in the precious metals sector, as it has a very large industrial demand component concurrently with a large investment, or monetary, demand component.
As a result, silver will normally outperform gold during times of waxing economic confidence and underperform it during times of waning economic confidence. This can be illustrated by comparing the silver-gold ratio to the S&P 500 index.
(Click to enlarge) The silver-gold ratio (weekly HLC bars) compared to the S&P 500 index (solid line). The strong correlation between the ratio and the SPX confirms that silver tends to outperform gold when confidence in the economy is waxing.
As a result of its large industrial demand component, silver's annual primary supply-demand balance (i.e., mine production plus scrap vs. industrial demand) is far more important than for gold. Historically, there have been large stockpiles of silver in government hands from the time when silver was still used as money , resp. as backing for "silver standard" monies that have long ago become defunct (the largest such official stockpiles were held by the U.S. government and the governments of China, India and the Philippines).
In addition, large privately owned stockpiles were also held following the silver bubble of the late 1970's, when the Hunt brothers together with Arab financiers attempted to "corner" the silver market.
These stockpiles were used for many years to balance a large primary supply-demand deficit in the silver market, which explains why silver was immersed in a downtrend for two decades following the 1980 peak in spite of the primary deficit. Investment demand turned negative after 1980, and the dishoarding of stockpiles held for investment purposes and the sale of government stockpiles more than made up for the shortfall from mine supply.
A number of silver analysts estimate that sometime by the early 2000ds, most of these stockpiles were exhausted.
In the meantime, the silver market's primary deficit has actually turned into a slight surplus, but investment demand has turned strongly positive and currently evidently exceeds the size of the primary surplus.
Due to the fact that silver's price is influenced by both industrial and investment demand, there can occasionally be phases when investment demand becomes its predominant price driver.
The 1976 – 1980 advance is actually a good example for a temporary breakdown of the "normal" relationship between silver and gold , especially in the latter phase of the rally in 1979. This is to say, in spite of waning confidence in the economy and the monetary authority, silver managed to outperform gold as it became subject to especially intense investment demand. It doesn't really matter that the Hunts attempted to corner the market – their silver demand also constituted investment demand. They weren't hoarding silver bullion because they intended to supply industry with silver, but because they were convinced the fiat money system was on its last legs.
One reason why silver can outperform gold in such a situation is probably psychological – due to its lower nominal price, it is also known as the "poor man's gold," i.e. it is used as an investment alternative to gold by people who consider gold too dear.
Lastly, silver is also a favorite plaything of speculators in the futures markets, as its higher volatility promises quicker profits for those willing to stomach the comparatively higher risk investing in silver entails.
Platinum Group Metals
Although PGM's tend to directionally correlate with gold as well, industrial demand is even more important for them than for silver. An estimated 70%- 80% of the total industrial demand is for the use of PGMs in automotive catalytic converters (the balance is largely demand from the electronics and chemical industries) . The global growth in the auto market combined with environmental legislation imposing exhaust emission standards is therefore the most important price driver from the demand side (leaving aside for a moment that a broad-based increase in almost all commodity prices is largely a by-product of monetary inflation).
Luckily for PGM producers (the bulk of PGM production is located in Southern Africa and Russia, with North American production a distant third), only small amounts of PGM's are needed in catalytic converters, which makes substitution a fairly unlikely prospect – these metals are extraordinarily useful as catalysts, and replacing them with substitutes has so far not proved economical.
Both jewelry and investment demand for platinum and palladium have increased strongly in recent years, with platinum representing a kind of "rich man's gold." Especially in some Asian countries, platinum jewelry is held in high esteem as a status symbol.
With the advent of ETFs backed by physical platinum and palladium, investment demand has received an additional shot in the arm by making it easier for investors to purchase the metals via the indirect route of buying ETF shares.
Palladium has been the best performing precious metal over the past year, as it is a relatively small market (about 7 million ounces are produced annually) and has experienced a slight primary supply-demand deficit. For 2011, it is estimated that supply will amount to some 222 tons (including sales of 30 tons from Russia's state reserves) compared to expected demand of 278 tons. The difference is expected to be made up from scrap supply.
This means that absent selling from Russia's reserves, the market could experience a substantial deficit in 2011 – provided global economic growth continues at a rate comparable to 2010. Russia's state-owned reserves (managed by the Gokhran agency) are a state secret, so no-one really knows how much palladium there is really available from this source. We do however know that most of the Russian palladium comes to market via Zürich in Switzerland, and according to sources there, there were already indications that Russian supplies from Gokhran's stockpile were likely to decrease by mid to late 2009. This is apparently ascertained by observing the quality of the palladium bars delivered from this source. If bars of lower purity begin to enter the mix, then it is usually a sign that they are "scraping the bottom of the barrel," so to speak. Still, in 2010 an estimated 30 tons came to market via Gokhran.
While the expected supply-demand deficit in 2011 could drive the palladium price up further, we would caution not to lose sight of the demand side of the picture. Should economic confidence decline, palladium's price will decline with it, as it will tend to discount a future return to surplus conditions. The current price is still below the record high achieved in 2001, when a severe shortage drove the futures price to over $1,000/oz. (in the cash market, the price was even higher. For instance, Ford reportedly bought 200,000 oz. of physical palladium at $1,600/oz. to ensure it would not suffer a supply disruption. With hindsight this turned out to be a costly mistake – Ford in effect top-ticked the market at the time). Investors must keep in mind that palladium is notoriously volatile and tends to fall just as fast as it rises when market psychology changes from bullish to bearish.
(Click to enlarge) Palladium was the best performing precious metal in 2010, besting even silver's outstanding rise. Since its 2008/2009 lows, the metal has risen in price by more than 300%.
With regards to platinum, Johnson Matthey, which is considered the foremost authority on PGM's, forecasts a slight surplus for 2011, so even more caution seems advisable in this particular market. On the other hand, platinum has seen a more subdued advance in the course of 2010 and is therefore less "overbought" than palladium.
Addendum – Ireland's Election
Over the weekend, Ireland's election results have produced what appears to be a strong rejection of the austerity program and bailout overseen by the previous Fianna Fail-led government. As the Telegraph reports under the heading "Ireland's new government on a collision course with EU," the former governing party was "wiped out" in the election (our emphasis).
"Exit polls and early tallies from Ireland's general election heralded political annihilation for Fianna Fail, the party which has ruled Ireland for more than 60 years of the Irish Republic's eight decades of independence.
The unprecedented and historic defeat, Fianna Fail's worst result in 85 years, makes the Irish government the first eurozone administration to be punished by voters in the aftermath of the EU's debt crisis. Voter turn-out was exceptionally high at more than 70 per cent, indicating public anger at the government and the EU.
Late last year, Ireland was forced to accept a £72 billion EU-IMF bailout to cover huge public debts that were ran up to save failed Irish banks.
The bail-out was designed to prevent financial contagion that threatened the existence of the euro, but according to economic forecasts, the cost of servicing Irish bank debt and the EU-IMF bank loans will consume 85 per cent of Ireland's income tax revenue by 2012, a burden that a majority of voters find intolerable."
Without a doubt, the euro area's simmering debt crisis is once again about to become more "interesting" (in the Chinese curse sense). The Irish election outcome illustrates a point we have frequently made in the past: the austerity imposed on euro area member nations subject to bailouts as a condition for receiving EFSF assistance is so unpopular with voters that it will in the end prove not to be politically doable. Prepare for more market turmoil as this becomes increasingly clear to market participants.
Charts by: Bloomberg, StockCharts.com, St. Louis Federal Reserve Research, Omega Research, Michael Pollaro