by Gary North
We look at the real estate markets in coastal cities and conclude, "these are bubble markets." Yet they have not risen as far and as fast as silver and gold have risen since 2001.
Nevertheless, most recent first-time buyers of gold and silver give no thought to what should be obvious: the moves of both metals over the last four years are anomalies. Other than believing they are geniuses, why should precious metals investors not be getting nervous?
Gold and silver are inflation hedges. Yet the Federal Reserve System is sending mixed messages regarding inflation. On the one hand, the FED has been increasing the adjusted monetary base at double-digit rates since late 2005. The other monetary indicators have followed. This can be monitored here (and should be).
On the other hand, the FED has also raised the federal funds rate by a quarter of a point every time the Federal Open Market Committee (FOMC) has met since mid-2004. This is the classic sign of anti-inflation policy. The short rates have been rising faster than long rates, which has now produced a flat yield curve. An inverted yield curve is a prelude to a recession. The yield curve can be monitored here (and should be).
So, which is it: recession or accelerating price inflation?
Right now, we are in "anyone's guess" territory, which is why wise investors had better monitor the statistics of these seemingly rival policies on weekly basis. It is not clear which FED policy is dominant today. A great deal is at stake.
THE FEDERAL RESERVE'S DILEMMA
The growth of the U.S. government's annual budget deficit is being matched by the growth of the balance of payments deficit. Wise investors look at these twin deficits and conclude: "This cannot go on indefinitely." So, they ask themselves: "What is likely to reverse these trends?"
The answer to the payments deficit is a fall in the value of the dollar. Foreign investors will cease buying dollars for purchasing dollar-denominated assets. This will reduce international demand for dollars, which will produce a falling dollar internationally. Prices of imported goods will rise.
But if this happens, how will the U.S. government persuade foreign investors to buy its T-bills? The obvious response is to raise short-term interest rates. This is what the FED is doing today.
Raising short-term rates has a negative consequence: it produces a recession. First the yield curve goes flat. Then it inverts. Then there is a recession. We are halfway there today: a flat yield curve.
So, it is possible to have simultaneously a falling dollar internationally (scenario #1) and a recession domestically (scenario #2).
The FED today seems to be moving to head off scenario #1. How? By raising short-term interest rates. Yet it is also clearly trying to head off scenario #2 by inflating the money supply. I am reminded of the Apostle James' warning:
A double minded man is unstable in all his ways (James 1:8).
If you have been following the price of gold and silver, both seem to have topped out. So, for that matter, has the Dow Jones Industrial Average. I contend that the reason for this hesitancy on the part of investors to buy or sell en masse is their confusion with respect to Federal Reserve policy. Until the FED makes up its collective mind, marginal investors will be hesitant to issue either "buy" orders or "sell" orders. I cannot blame them.
THE LOGIC BEHIND THE PRECIOUS METALS BOOM
The FED, beginning in late 2000, saw what had happened to the yield curve: it had inverted. That was when I predicted a recession in 2001. The FED saw this, too. The FED began cutting the fed funds rate a quarter of a point at a time.
Then came the 2001 recession: March. The FED continued to reduce rates. Then came 9/11. The FED continued to reduce rates. The housing market continued to rise, and gold and silver at long last began rising. That was when I issued a strong "buy" recommendation for gold: the fall of 2001.
Gold in 2001 had been battered by 21 years of downward pressure. It had gone to $840 in early 1980. Despite a doubling of the price level, 1980—2000, gold declined to the mid-200s in 2001. I became convinced that an anti-bubble process was at the end of the road.
Gold is not a recession hedge. It is an asset that can be sold to raise funds in a crisis. It gets sold in recessions because people want to raise cash. Selling any asset is a way to raise cash. Gold is not under any king's-X safety umbrella.
Silver is even less protected from recession-induced sales, which is why silver's price is more volatile than gold's. It has no central banks buying it during recessions. Meanwhile, demand slows because the economy is slowing. Silver is an industrial metal and to a lesser extent an ornamental metal. Demand for most metals falls when the economy goes into recession.
There is a longtime myth of gold that has been popular in every pre-recession period. Recent buyers console themselves by saying: "Gold did not fall during the Great Depression. It went up." In the 1930s, the U.S. was still on the gold standard internationally. By law, the U.S. government bought gold from gold mines at $35/oz. So, the gold market had a legal floor.
That policy ended on August 15, 1971, when Nixon unilaterally took the United States off the international gold standard. So, the experience of the Great Depression is economically irrelevant to today's gold market. Central banks may buy gold or they may not, but they are not compelled by law to buy it. All we can say with confidence is that they will not buy silver, which is no longer a money metal.
Gold fell in the 1974/75 recession. Then it rose in the Carter-era inflation. Then it fell by 50% in the 1980/81 recession. Then it fell in 2000 prior to the 2001 recession.
My point is that gold, as an inflation hedge when price inflation exceeds what the experts have forecast, should not be regarded by investors as a universal solution to the gyrations of Federal Reserve monetary policy.
Silver is even less of a hedge. It has been de-monetized, so it is even more a captive of the overall economy.
The FED is trapped long-term in a policy of "inflate or die." It is committed to the absurd premise that a committee of academic economists (FOMC) is a better source of monetary policy than the free market. The FED has created a boom economy — i.e., a universal bubble economy — through the constant expansion of money. Like addicts, investors, consumers, and debt-issuing governments demand ever-more money from the Federal Reserve. Everyone has factored in 2% to 4% monetary depreciation. If the FED fails to provide this, the entire debt pyramid is threatened with collapse.
So, we find that the FED does not stabilize money. It expands the money supply at varying rates. Sometimes this expansion is insufficient to goose the economy into more growth. The economy then falls into recession. The FED's response is always the same: create even more money.
This process of varying rates of monetary expansion does not immunize gold and silver from wide swings in price. In the case of the period 1980 to 2001, the contraction wiped out 90% of investors' asset value, if you factor in the 50% loss of the dollar's purchasing power.
A new generation of investors has arrived. It took them at least two years to believe that a new bull market had arrived: 2001—2003. Then they hesitantly began getting into the precious metals' market. They have done well.
They are newcomers. They don't understand fully why they bought. They just understand that their investment's market value has risen. Remember: "Genius is a rising market." They are tempted to regard themselves as geniuses.
If the economy goes into a recession over the next 12 months, the precious metals are unlikely to continue their upward move. The pressure on asset-holders to sell in order to gain cash is always a problem for asset holders who choose not to sell. They see the value of their holdings fall. Yet prices in general continue upward.
I do not expect a fall comparable to what happened to gold and silver after January, 1980. That was an historically unique period in the post-World War II era. The rate of price inflation under Carter soared. This, coupled with Bunker Hunt's silver play, created panic. Then the Soviet Union invaded Afghanistan in December, 1979. The metals mania exploded for one month: January, 1980. Then it ceased, overnight.
Still, there will be selling pressure if the recession hits, as it looks as though it will hit, if we take seriously the flat yield curve. This is not written in stone yet, but the behavior of the metals markets and the U.S. stock market does point to increasing doubts concerning the continuation of the economic boom.
In a recession, asset values tend to fall as people become desperate for cash. Fear is a great motivator. So are margin calls. The marginal sellers of assets are more active than the marginal buyers of assets.
I am issuing this warning because I know how many of my subscribers have not gone through a recession-induced fall in the precious metals markets. I don't want new investors to conclude that the boom, 2001—2006, was a fluke, a bubble that will not return for decades, which was the case after January, 1980. The gold and silver markets, unlike the housing markets, are not driven by long-term government-subsidized mortgage money. So, I do not call them bubble markets.
Nevertheless, they are markets. They respond to supply and demand. Recessions increase the supply of assets offered for sale and reduce demand for these assets. The quest for ready cash in a recession is a universal aspect of all recessions. Don't expect the next recession to be different.
The FED stands ready to inflate its way out of the next recession. It seems already to have begun. This is the case for the precious metals. But it is a long-run case, not a full-time case.
March 15, 2006
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