‘Hey, You, what’s that sound?
Everybody look what’s going down’
— That sound? It’s the gurgling of liquidity flowing out of the commodity markets. As is the market’s wont, everyone is heading for the exits at the same time. Panic and fear are the two operative emotions. Rational thinking be damned. That’s what leverage does to the thought process.
— Today we’re going to hazard a guess as to what is happening and why – and what you should do about it. We’ll discuss the precious metals specifically in a moment.
— So, what IS happening?
— Put simply – and perhaps too obviously – liquidity is evaporating. For months the bulls have told us that commodities were rising because of strong demand from China, emerging markets and, umm, China. While there’s certainly some truth to that, it’s not the real story.
— Commodities have been on a tear because of loose global monetary policy. The world’s main central banks have handed out money stupidly thinking it would engineer sustainable economic growth and reduce unemployment. Standard Keynesian wishful thinking.
— All it did was put liquidity in the hands of speculators. And the best markets to speculate on are the commodities markets. It’s the biggest casino in town.
— But surprise surprise, the result was inflation. Firstly, it caused asset inflation, which is apparently good because it increases wealth. But then the bad inflation started emerging. Prices of everyday things started to rise. A couple of regimes were overthrown in the Middle East and social unrest began creeping in elsewhere.
— Emerging markets started to tighten monetary policy. Europe raised interest rates. In June Ben Bernanke will do his best version of tightening by not printing any more money.
— All this equates to a global tightening of liquidity. The house is not handing out anymore cash to play with and so the speculators have bailed. Now it will be up to the real economy to determine where prices settle. That could be interesting. Our guess is the global economy will again slow down.
— Without monetary assistance, growth will be hard to come by. And we’re moving into a period of fiscal contraction too. So while a 2008 style collapse looks unlikely, industrial commodities will probably struggle in the months ahead.
— The thing to consider with commodities is that it’s a leveraged market. The punters getting involved don’t go out and buy a few pounds of copper and sit on it and wait. They take a leveraged position. They put down a few thousand dollars to gain exposure to tens of thousands of dollars’ worth of metal. In effect, they are trading paper commodities.
— So the overnight action looks more like a reaction based on liquidity rather than any fundamental economic news. But in a world of central bank driven markets, liquidity is everything and fundamentals are secondary.
— We have little idea of the real supply-and-demand dynamics of the industrial commodities markets. That’s the preserve of our mate Dr Alex Cowie over at Diggers and Drillers. As a proponent of sound money, our beat is the precious metals, gold and silver.
— So let’s check out the action in silver, which was on fire, but has now been drenched. We’ll show you who has been doing the drenching in a moment.
— But first, some context. Silver is a fascinating metal because throughout history is has been a monetary metal. During the late 19th and 20th centuries it was ‘de-monetised’ (via coercion from the US and Britain, we should add). But its unique properties saw it become widely used as an industrial metal. Due to monetary mismanagement by the issuers of paper currencies worldwide, in recent years silver has again come to be seen as a monetary metal. It now fulfils two roles and is hugely important.
— But there is another game going on in the silver markets. To understand what is happening you need to know that, like other commodities, the prices you see quoted every day are set in the ‘paper’ markets. That is, the futures market.
— One silver contract represents 5,000 ounces. At say, $40 an ounce, this represents a position of $200,000. But you don’t need to pay that upfront. You put down a ‘margin’ instead. Back in January, the margin set by the CME Group (the owner of the futures exchanges in the US) was $11,138. So to get exposure to $200k of silver, you need to come up with just over $11k. That’s leverage.
— Since late March, the CME has continually increased margin requirements. That’s fine in a rising market because it wants to make sure its not encouraging more leverage as the price of the metal rises. Fair enough.
— But what is truly strange is the CME’s actions over the past few days. It has continued raising margin requirements even as the price falls! Effective 5 May, the initial margin requirement to buy a silver contract is now $18,900, up from $16,200 just a few days before. Then, from 9 May, the margin requirement will increase again – to $21,000!
— At the current silver price of around $35, that represents a margin of 12 per cent. This compares to a margin requirement back in November of just 6.5 per cent.
— If this has happened in any other market, please let us know.
— Our guess is that is hasn’t. But that’s because the likes of JP Morgan and some other TBTF banks don’t have huge paper short positions in other commodities.
— When you buy a paper contract, someone else takes the other side of the trade. When the contract expires, you either decide to ‘roll’ it into the next month’s contract or elect to pay up the full value and take delivery of the metal. The party who is ‘short’ the contract must then deliver the metal.
— Here’s the problem. The parties who are short are concentrated amongst a few big banks. They don’t have the metal. And they’re terrified that the speculators want to take delivery. If this happens, the short sellers will be forced to buy in the (extremely tight) physical market, pushing prices up big time.
— That has already happened to a certain extent. But our guess is that $50 silver was the line in the sand. The line was drawn in extremely thin trade on Sunday night when silver started its price dive. The CME group came in right on schedule with margin hikes and it has kept increasing the margins forcing the speculators out of the market.
— Weak hands are now selling into strong. Soon, the banks will need to cover again and the battle will be back on. We’re in a long-term precious metals bull market. More accurately, we’re in a bear market for fiat currencies.
— After the precipitous price drop of the past few days, we’d guess now is a good time to swap paper money for the real thing.
For Daily Reckoning Australia