The Silver Rally Could Turn Epic As Inflation Continues To Climb

| About: iShares Silver (SLV)


Despite the rate increase Wednesday silver is continuing to move higher and is now starting to noticeably outperform gold.

Inflation is heating up and is likely to continue higher. Moreover, there is now a 100-basis point disconnect between the CPI, and the PCE.

It appears the Fed's inflation gauge (PCE) is downplaying inflationary pressures, suggesting the Fed could enable real inflation to go much higher.

The gold to silver ratio is coming off an extreme level of over 80 and implies the silver rally is just getting started.

Higher than anticipated inflation coupled with several other constructive factors are likely to drive SLV/silver prices significantly higher going forward.


Silver Rally Could be Epic as Inflation Continues to Climb

Silver/iShares Silver Trust (SLV) rose by more than 1% on Wednesday, despite the Fed’s decision to increase the Federal funds rate by another 25 basis points. Perhaps even more significant is the fact that SLV has appreciated by about 5% over the past several trading sessions leading up to the Fed decision. This is a stark difference to the silver selloffs that usually precede telegraphed rate hikes. So, what is it this time, has something changed in the silver market?

It’s all about inflation, and there are clear signs the inflation situation is significantly hotter than the Fed is seemingly implying. In addition, the gold to silver ratio is beginning to back off extreme highs, silver is staring to noticeably outperform gold, and the dollar could provide additional tailwinds to silver’s already favorable backdrop. Ultimately, the combination of these underlying factors coupled with higher than anticipated inflation will likely drive silver prices significantly higher in the second half of this year and beyond.

Background Information About SLV

SLV is an exchange-traded fund that is designed to give investors a cost-efficient way to gain access to the silver market without having to buy silver futures or the physical metal. The SLV ETF fund is engineered to mimic the spot price of silver. Each share owned by an investor represents a fractional ownership in the fund, which holds over 325 million ounces of physical silver worth roughly $5.33 billion.

SLV is an efficient and convenient trading vehicle, as it mimics silver's spot price, yet investors do not need to deal with exchanges that facilitate futures contracts, and do not have to pay prices over spot to procure the physical asset. It is also very liquid and can easily be bought and sold like any other highly liquid stock or ETF. In addition, SLV has very attractive options that can be traded with great ease.

Since SLV mimics silver’s price almost exactly, I will use SLV and silver interchangeably throughout this article.

The Fed Decision

The Federal Reserve raised rates on Wednesday, so the current Fed funds rate is now 1.75-2%. Moreover, officials signaled the likelihood of two more rate hikes throughout this year. This should come as no surprise as the Fed has repeatedly hinted that it wants to raise rates 4 times this year.

However, market participants don’t seem to be so convinced that the rate hike trajectory is going to be quite as robust as the Fed suggests. Currently, target rate probabilities for the end of the year suggest that market participants see a 6% chance rates will remain unchanged, and see about a 45% chance rates will either remain unchanged or will be just 25 basis points higher at year’s end. Chances that rates will be 50 basis points higher are 52.4%, so the market appears to be largely split between a Fed funds rate that is either .25% or .5% higher by the end of this year. Either way, these are not significant increases.


Why is this important? Because low rates are good for inflation, and inflation is the single most significant factor that drives silver and gold prices. An important element to point out is that the Fed is and continues to be intent on downplaying inflationary pressures in the economy. To realize this, one must look no further than the inflation gauge the Fed uses, the core PCE, which is continuously below other widely followed inflation indicators. To compound the issue, the Fed has stated that it is prepared to allow inflation to rise above its 2% target rate, which suggests real inflation could go significantly higher, and this is very bullish for silver prices.

Inflation Picture

Let’s start with the core PCE, the inflation gauge the Fed uses. The core PCE is currently at only about 1.8%, and since the Fed is prepared to let inflation rise above 2%, possibly to 2.5%, or even higher to keep growth pumping, real inflation is likely to go much higher. It is important to note that the last time the core PCE touched 2% was in 2012, when silver prices were much higher.


Now, let’s look at other widely followed inflation indicators that may portray the real inflation picture more accurately than the continuously subdued PCE. The consumer price index CPI, which is calculated similarly to the PCE is showing inflation at 2.8%, that’s a massive 100 basis point disconnect from the Fed’s gauge. Moreover, this is about a 120-basis point YoY increase, and a 30-basis point surge just over last month. These are the highest CPI readings since 2012, and this time the clear trajectory is higher, not downward.


We can also observe the purchaser price index PPI. The PPI final demand is at 3.1%, also the highest level it’s been since 2012. Perhaps more importantly, the PPI final demand goods prices are at over 4% right now. This is rather staggering and illustrates that raw materials necessary to make countless consumer products are more than 4% higher today than they were at this time last year. These types of costs are bound to be passed on to consumers which suggests real inflation along with consumer prices is likely to go significantly higher. Also, with rising oil/energy costs and other raw material increases there is no indication that this is a transient phenomenon, or that prices will level off or decline any time soon.


The Fed claims that inflation is relatively tame, and under control, but I find this rather difficult to believe. It appears that the Fed uses a convenient gauge to assess inflation pressures but it does not make sense that inflation will remain “subdued” for long. Also, with the economy at or near “full employment” wage growth should accelerate providing additional pressure to the inflation picture.

Gold to Silver Ratio

One of my favorite indicators to look at when assessing prospects for silver prices is the gold to silver ratio. This essentially shows how many ounces of silver one ounce of gold is worth. Throughout recent history this ratio has bounced around between about 30 and 80. The lower end of this range has traditionally served as an indicator that a top to a gold/silver cycle is in and vice versa.

The reasoning behind this is rather simple. In early stages of bull market run or at the height of a bear market silver gets oversold and overshoots gold to the downside. Also, silver often underperforms gold and in the early stages of a bull run and this causes the gold to silver ratio to increase. On the flip side, silver often begins to outperform gold in the mid and late stages of a bull market cycle and the ratio thus decreases.

In March of this year the ratio hit over 81, this is actually slightly higher than the prior silver lows in 2003, 2008, and 2016. Each one of these points birthed significant rallies, although the 2016 one was stunted. Nevertheless, from 2003 – 2008 silver nearly quadrupled, from 2008 – 2011 silver more than quintupled, and in 2016 silver surged by 40% in 6 months. What will 2018’s 81+ gold to silver ratio bring? It’s impossible to say exactly, but it could be epic.

Tariffs Likely to Weigh on Dollar

All this tariff and trade war talk could end up being quite negative for the dollar, especially if it ever turns into action instead of just words. Do you know what else is damaging to the buck? Trillion-dollar budget deficits, an unsustainable national debt, $500 billion trade deficits, rising inflation, record amounts of all types of debt, as well as other factors.

I continue to believe that the overall trend remains lower for the buck despite a relatively robust economy in the U.S. and a rising interest rate environment. Another important factor to consider is that the U.S. economy won’t remain “strong” forever. A recession could hit as soon as next year, or 2020, and when it does there will be no more rate hikes. To the contrary, there will be more easing, and very likely a lot more QE. This will put enormous pressure on the U.S. dollar, inflation will likely spike, and there is no telling how high silver can go in such an environment. Probably significantly higher than the $55 highs reached in 2011.

Silver Now Leading Gold

As I mentioned earlier, the gold to silver ratio is important, because as silver begins to outperform gold the ratio declines. The ratio is coming off an extreme multiyear high level so silver’s outperformance is likely just beginning. The precious metals are likely transitioning from the early stages of the bull market which started in early 2016 to the early mid stage during which silver is just starting to outperform gold. If this trend remains silver should continue to significantly outperform the yellow metal into year’s end and beyond.

Chart GLD data by YCharts

The Bottom Line

A goldilocks environment spearheaded by higher inflation appears to be materializing for silver. Both PPI and CPI figures are the highest they’ve been since 2012 and are both in clear upward trajectories. This suggests that inflation could stay elevated for longer and that the current inflationary environment is likely much more than just a transient phenomenon.

Moreover, a significant disconnect appears to be developing between what real inflation is and what the Fed sees inflation as being according to the PCE. This dynamic allows the Fed to continuously downplay inflationary pressures in the economy and should enable inflation to rise much higher before the Fed implements comprehensive steps to stunt growth. Additional favorable variables include a falling gold to silver ratio, a clear outperformance in silver prices over gold’s, dollar pressures, as well as other elements. Ultimately, it appears that the stage is set for a significant second half rally in silver and I expect SLV prices to be substantially higher by year’s end.

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Disclaimer: This article expresses solely my opinions, is produced for informational purposes only, and is not a recommendation to buy or sell any securities. Investing comes with risk to loss of principal. Please always conduct your own research and consider your investment decisions very carefully.

Disclosure: I am/we are long SLV.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long SLV and SLV call options