In The Lead – Deflation! Inflation! How About Neither?

by Jon Nadler, Kitco Metals Inc. on May 21, 2012 · 0 comments

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Precious Metals CommentaryPrecious metals started the trading week in mixed fashion with initial spot bids showing gold and silver prices marginally lower while platinum and palladium moved notably higher.

The US dollar resumed its upward course this morning after the brief pause that was noted on Friday. The trade-weighted index had the greenback trading at 81.30 at last check while crude oil advanced to $91.65 per barrel (up less than 20 cents). Spot gold opened near $1,587 with a $5+ per ounce decline in New York.

During the overnight hours gold managed to touch the psychological $1,600 mark in the wake of pro-growth remarks coming from Chinese Premier Wen. Despite the Chinese leader’s overt concern about a too-sharp slowing in the country’s economy, the reality is that the real estate sector still contributes 13% or more to the GDP and is thus still the pivotal factor in whether or not China experiences a hard landing in months to come.

At the end of the day, once again, the gold market is exhibiting its dire addiction to stimulus and more stimulus no matter what country might be contemplating it. The dependence on easy money as fuel for rallies to the upside remains the defining character of this market. Hedge funds have reduced their exposure to commodities overall by 15% in the latest reporting period, with exposure to gold taking the biggest hit and resulting in what Bloomberg News this morning called a "flight from gold" by investors.

Despite the recovery that pulled gold prices back from bear market conditions and lows under the critical $1,527 pivot point, the latest set of CFTC positioning reports did not offer much in the way of encouragement for the bulls. The net speculative length in gold is currently hovering near a one-year nadir of just over 330 tonnes and is underscoring a market that is riddled with a lack of faith and that is now being pressured by emboldened short-side players. However, with longs being as few in numbers as they presently are, a pop in gold prices could well materialize ($1,640 anyone?) if such players attempt to rebuild positions.

The situation in silver‘s market positioning is apparently a bit more positive after the drop to the recent lows and the ETF niche tallied purchases of 49 tonnes on the period. However, as Standard Bank’s commodity analysis points out this morning,

"The continued increase in shorts is a cause for concern, as a bearish view on silver appears to be gaining traction. Accompanied by the decrease in longs, this does not bode well."

For the moment, the white metal appears caught in the $26-$30 trading range and pitched floor battles might ensue between opposing sides when and if those ends of the price spectrum are once again touched. Monday morning’s opening bids came in near the $28.25 level (a 49 cent drop per ounce).

Platinum climbed $7 this morning and was quoted at $1,458 the ounce while palladium moved $10 higher to reach $612 per ounce. The CFTC reports showed still-strong levels of short positions and a market principally dependent of supply disruptions from South Africa in order to be able to move substantially higher

The Wall Street Journal notes that "Platinum faces serious supply-side risks. While South African platinum mining output is expected to increase slightly this year as producers ramp up capacity following widespread production stoppages in the final part of 2011, if obstacles to production re-emerge, the resulting tightness in the market could push up prices."

On the other hand, platinum market surpluses continue despite some 50% of producers of the noble metal incurring net losses for every ounce they produce. Refiners Johnson Matthey estimate that the global platinum market was in oversupply by 430,000 ounces in 2011. The specialty-chemicals firm anticipates that a similarly-sized platinum market surplus could be on tap this year as a decline in mine production is countervailed by stalling demand from the automotive sector and by lower demand from the glass and petro-chemical industries. JM envisions platinum trading between $1,450 and $1,750 over the coming half-year.

Platinum market observers are wondering which one of the suppliers will "blink" first and begin withholding supply instead of sitting around and simply hoping for higher prices to ease their balance sheet pain. Meanwhile, ETF-based palladium net selling (21,000 ounces) emerged during the latest reporting period and its first-in-five-weeks presence indicated some cracks in the former levels of speculative investor interest in the market.

Well, it turns out that we might have to wait a bit longer for the advent of the end of the world’s oil supplies, albeit the nation that found a bunch of it last week is not the most "reliable" of suppliers for various reasons. Iran discovered what could be more than 12 billion barrels of black gold under the floor of the Caspian Sea. Leaving aside the gruesome details of how dinosaurs may have contributed to global warming and to their own demise, the net result of their extinction still fuels humankind by an overwhelming margin and thus the discovery is remarkable, no matter who claims title to the pool of goo.

That kind of mega-deposit of crude could boost Iran’s current reserves by about 10 percent and is the size of all of what Algeria is thought to possess. The entire basin may contain as much as 33 billion barrels of dino juice — almost double of what the North Sea region is estimated to hold. Along with that much oil the region is also likely to eventually yield near 8 trillion cubic metres of natural gas.

The weekend brought a slew of conflicting news headlines concerning Greece and the odds of it remaining or not remaining in the euro zone. The G-8 meeting yielded nothing to bite into in terms of any concrete steps to resolve Europe’s troubles, but, hey, that came as no surprise to many market observers. They have by now lost track of the number of "be-all/end-all" meeting that have taken place over the past couple of years on the subject.

You say you want some tasty…pabulum? Well, how about the G-8 "statement" that sounds about as trite as it can possibly be?

"We agree on the importance of a strong and cohesive euro zone for global stability and recovery. We commit to take all necessary steps to strengthen and reinvigorate our economies and combat financial stresses, recognizing that the right measures are not the same for each of us."

Yawn.

The common currency did not stray very far from the $1.27 level against the US dollar this morning. Some of Europe’s leaders have not refrained from commenting quite publicly about the prospects for Greece to leave the union even though the costs involved in such a departure are estimated to cost Germany and France about 3% of their annual economic output respectively. However, the exit costs are not the potential problem per se for the EU.

The real "cost" could come in the form of a loss of confidence among denizens of other financially troubled nations and what their actions (let’s just call it taking money out of the bank) might do to an already stressed-out European banking system. Take, for an example of the type of the aforementioned loss of confidence, the 700 million worth of euros that depositors withdrew from Greek banks in a single day last week.

No one has yet called the Greek event a "bank run" but one can easily see why similar depositors in Spanish or Portuguese banks might get ideas about what to do with their euro before their governments suddenly propose exchanging account balances into "reborn" national currencies. The difference is that Spanish depositors could siphon off perhaps as much as 10% of 1.55 trillion euros to be found in their country’s bank deposit accounts and Portuguese ones some 133 billion of same. Curiously, no financial news source has yet mentioned a run on gold coins or bars in the wake of the hefty Greek bank withdrawals.

Another place on the globe where the populace is apparently clamoring for dollars, but not gold, in their quest for the ultimate "hard" currency is, once again, Argentina. Faced with restrictions on the amounts of dollars they may purchase, Argentines have been seeking greenbacks aggressively enough to push the unofficial exchange rate of the peso against the US currency to 5.5 to 1 versus the official 4.7 to 1. The black market in dollars has been flourishing ever since newly installed President Cristina Fernandez imposed currency restrictions, import caps, and other drastic economic and financial measures.

Interestingly, the Greek problem and the EU’s degree of exposure to it are seen as having no deleterious effects on the American financial system. The US banking sector seems to have little in the way of exposure to Greece as such. As things stand right now, America’s banks are being labeled as merely "wary" about the waning of the effectiveness of the ECB’s giant ($1.3 trillion) cash injection into the region’s financial system. However, there is a potentially harmful impact on US exports to Europe. A deep crisis in the Old World could put at least a portion of the 25% of the total of America’s exports that normally flow in that direction, at risk.

Something else that is at risk of not materializing are the two extreme outcomes of the crisis that was. As we mentioned numerous times in these columns, while central bank monetary policies outwardly carried the risk that parts or all of the global economy would fall into inflationary or deflationary paradigms, they have managed to steer a middle-course that has thus far avoided both of those undesirable consequences. Hard money publications have beaten the subject to a pulp, if not to death, with dire predictions of either a replay of 1929-1933 as being upon us, or the return of the Weimar Republic’s hyperinflation disaster as being a reality any minute now.

It turns out that both visions are being proven incorrect. The deep decline in consumer prices that would be the result of alarming joblessness levels has not materialized. The Fed’s response to the crisis — massive injections of liquidity- has not yielded inflation higher than the current 2.3% level, a metric that is regarded as a "non-event" in financial market terms. The reasons for these missed predictions can principally be found in how their authors regarded deflation and inflation drivers.

The deflationist camp has argued that economic "slack" would hammer wages and prices down without a doubt. The inflationist faction held out for soaring prices on the belief that the Fed’s largesse would debase the currency as surely as it did back in 1980 and even more so. The Wall Street Journal suggests that, to some extent, the two opposing views are canceling each other out at this time. This means that we might need to look elsewhere for factors that will move prices and/or the Fed’s policy as we go forward.

Enter the idea of public expectations. What the Wall Street Journal calls to be a more "ethereal factor," could be the most important factor of all when trying to forecast the future of prices. This is so because:

"When households and businesses expect consumer prices to take off — as they did in the 1970s — they push for wage and price increases in anticipation of these events, triggering inflation. But when they expect inflation to be little changed, it turns out, it actually remains little changed," advises the WSJ.

Furthermore, "Measures of the public’s inflation expectations have remained remarkably stable since the financial crisis, despite worries on both sides of the equation. Households surveyed by the University of Michigan, for instance, have expected inflation between 2% and 4% in 36 out of the past 40 months since 2009. Measures of expected inflation over five years in the Treasury Inflation Protected Securities market have moved narrowly between 2.1% and 3.3%;" the WSJ found.

The situation prompted Frederic Mishkin, a Columbia University professor and former Fed governor to caution that “Expectations are more important than many people had recognized.”

This is more than just an academic development. It affects the Fed’s plans for interest rates. The Journal concludes that

"Deflation now looks like much less of a real threat than a couple of years ago. That means there is less reason for the Fed to try to prop up prices. At the same time, if a spurt of inflation isn’t a threat either, that gives the Fed leeway to do more to attack the unemployment problem. This is one of the next intellectual battlegrounds for a divided Fed as it ponders what to do next."

Place your bets. We will still go with the "middle-of-the-road" scenario. Not necessarily a "Goldilocks" paradigm, but no TEOTWAWKI headlines either.

Until Wednesday,

Jon Nadler

Senior Metals Analyst — Kitco Metals

Jon Nadler
Senior Metal Analyst

Kitco Metals Inc.
North America

Disclaimer: The views expressed in this article are those of the author and may not reflect those of Kitco Metals Inc. The author has made every effort to ensure accuracy of information provided; however, neither Kitco Metals Inc. nor the author can guarantee such accuracy. This article is strictly for informational purposes only. It is not a solicitation to make any exchange in precious metal products, commodities, securities or other financial instruments. Kitco Metals Inc. and the author of this article do not accept culpability for losses and/ or damages arising from the use of this publication.

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