SLV: Recent Drop In Real Interest Rates May Portend Another Breakout In Precious Metals

Summary

• Silver and gold have been stagnated for nearly a year as real interest rates have remained near all-time-lows.
• Continued Q.E efforts have pushed real interest rates to new lows - causing my implied fair-value of gold measure to reach nearly $2100/oz.
• While the gold-to-silver price ratio is still historically high, gold may be favorable in the short run due to its minimal cyclical dependencies.
• Economic data is now showing clear signs of a potential "double-dip" recession which could cause disinflation and a decline in industrial metal value.
• SLV is superior to physical silver for larger amounts of money as it does not come with big premiums and is far more liquid.

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Like most markets today, the precious metals market seems increasingly mired in media-frenzy with highly sensationalized arguments and views from both bulls and bears. While emotions play a crucial role in short-term trading, I believe that it is almost always best to focus on the hard data when making long-term investing decisions. This is particularly true for precious metals, which, contrary to popular opinion, are usually priced quite rationally and can be predicted mainly using interest rate data.

First, what is silver (NYSEARCA:SLV)? It's a slightly rare metal that is generally seen as attractive, making it a store of wealth and has some industrial uses, giving it economic value. Silver differs from gold because it is more abundant, generally seen as less attractive, and has greater industrial demand. About half of silver's demand comes from industry as it is a critical component in renewable products such as electric vehicles.

Understanding silver's economic value is essential to see its risks more clearly. Silver carries greater sensitivity to economic fluctuations, particularly in the global manufacturing sector. Silver is less economically sensitive than base metals (such as iron, copper, and nickel) but is far more sensitive than gold. Hence, as global manufacturing growth has been slowing for decades, the silver-to-gold ratio has declined. This decline may also be due to preferential treatment of gold from world governments and financial institutions. In the long run, it seems likely that the silver-to-gold ratio will revert to millennia-held levels of 1:15, which implies a 380% gain for silver (the ratio is 1:72 today), though this mean-reversion may still be many years away.

Many silver investors last year had hoped that we would soon see such a meteoric gain for silver. While the metal went through a strong bull market, it has stalled for about a year around the $25 level. The price of gold has stalled as well. While some are calling this stalling a sign of market manipulation from institutions, there has also been a lack of economic changes necessary to boost the silver price further. That said, as we look around the corner, it appears we may see these necessary shifts sometime within the next year that may cause another breakout in the silver market.

New Low In Real Rates Portends a Breakout

The price of silver and gold depends greatly on the inflation outlook and real interest rates. Real interest rates are the rate paid on a risk-free investment less the inflation outlook. In other words, it is the real economic return of a risk-free investment. Fortunately, this rate can be directly measured by the inflation-indexed Treasury bond rate, a type of Treasury bond indexed to the consumer price index. Since an inflation-indexed bond has no inflation risk, it often has a meager and often negative yield.

In the long run, precious metals are also indexed to the consumer price index. While the CPI has its limitations and controversies, the correlation between inflation-indexed rates and the price of silver and gold is startling. See below:

Data by YCharts

While the relationship is far from exact, it is still quite strong and, in my view, is the primary driver of silver and gold's price. The inverse relationship exists due to the simple fact that when investors are losing economic value in bonds/savings, they flock to precious metals, which, ideally, retain their value in the face of inflation. More technically, we could say the comparative economic value of precious metals rises as it declines for fiat currency.

Very importantly, the inflation-indexed rate (i.e., real rate) recently broke below the key -1% level. This means that investors in Treasury bonds are expected to have a negative 1.15% return after inflation. The rate has never been as low as today, meaning the U.S dollar has never been as a poor investment as it currently is (in regards to real yields).

When I wrote about silver last, it was not entirely clear that the inflation-indexed yield would break deeper into unprecedented negative territory. This largely depended on prolonging the Federal Reserve's quantitative easing policy, which reduces real-interest rates (by simultaneously creating inflation while lowering yields through bond purchases).

Since the real yield has decisively broken lower in recent weeks, we have a robust bullish signal for precious metals. As measured by a simple statistical model based on real rates, the implied fair value of gold has increased to $2072/oz. The price of gold is still around $1820/oz, so the yellow metal is hypothetically undervalued by ~13%. Of course, since the decline in the 10-year inflation-indexed rate is so decisive, I believe the fair value of gold will continue to rise. Eventually, more will realize this shift and may soon fuel a breakout in the actual price of gold.

Manufacturing Slowdown May Slow Silver

While silver's price is historically low compared to gold, we must consider what a slowdown in manufacturing may mean for silver. Global manufacturing collapsed last year and then rebounded at such a rate that it appears to have overheated, with production costs climbing through the rough.

If there were a spectrum of metals from iron as the most economically sensitive and least precious to gold as the most precious and least economically sensitive, silver would probably be right in the middle. In my opinion, its precious metal value is currently on the rise, while its economic value may be headed for a temporary decline.

Silver is highly correlated to the base metals ETF (DBB), which contains copper, nickel, and other industrial metals. This fund has a solid relationship to the breakeven inflation rate (measured as the difference between fixed Treasury bond rates and inflation-indexed Treasury bond rates - a key Federal Reserve measure). The inflation breakeven rate is highly correlated to the U.S Manufacturing PMI, a survey-based index that is a firm indication of current U.S manufacturing economic growth.

As this manufacturing growth rises, demand for raw commodities increases which cause prices to rise. This is interrelationship can be seen clearly below:

Data by YCharts

Manufacturing growth collapsed last year during the onset of COVID lockdowns which caused a major decline in inflation and metal prices. However, immense government stimulus fueled an extreme rebound in the manufacturing sector which pushed inflation and metal prices back to historically high levels. The question is, will today's high manufacturing growth rate remain?

This touches on the related question of "is inflation transitory?" The U.S manufacturing PMI has declined slightly from its high level, and the inflation breakeven rate has also stopped rising. Since manufacturing growth is almost always cyclical, inflation is also cyclical in the short run. This alone means that the major impulse for higher industrial metal prices is no longer benefiting the market.

This also comes as the U.S eviction moratorium ends and as some political leaders flirt with the idea of renewed lockdowns. These are both negative factors for the U.S manufacturing sector since the boom in demand last year may be upended. Even without such "X factors," U.S consumer confidence remains depressed while household and corporate debt are at an all-time high. While the property market has never been as rich as it is today, the spike in new home sales is collapsing at a very rapid pace.

Altogether, there are tell-tale signs that last year's economic rebound is now in reversal. This comes as no surprise since last year's boom did not occur due to fundamentals but due to immense governmental stimulus and breaks, most of which are over. While this may not necessarily bring about a recession, it will almost certainly cause a decline in manufacturing growth which should cause the spike in demand for industrial metals to end. At this point, I do not believe this will cause a major crash to the price of silver due to today's negative real interest rates, but it may slow its rise or prolong its stagnation.

The Bottom Line

Today's silver market is in a rare situation where its precious metal value (i.e., store of value, hedge against monetary chaos) is rising while its industrial value is seeing a short-term peak. This boosts the fair value of precious metals as the investment value of the U.S dollar becomes more negative. If the economy renters a disinflationary dynamic of falling consumer demand, as is evidenced, then vehicle sales will likely decline, which is bearish for silver. That said, considering the Federal Reserve has no concrete plans to end Q.E, I expect real interest rates to remain at all-time lows and would not be surprised to see them fall even further.

Overall, SLV's short-term outlook is not as strong as its long-term outlook. If "double-dip" recession fears arise, as I expect, then silver may decline back to the $20/oz level or lower. However, I do not believe this will last as such concerns will only allow the Federal Reserve's Q.E policy to become more aggressive, benefiting the value of precious metals. Putting this together, I expect we may soon see another breakout in gold, eventually followed by silver.

Note, Is SLV Just Paper?

With the strength of global supply chains in uncertain territory, it seems any discussion of SLV must contain its counterparty risks. The retail price of physical silver (roughly $33-36/oz) is currently much higher than the spot price that SLV tracks. Understandably, many are concerned about a global financial reset that could create hyperinflation that would expose SLV's counterparty risks.

While this potential counterparty risk is something to keep in mind, SLV is legally backed by physical silver and is redeemable in substantial sums. The related CEF (PSLV) is easier to redeem, though SLV has superior liquidity and trading volume. Personally, unless there is a complete breakdown in the legal system, there is a limited economic difference between SLV and physical silver besides immense premiums in the physical market. In my opinion, popular fears regarding SLV's backing are pushed by physical silver retailers, which generate enormous profits from those premiums.

The way I see it, it may be wise to have some physical metal in one's personal coffer. However, SLV is more suitable for more significant sums of money since it is far more liquid and less expensive. In my view, if there is ever a crisis that is so extreme that SLV cannot meet obligations, then most people will have more important things to worry about than their portfolio's value.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of SLV either through stock ownership, options, or other derivatives. 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.