Commodities and a stalling economy

2011-MAY-14

The sharp fall in prices over the last few weeks was not confined to precious metals, but affected a wide range of other commodities. Their prices have been rising for some time, reflecting dollar weakness, and there is little doubt that the whole complex had become over-bought.

The sell-off coincided with growing evidence of a slowing American economy. It is becoming clear that the Fed’s monetary stimulus has had little economic benefit and analysts are revising their GDP forecasts downwards. Simplistically, this lowers potential demand for all commodities, including energy, so on the face of it prices must be too high. But this simple argument ignores the fact that the price of any commodity also reflects the value of the currency in which it is priced. So in dollar terms, commodity prices have risen strongly, but in real terms many of them have hardly risen at all.

Not that it is easy to separate out currency weakness from increasing commodity demand, but we can easily understand the principle. It allows us to sensibly dismiss arguments that commodity prices have been in some sort of bubble and instead accept that high rates of monetary inflation are undermining the purchasing power of paper currencies.

And now that America faces a disappointing economy, we must think about the Fed’s next monetary response, rather than just the effect on commodity demand. A weakening economy must surely encourage the Fed to continue with monetary easing when QE2 ends next month. The Fed is paranoid about the risk of sliding into deflation, and will do anything to stop it. This is generally bullish for gold and silver, so we can conclude that the events that triggered a decline in commodities should also be positive for precious metal. However, other commodities are unlikely to fall much, because their prices should reflect continuing dollar weakness. The mini-crash of the last few weeks may be a buying opportunity for the whole asset class, particularly when countries like China continue to dump dollars for raw materials.

But there is also a big change in pricing dynamics for gold and silver, which everyone in the blogosphere has missed, and it is simply this: the underlying reason behind the take-down in gold and silver is that the commercial shorts know the fundamentals have turned against them, and they also know that they have been wrong-footed. They are not blind to a further extension of zero interest rates and the inflation risk from that. Nor are they blind to the turnaround in central bank demand for gold. Nor are they blind to rising demand for gold and silver from the newly-affluent in Asia.

These are just a few of the changes that have taken place in the financial markets since the collapse of Bear Stearns and Lehman Bros. Because of these changes the commercial shorts desperately needed a get-out-of-jail card, and that was the logic behind the manipulation of gold and silver prices. They have reduced their shorts and have probably acquired stakes in the big ETFs, which they can redeem for physical metal to meet demands for physical delivery. They are now set up as much as they can be for the new realities in precious metal pricing.

Understand this and you understand the fundamental shift that will drive gold and silver prices in the coming years.