Is There A Limit To Precious Metals Prices?

Gold and silver prices continue to skyrocket as we expected.  Most of the recent price movements have been driven by supply and demand factors that are yet to be fully understood by the broader public.  But as prices move ever higher, the commentary in favour of some kind of precious metals bubble gets louder.  So, outside of fundamental supply/demand dynamics, is there a justification for these prices?

First off, gold and silver prices may be at (gold) or approaching (silver) nominal highs, but are well below inflation-adjusted highs.  Depending on your definition of inflation, the inflation-adjusted high for gold is about $2,200 per ounce.  For silver it is about $850 per ounce.  Both were set in 1980.

When we talk about fundamental values for both, we are not really talking about any intrinsic value.  What we are really talking about is their value as alternative forms of money.  Again, and this point cannot be stressed enough, the price of gold does not change – the currency you are comparing it to does.  If the price of gold rises in US dollar terms, this simply means that the US dollar is losing comparative value as a means of exchange.

In this context it is entirely appropriate to compare precious metals in inflation-adjusted terms.  Inflation itself is a monetary phenomenon that is nothing more than currency debasement.  And so it stands to reason that the more a currency is debased the more an alternative is to be sought.

Those inflation era highs can be a good basis of comparison, but it must be remembered that they were set during double-digit inflation and interest rates.  We are not there, yet.

In terms of currency alternatives, though, the present time may be the most dangerous.  The just-concluded 3rd BRICS summit (Brazil, Russia, India, China, and recently added South Africa) showcased a lot of open talk about replacing the dollar as the world’s reserve currency.  They even went so far as to begin discussing details of trade regimes that are denominated in local currencies instead of US dollars.

This is not the only time a dollar alternative has been discussed.  In fact, the dollar noise is growing louder.

How would this all impact gold, and by extension silver?

For one, any new global currency regime would have to include the metals – even under the auspices of the International Monetary Fund’s (IMF) Special Drawing Rights (SDR).  So if we turn to the largest holder of gold, the United States, we can draw a speculative line between its gold holdings and the Federal Reserve’s balance sheet.

The US dollar is a function of the credit extended by the Federal Reserve, which is far above simply the number of Federal Reserve Notes in existence.  Currently (as of April 14, 2011) the Fed has extended an astounding 2.7 trillion “dollars” to the financial system, including $1 trillion in actual currency and $1.18 trillion in bank reserves.

Backing this currency is $1.37 trillion in US Treasury Securities, $131 billion in federal agency debt (Fannie Mae and Freddie Mac), $937 billion in mortgage-backed securities, $43 billion in Treasury currency, and some other assorted “assets”, including $5.2 billion in IMF SDR’s.  Gold only accounts for $11 billion.

But the gold stock (certificates) on the Federal Reserve’s books is being valued at the same price as the 1933 dollar devaluation, $42.2222 per fine troy ounce.  In total, the Federal Reserve is currently using 261,499,000 troy ounces of gold as “collateral” for the dollar at 78-year old prices.

If we value these holdings at current market prices ($1,485), the value on the Fed’s books would be $388 billion, still only 14.3% of the Fed’s liabilities.  To fully back the dollar with gold would mean a price of $10,337 per ounce.  And that gives the Fed full credit for its gold holdings.

We know that not all of the government’s gold is actually in the possession of the government at Fort Knox.  The US has been leasing gold for years.  The exact proportion of actual, physical gold to paper claims (leasing agreements) is, and will be, unknowable.  But if we are talking about a paradigm shift in the international financial system then paper claims will not be enough.

This may seem like an outrageous proposition, but considering the lack of support for the dollar right now the conditions are ripening for a Bretton Woods-style change.  Even if there is a move to SDR’s, there has to be some collateral behind them far above just financial paper, including US Treasuries.  In any conversion, the price of gold will have to be adjusted to any set proportion of capital contributions to the new international regime(s).

Since the US is the biggest holder (we think) then it may get the largest credit and/or concessions.  That may mean some amount of Fed “assets”, including mortgage notes and US Treasuries will be allowed as currency collateral.  Or it may include other commodities such as oil – which the US is in possession of in its strategic reserves.

Whatever may happen, we know that a gold coverage of 14.3% of all dollars is likely not nearly enough.  Just to get to a 50% collateral arrangement, the price would have to rise to $5,168 per ounce.  Since silver is historically related to gold at 16 to 1, that would translate to $323 per ounce of silver.

For many people this line of thinking is far-fetched and may seem like lunacy and fear-mongering.  Yet these are exactly the kinds of discussions that foreign governments have been having for well over a year.  Investors should not sit back and allow recency bias (the belief that because something has not happened in the recent past it will not happen at all) to blind them to what is a real possibility.

Context conditioning is certainly at play – people have now grown accustomed to massive monetary intervention.  Four years ago the thought of the Federal Reserve’s balance sheet above $1 trillion was just as offending.  Federal Reserve purchases of US Treasury debt was thought an absolute impossibility.  So there has already been a paradigm shift in the dollar’s structure.  Why should we expect that everyone is on board with it?

Now that we have become partially untethered to past “rules” and practices of monetary conventions, can it not be just as likely that the ultimate solution will be in the opposite direction of the current altered regime?  Fundamental shifts are both unpredictable and volatile.

Getting back to gold and silver prices, there is no ceiling in the context of dollar uncertainty.  Being so far below inflation-adjusted prices provides ample support on its own.  Any additional probabilities of currency realignments just adds to that support.  Whether or not the dollar’s reserve currency status is revoked is only part of the equation.  In the much bigger picture, people around the world are growing very tired of always getting the short end of universal debasement and manipulation (and this is not just a US creation).

While we may not yet have passed the tipping point, we should at least consider that there may come a time when paper claims on assets will no longer be provided the same value as real, tangible assets.  Any shift toward that perception, whether a radical overhaul or even a partial change, requires a fundamental revaluation of the relationship between currency and metal.

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

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