Precious Points: Gold and Goldilocks
The longer the Fed perpetuates the notion that inflation is contained despite rising action in the metals, the more we can assume the metals will continue to rise, if only gradually.
Even though the average person sees high prices everywhere they turn, last week saw a significant decline in inflation expectations as measured by inflation-adjusted treasuries. Consumer confidence was up, oil and gasoline were well off their highs for the year, and inflation was looking more and more contained. Meanwhile, gold moved back over $630 and silver took out the September high by closing at $1340. Investors accumulating metals want to buy dips, not chase a run, so why buy now? Ask Goldilocks.
As we've warned over the past three weeks, market conditions have been such that these metals should rally to about their September highs, not significantly higher. With the so-called "Goldilocks economy" unfolding roughly as the Federal Reserve has expected, metals traders have to wonder how far these gains can go before a correction. It's difficult to predict the emotional, knee-jerk reactions traders will have when news first hits, but we can soberly deliberate the pros and cons of economic facts over the longer term. Whether or not the modest odds of a rate cut in early 2007 are realized, whether or not the Fed changes rates at all in the next six months, the key question for precious metals and miners over the intermediate term will be how changes in interest rates and the evolving economic outlook will affect spot prices.
We said last week that the Bernanke Fed has done an excellent job talking down inflation while simultaneously positioning itself to cut rates if necessary, the most likely catalyst being spillover from the housing slowdown. While some see a collapse of the derivatives and mortgage lending industry as inevitable, the Fed can still point to strong earnings, bank lending, and business spending and credibly say the damage is contained. The potential for a rate cut, along with ongoing increases in money creation and credit debt, seem to be the real upside risks to inflation, but the Fed chooses to lay the blame on high employment and growth. So, with earning reports at a minimum, attention next week may very well center on economic data for housing, jobs and GDP, among others.
While the early part of the week may appear bleak, with lower durable goods orders and existing homes sales, a Q3 GDP of 1.8% on Wednesday, up from a previous 1.6%, would be more hard evidence of the Fed's "expanding economy". Increases in personal spending and auto and truck sales would almost seem to seal the deal, initial claims notwithstanding. This sort of affirmation would be bullish enough to stave off rate cuts for the time being and rejuvenate investment without triggering rate hikes. Generally it would it keep the economy in that "just right" Goldilocks bubble and moving upward without being inflationary.
As long as the economy continues to respond to Bernanke's steady hand, the Federal Reserve is not likely to change interest rates at all. If it ain't broke don't fix it. If the Fed wins out, eventually the economy may become too hot, which would obviously precipitate a rate hike. If we continue to sputter and slow, the current rate is still neutral to accommodative and its far easier for the Fed and the Treasury to increase liquidity behind the scenes through open market activity and money creation than with the blunt tool of interest rates, though acute crisis could prompt a rate cut. Nonetheless, with the future anything but certain, a seasoned trader will no doubt want to prepare for all contingencies.
Common sense might seem to dictate that lower interests rates increase liquidity and fuel speculation on just about everything, including precious metals, and vice versa. While at times this has been the case, that relationship has not been so certain over recent years. At the very least, there has been a lag between rate changes and what would seem to be the corresponding appropriate action in metals. For example, the huge run up in the metals from late 2005 to May of this year began in earnest as Greenspan was about midway through his incremental rate hikes. Rather than signaling the end of easy money and stifling metal prices, the rising interest rates were seen as the Fed's capitulation and confirmation of excess liquidity. The quarter point increments were not believed to be keeping pace with the meteoric rise in lending and hence the parabolic move in the metals. The stock market rallied concurrently because the higher rates indicated relative economic health in which to invest after a dramatic downturn.
We only have to go back to the early 90s to find a period where gold and silver fell along with interest rates. Then, while interest rates steadily dropped, gold meandered downward to under $330/oz as investors saw themselves in a period of disinflation and tight money. Only when the nominal Fed funds target steadied at 3% did the market believe money was cheap and gold start to rise again.
Gold London PM Fix 1985- present
So, on which side of the fence should gold and silver holders be sitting, given that we've recently seen metals actually increase in price, even go parabolic, in a climate of rising interest rates, and Bernanke easing rates by 25 basis points in 2007, as some still expect he might do, could be seen as a confirmation that rate hikes were overdone and cause selling in gold and silver? The answer, as with almost all investments, depends on time frame, but both developments ultimately point to higher metals prices. It's important to understand that, with this highly flexible Fed under Ben Bernanke, historical trends should only be part of the analysis. Still, realized rate cuts might prompt some selling, but will eventually create stronger investment demand for metals as the dollar comes under pressure and speculators resume buying.
Rate hikes and the Fed's current hawkish stance are also bullish for gold and silver. We've continually repeated since the October FOMC statement, the Fed is now on the side of precious metals, or, at least, they're no longer in the way. The Fed simply could not rest with gold and silver shooting to the moon, but they now appear content with allowing modest, gradual gains. If anything, higher commodity prices reinforce their view that the economy will continue to expand at lower levels of non-inflationary growth if energy prices remain low.
Why buy now? To the extent that this picture remains intact, we would expect to close in on $700 gold and $15 silver in gradual steps, but expect profit-taking to bring any rapid increases back in line with a more modest uptrend. While we don't currently see any reason for a dramatic selloff, the chart below shows how far silver can fall and maintain the integrity of its bull move. Should we reach it, look for a supreme buying opportunity close to $11. A similar setup is mounting in gold, with a buy target at about $555. Though it's not a new product, if silver-lined clothing captures the popular imagination and takes off, all bets are off. For more technical and fundamental analysis, join us in the forums.
Featured Mining Stock
North American Palladium Ltd. (PAL)
Canada is renowned for its international mining industry. Strict regulation makes Canadian miners among the safest and most reliable in the world and the country's rich natural resource deposits support a strong domestic industry as well. But, there's only one Canadian company that is a primary palladium producer and that is North American Palladium, the best pure play on this often overlooked commodity.
Palladium is one of the platinum group metals and, in fact, to the untrained eye, palladium and platinum are virtually indistinguishable. The two have similar properties including high conductivity, ductility, resistance to oxidation and corrosion, and a high melting point. Though it's difficult to estimate precisely the global supply of palladium because the size of Russia's stockpile is a state secret, palladium is roughly three times as plentiful as platinum, which is about three times more expensive. Still, as you can see in the chart below, palladium has enjoyed much of the same pricing benefits as gold, silver and platinum, but with much less attention.
Essentially, palladium can be substituted for almost any industrial use that requires platinum, but at a much lower cost. By far the single greatest use of palladium is in the catalytic converters that minimize dangerous exhaust from automobiles. Palladium is also used in some electronics, dentistry, and, increasingly, in jewelry. It's expected that the bulk of future catalytic converters, including new models for diesel engines, will contain palladium instead of platinum.
Most of the world's supply of palladium comes from Russia and South Africa, but these may be considered less than ideal regions for investors to put their money. North American Palladium's Lac des Iles deposit in Ontario contains one of the largest open pit palladium reserves in the world and has the benefit of being just north of the border. Earlier this year, PAL not only began underground mining at Lac des Iles, it also instituted an aggressive exploration campaign to increase base metal production in the area, primarily copper and nickel. In September the company announced successful drill results at Shebandowan Nickel/Copper Project, about 100km southwest of Lac des Iles Mine. North American Palladium has options to earn a 50% interest in the Shebandowan Property through its joint venture with Inco Limited.
The major factors affecting PAL's revenue quarter to quarter are palladium production and spot price. In fact, 50% of the company's revenue is directly earned through palladium sales. And, since PAL delivers all its palladium production to the spot market, primarily to auto manufacturers, it is highly levered to palladium prices. As of this summer, all of its resources, including base metal by-products, are unhedged.
The major risk is that all of PAL's production currently comes from one mine and the surrounding area. Any ill occurrence that would impair Lac des Iles would seriously and materially impact the company's bottom line. Still, the move to further diversify its assets will probably stabilize, if not increase PAL's overall profitability potential. The company also has a deal to explore a potential palladium site in Finland.
The chart above shows PAL has found a bottom after declining all summer with the rest of the mining sector. Finding support at its 200 day moving average, it is now hovering above the 50-day level. Though increased production at higher ore grades in both the open pit and underground mines at Lac des Iles continue to lower per ounce costs, even while spot prices rise, the company currently operates at a loss of about $0.67 per share and PAL expects to issue warrants to fund operations over the next twelve months. The next direction the stock takes will probably depend on the price of the precious metals, but in the intermediate term, once the refinancing is complete, North American Palladium will be in an excellent position to capitalize on nickel, gold and palladium demand and price increases as it moves toward profitability.