Can Gold and Silver Rally? | Lakshmi Capital
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Can Gold and Silver Rally?

Posted January 31st, 2011

Posted January 30th, 2011

With precious metals dropping seemingly every day so far this year, the question on many investors’ mind is whether gold and silver can sustain the rally they witnessed on Friday. While most market pundits believe that fear regarding the Middle East sparked precious metal buying on Friday, the reality is that both gold and silver were oversold markets, and both were fast approaching strong technical support levels.

For an indication of conviction behind Friday’s rally, we can view the volume on the silver futures contract as well as the SLV.

Silver Futures Price and Volume Chart

SLV Price and Volume Chart

selling during the first four days of last week that saw silver sink to 2-month lows occurred on falling volume

The above charts show the front month silver futures contract and the SLV, along with their corresponding daily volumes. As shown by the red trend lines, the selling during the first four days of last week that saw silver sink to 2-month lows occurred on falling volume. Usually when trends are accompanied by decreasing volume, it indicates that traders’s conviction in the trend’s continuation is also falling. A reversal of the trend on strong volume can be a signal that the trend reversal will continue.

Friday’s rally saw both silver futures and the SLV trade 4% higher on large volume, signifying a possible end to the correction in the white metal. Silver futures traded ~76.4k contracts, 30% more than the 45 day moving average. The SLV traded 32.8 million shares, 21% more than the average. The significance of this increase in volume is apparent when considering that silver rallied on Wednesday, but on low volume. From the lack of participation, one could have surmised that the rally would have been short lived.

We remain bullish on silver prices in the long-term, and think that the current correction could be close to running its course. As fear in the Middle East and other concerns abroad could cause a US dollar rally, we would also like to analyze the ongoing relationship between the US dollar and precious metals.

The Dollar Index vs. Precious Metals

Much has been made of precious metals’ relationship to the US dollar. In times past, the purchase of precious metals and commodities in general was thought of as a play on a weak dollar. Since commodities are traded in the US in dollar form, a cheaper dollar makes commodities look cheaper to foreign buyers, giving them support.

However, in recent times, the dollar as it is traditionally thought of has had little correlation to precious metals prices. A chart of gold and silver vs. the Australian Dollar and US dollar index (DXY) is posted below.

Gold, Silver vs AUD, DXY Chart

The reason the dollar index has had such a enigmatic relationship with precious metals is because it is no longer an accurate measure of the US dollar’s purchasing power

The purple line shows the US dollar index, the white line shows the Australian Dollar against the US dollar, the yellow line shows gold and the light blue line shows silver.

As can be seen, the dollar index has had both a positive and negative correlation to precious metals prices over the past year. During the period between June and November 2010, there was a strong negative correlation, but during all other times (especially the past month), gold and silver have actually been positively correlated with the US dollar index.

The reason the dollar index has had such a enigmatic relationship with precious metals is because it is no longer an accurate measure of the US dollar’s purchasing power. The US dollar index is comprised 58% against the Euro, 14% against the Yen, 12% against the Pound, and the rest against the Canadian dollar, Swedish Krona, and Swiss Franc. The same problem afflicting the US, debt, is hurting these other currencies as much or even worse than the US dollar. Therefore, we could easily be (probably will be) in an environment where the “dollar” as measured by the dollar index is strengthening, but the purchasing power of the dollar is weakening.

To illustrate the weakening status of the US dollar, we included the Australian dollar on our chart. As can be seen, the Australian Dollar tracks very closely to precious metals prices. As Australia’s economy is very strong and their government’s fiscal position is even stronger, Australia’s economy is the opposite of the major currency economies, in that it is growing, not heavily indebted, and has extremely low unemployment (5% as of 12/31/10). We expect the currencies of countries such as Australia, Canada, Sweden, and Brazil that are commodity-rich to continue to outperform the US dollar.

All Major Currency Economies Suffer from the Same Problems

The data regarding the dollar index’s ambiguous relationship to precious metals confirms our belief that all major economies are suffering from the same money-printing, lack of organic growth environment that the US does. The Eurozone is heavily indebted, but suffers from slack GDP growth. The only way the Eurozone will be able to survive is through bailouts and other inflationary policies by which Euros are created out of thin air, then used to pay back debts. The UK is in a terrible position, as their GDP growth actually went negative last quarter, which will most likely prompt policy makers to turn on the printing presses and attempt to inflate their way into at least nominal GDP growth (even if this is nothing more than pure inflation). Japan is the most heavily indebted country in the world, and their government has already been vocal in their adoption of currency debasement and quantitative easing in order to support their exports.

Simply put, all the major currency economies have no real engines of growth but need to pay back enormous debts and so they are engaging in competitive currency debasement in order to generate artificial demand for their exports.

What Does this Mean for Precious Metals and Commodities?

If you haven’t already guessed, we believe this is extremely bullish for commodities and precious metals in particular going forward. The worldwide debt issues combined with slow GDP growth is a problem that is not going away anytime soon. Until employment, housing, and other economic growth is felt in the street, the Fed and central banks around the developed world will have a free license to print money and undertake inflationary policies. If the economy does well, inflation will come. If the economy does not do well, governments will print money to the point where it looks good on a nominal basis, and then inflation will be even more rampant when it does come.

Either way you cut it, precious metals look good for the long-term.


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