Dec. 4, 2006 — Last week we made the case it was not too late to buy into the precious metals rally and revised our standing forecast to reflect the fact that gold and silver had overtaken their September highs and are now in a position to challenge the highs for the year based on interest rates and economic outlook. The article anticipated much of this week’s chatter as the bond market moved to price in greater odds of a rate cut in the first quarter of next year. In fact, we specifically examined gold’s response to changes in the Fed funds rate in recent history and looked ahead to a possible “sell the news” reaction if the Fed actually realizes the current rate-cutting expectations.
For weeks, we have been outlining how the Fed’s steadily hawkish comments had put it in a position suddenly to cut interest rates if economic data deteriorates. Where we were wrong last week, or at best even, was in our anticipation that the Fed would continue to be accurate in its forecast of the economy’s future. Of course, the Fed had been looking for a moderately expanding economy and, as we now know, manufacturing data on Thursday and Friday pointed to both a slower economy and higher inflation, precisely the bugaboos of which Bernanke warned in his speech on Tuesday.
Fortunately, our error was too much caution and, as the economic outlook began to sour, the dollar steepened its decline, sending metals higher. Bernanke’s speech reaffirmed our bullish interpretation that the Fed will not view modestly higher commodity prices as inflationary and actually sees increased mining activity as sign of a strong global economy. He also described the cost of capital as “low,” confirming our view that current interest rates are modestly accommodative and bullish for metals, particularly in an environment of rising interest rates in Britain and potentially Japan. To last week’s assessment should be added the note that current high levels of liquidity decrease the odds that a lower Fed funds rates would spark gold and silver selling as it did in the early 90s, when rate cuts were an admission of an obvious overly restrictive monetary policy.
Last week we said the Fed is now on the side of precious metals, or at least they are 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.
And buyers were rewarded this week with a 1% gain in gold and 4% for silver. While the economy currently appears to have cooled somewhat below the comfortable Goldilocks level, the bullish picture we have been tracking has only gotten hotter. We continue to caution that to avoid overstepping the Fed’s tolerance for higher prices, precious metals, at least gold, should avoid making huge, headline-grabbing gains. While up 12% since the October FOMC statement we heralded as a screaming “buy,” gold has in fact moved in a discrete, orderly fashion. Silver, on the other hand, probably due to its superior fundamentals and ‘stealth’ status, is beginning to look parabolic on the weekly chart. We never expected the triangle most people were seeing actually to hold, and silver has broken out to near our two possible targets. If we are correct, silver will find resistance between the 14.11-14.16 area. But, as the white metal is not generally used to gauge inflation, and can therefore be tolerated to run higher, it might, in favorable market conditions, break through this range and make a slightly new high for the year above $15 before some temporary consolidation back into this area.
Looking to the week ahead, it’s obvious that if the economy stays on ice and the Fed cuts rates sooner than expected, aggressive precious metals traders will want to be “all in” as gold and silver rally to take out the year’s highs and, if China makes good on its threat to diversify out of dollar reserves, maybe even challenge all time highs in 2007. But, it is important to keep in mind that it is still unclear to what extent old benchmarks in the ISM still prognosticate the health of the current non-manufacturing based economy. Some of the economic data that set off the recent selling in equities could be revised upward, but even so, with the Fed’s focus squarely on jobs, as described by Chairman Bernanke on Tuesday, next week’s data could very likely outweigh this week’s news whether good or ill. Furthermore, the current action in stocks, bonds and commodities is exacerbated by aspirational terrorist threats to online banking and ATM systems, factors that decrease investor rationality and emphasize technical rather than fundamental analysis. To the extent that the perennial terrorist threats fail to materialize during this holiday season and economic data comes to reflect moderate expansion instead of recession, cooler heads and optimistic outlooks, not necessarily inducing rate cuts, could still prevail and this would put serious brakes on the recent gains in precious metals.
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