Fed's Currency Intervention Reinforces Precious Metals Prices

There is absolutely no coincidence that the rise in precious metals prices coincides exactly with monetary intervention by the Federal Reserve.  A currency intervention like last night’s certainly qualifies as another round of intervention.  Alan Greenspan, no monetary hawk himself, wrote all the way back in 1966 that, “Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights.”

Since dollars themselves are nothing more than debt, printing more simply increases the number of paper debt claims against hard, productive assets.  Creating dollars from thin air reduces national wealth – productive economic processes that expand production potential (including innovation and services) should be the driving force of monetary expansion.

Gold, and to a lesser extent silver (poor man’s gold), have done exactly what Greenspan alluded to.  Precious metals have protected accumulated property against the tidal forces of inflationary expansion. 
The destructive potential from the increase in price levels is a relative function.  The harm from rising prices comes from relative movements to real production and wages.  If prices rise faster than wages, the effects are harmful (conversely, if prices fall faster than wages, the resulting deflation can be beneficial). 

Rising prices have drastic effects on accumulated savings, robbing them of future purchasing power.  When this happens many investors believe that the answer is to move savings into higher yielding securities (giving rise to the myth that high interest rates are an anathema to rising precious metals prices).  But in chasing higher yields investors will always be behind the inflationary curve.  No matter how much periodic interest you procure it will have eroded by the time you get the next payment.  In other words, the temporal component of investment itself is elastic and works against you.

What those investors fail to realise is that the purchase of gold or silver is not a currency-based investment, it is an outright alternative to the debasing currency.  During periods of debasement, businesses and investors have a choice of accepting depreciating dollars for their physical labors or output, knowing full well that they will be able to buy a declining amount of goods or services, or to receive an exchangeable asset that will not be debased, and thus store its exchange value for future purchasing power.

This seems a bit far-fetched in today’s world of debit cards and floating currencies.  After all, you won’t be able to walk into the grocery store and pay for food with gold coins.  But it isn’t a medium of exchange that gold investors are seeking.  As long as there is enough currency (which the Fed is more than taking care of) metals investors are only seeking a store of value that cannot be diluted.

As the number of dollars in existence increases through each of these seemingly unending expansionary monetary policies, the laws of supply and demand are acting upon the real physical economy.  More dollars chasing the same amount of goods simply means higher prices.  Without a concurrent expansion in real production and real wages, the net effect to individuals is a loss of both current and future purchasing power.  Can it only be coincidence that gold prices have risen so much in the decade of the 2000’s while real wages have stagnated over the same period?  Have liquid asset prices increased enough compared to the beginning of the decade?

At some point this loss of power forces individuals and investors to seek relief.  Some will chase yield, which currently means moving well down the risk curve.  Some will choose metals that have a relative sticky supply potential.  As more people seek monetary alternatives relative to the stable or slightly growing supply of physical metal, the price in dollars of precious metals rises.

The reality of this exchange process is simply that the price of gold or silver does not change.  The value of the currency it is priced in changes.  So if gold rises in dollar terms, this simply means that the dollar has lost value.  And as more individuals seek relief from this insipid inflationary circumstance, the relative ability to supply actual metal becomes the marginal factor in determining the exchange rate between currency and metal.

We have been watching the price action for silver as it has related to demands for the physical metal in the futures market (see our article from February 24).  The delivery month of March saw fewer contracts stand for delivery than did December (although fewer cash settlements thus far), but the lack of actual deliveries so far into the month continues to point to a lack of available metal.

According to available figures from the Comex, there were funds deposited at the February notice dateequal to demand for physical delivery of about 9.5 million ounces of silver.  That is not a massive withdrawal demand for an exchange that shows dealer inventory around 100 million ounces.  Yet, as of March 17 only half of that demand has actually been fulfilled (futures contracts specify that delivery is contractually obligated to occur before the end of the month).

If there is not enough available metal it seems that sellers would be forced to lease physical silver to satisfy demand.  But we have seen lease rates decline modestly throughout the month (after moving sharply higher in February).  This means that there may be a potential jump in leasing rates as the month end draws closer, which would confirm the lack of available metal.

The spot price of silver seems to have found a floor at $34 per ounce despite all the liquidity unwinding related to the yen.  This is also a sign of tight physical markets since investors on the long side refused to give up their positions in the face of both uncertainty and heavy volatility.

The entire premise of increasing investor demand is based on the Fed’s monetary expansion.  So any new potential increases in money stock will only embolden current investors and attract new ones.  Today’s coordinated central bank action is another signal that monetary expansion is not yet over.  And furthermore it may be the prelude/excuse to QE 3.0 – The Bank of Japan is already there.  The commonality through the last 20-five years is that more money is the solution to every crisis.

The ability of central banks to enforce monetary stability is somewhere between their ability to foresee crises and their ability to enforce stable prices.  That is, they are wretched currency masters.  The “Plaza Accord” of 1985 was instituted to depreciate the dollar at the expense of the yen and the German Mark.  It worked so well that another agreement was needed to halt the dollar’s depreciation just two years later. 

The second accord had little effect and the yen kept on rising until Japan’s asset bubbles collapsed (due in part to the inability of its yen-dependent export economy to keep pace with asset prices).

So this new currency agreement means that the New York Fed is selling dollars openly in the forex markets.  But what/whose dollars are they selling?  Given the history of the Fed and its actions (often contra its stated intentions) precious metal investors already believe they know the answer, and metals prices have risen accordingly.

Full disclosure:  ACM currently holds long positions of physical metal mutual funds and call options in client accounts.

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