Summary
- The market appears to be underestimating the possibility that inflation remains above target over an extended timeframe, with real interest rates again turning deeply negative, despite higher nominal rates.
- I expect the precious metals bull market to resume once the Fed slows down the pace of rate hikes.
- Silver is more interesting than gold because of low physical inventories, bullish positioning by commercials, excellent long-term fundamentals, and a more depressed valuation.
- The Sprott Physical Silver Trust provides an efficient way to speculate on the silver price, has tax advantages, is fully backed, and can be redeemed for physical bullion.
Summary
The precious metals bull market is on pause due to the ongoing monetary tightening cycle. Nonetheless, the market appears to be underestimating the probability that inflation remains above target over an extended timeframe, with real interest rates in deeply negative territory, despite higher nominal rates.
If the Fed slows down the pace of rate hikes, which could happen by year's end, the bull market will quickly be back on track. As gold and silver have recently been battered down significantly, there is a good margin-of-safety opportunity to start accumulating a position in physical gold and silver (and selected miners). I plan to keep adding on weakness to be ready for the moment the Fed pivots to cutting rates, which I expect will be the catalyst for new all-time highs.
At the moment, several factors are making silver the more attractive metal relative to gold. Such circumstances include: low physical inventories, bullish positioning by commercials, excellent long-term fundamentals, and a more depressed valuation.
The Sprott Physical Silver Trust ( NYSEARCA: PSLV ) provides an efficient vehicle to speculate on the silver price. Compared to alternative bullion exchange-traded funds ("ETFs"), it offers tax advantages to U.S. investors, it is fully backed by unallocated silver, and it can be redeemed for physical bullion.
The precious metals bull market is on pause
Currently, the gold and silver markets are gripped by fears that the Fed will have to hike interest rates much higher in order to get inflation back to 2%.
Let's start by looking at gold. In dollar terms, gold is down by 6.1% year-to-day. This is partly an optical illusion related to the strong dollar. In fact, when we look at the gold price in euros, British pounds, and Japanese yen the gold price is actually up in all of them (by 6.2%, 9.6%, and 16.2%, respectively). However, given that nominal rates have been rising significantly and at an unprecedented pace, it is actually remarkable that gold is holding up so well. The Fed funds rate has risen from 0.25% to 2.5% since the beginning of the year, while the 10-year yield has risen from 1.6% to 3.3%.
Federal Funds effective rate (Federal Reserve Bank of St. Louis)
But the 10Y breakeven inflation rate has barely budged from around 2.4%. The market is pretty confident that the Fed has the situation under control and that it will be able to bring inflation down to its 2% target.
10-Year Breakeven Inflation Rate (Federal Reserve Bank of St. Louis website)
This creates the possibility of an asymmetric bet. Consider the following scenario. Over the next few quarters, the inflation rate relaxes somewhat, but it stabilizes far above the 2% target, e.g., around 6-7%. Meanwhile, the Fed keeps raising rates to 4-5%. However, it makes use of the lower inflation prints as an excuse to slow down the pace of rate hikes, and eventually stop them.
This picture is corroborated by the expected future path of the Fed funds rate, as estimated by the Federal Reserve Bank of Atlanta. The Fed is expected to continue tightening aggressively until the end of the year, and then at a slower pace until the middle of 2023, when it will pivot to cutting rates.
The expected future path of the three-month average fed funds rate (Federal Reserve Bank of Atlanta website)
Assuming long-term inflation expectations adjust accordingly, as the market gets used to persistent inflation, real rates would turn deeply negative again. This would drive a considerable appreciation of precious metals, possibly to new all-time highs.
The basic assumption here is that the Fed is not going to raise nominal rates above the inflation rate. I consider this extremely unlikely, because the U.S. debt-to-GDP ratio is far higher than in Volcker's era, and thus higher nominal rates are unsustainable. Keeping real rates in negative territory, which is a form of financial repression , is the most politically expedient solution to the high-debt burden of most advanced economies, and history proves that democratically elected politicians always end up choosing the easiest way out of a problem.
Let me finally remark that politicians, and not central bankers, are becoming the group most responsible for affecting inflation. The big picture is that, in spite of a temporary tightening of monetary policy, fiscal policy will remain accommodative, and thus continue to fuel inflation. This is very bad for savers but provides the best possible environment for precious metals.
Silver is cheaper than gold
Let's now look at silver. Silver follows gold, often with a lag, and with more volatility. This time, however, an interesting discrepancy is emerging. Silver has been battered down much more severely than gold. It is down 19.2% year-to-date in dollar terms, but it is also down significantly in all major currencies.
Silver is not only a monetary metal but also an industrial one. Given the current widespread recession fears, it makes sense that it is suffering more compared to gold.
However, there are several factors, both short-term and long-term, to be bullish on silver. These include:
- Falling physical inventories
- Bullish positioning by commercials
- Slowing secondary production
- Long-term decline in silver grades
- Accelerating demand from green technologies
Let's unpack them one by one.
Tightness in the physical market is evidenced both by the backwardation of the futures curve and by falling inventories.
The following picture shows the volume of physical gold and silver held in the LBMA vaults offering custodian services. While gold inventories are roughly stable, silver inventories have been falling constantly through the year.
This becomes even more significant when zooming out. Currently, silver holdings are at the lowest point since reporting started in July 2016.
Next, let's look at the Commodity Futures Trading Commission's ("CFTC") weekly Commitments of Traders ("COT") report from last week, which provides a breakdown of the net positionings of commercial and speculative traders in the U.S. futures markets. Usually, commercial traders are the smart money. If you look at the historical time series for the net positioning of commercial traders and compare it with the time series of the silver price, you will notice that commercial positioning usually bottoms when the silver price reaches a top, and it tops when silver bottoms. Positioning by commercial traders has just turned positive.
Silver price (above) and net positioning by commercial and speculative traders (www.tradingster.com)
On the supply side, we have two longer-term factors at play. First, silver grades are declining worldwide.
Silver grades are declining worldwide (Silver Institute website)
Second, most silver mining is actually a by-product of other industrial metals. Due to the energy crisis and COVID lockdowns, supply of such metals is projected to slow down, as industrial demand from Europe and China weakens.
Global silver production from 2012 to 2021, by primary source metal, in million ounces (Statista website)
Some useful numbers to keep in mind. Total supply of silver in 2021 was 997 million ounces (total demand: 1.05 billion ounces), of which 822 million ounces from mining, of which only 230 million ounces are primary production. The rest is mostly a by-product of lead, zinc, copper and gold mining.
Besides mining, the other important source of silver supply is recycling. In 2021, recycling accounted for 173 million ounces. This was an eight-year high. It would be interesting to study whether recycling can keep up at these rates or not going forward.
Finally, let us turn to the demand side. Silver is both an industrial metal and a monetary metal. I already discussed why monetary demand is going to turn bullish on the backdrop of financial repression. Looking at industrial applications, the picture is still quite bullish.
Let us remark that the industrial uses of silver are very diverse and account for roughly 50% of total silver demand. In the future, the main source of demand growth is projected to come from the green revolution, in particular electric vehicles ("EVs") and photovoltaics.
The average solar panel employs roughly 10 grams of silver per square meter. This may not seem like much, but total silver demand for solar technologies has been rising exponentially at an 8% average rate since 2012. This means that solar demand is already accounting for roughly 11% of total silver demand, and growing.
In fact, the U.S. solar sector is projected to quadruple by 2030. This does not mean that demand for silver will also quadruple, since thrifting, that is the improvement in solar technologies, is driving down the amount of silver employed per solar panel. I am not able to estimate how important thrifting is going to be going forward, but I have read expert opinions that thrifting is reaching a plateau.
There are roughly 25-50 grams of silver in an EV's battery. However, EVs are probably going to be relatively less important for silver. I estimate by 2030 an annual demand of about 40 million ounces per annum from the EV sector, which is less than 5% of current mining production.
Why PSLV
Physical coins and bars offer the advantage of direct ownership outside the financial system. While they represent the best form to store precious metals long-term, they are not suitable for short-term trades, because of liquidity, mark-ups, and the inconvenience of storage and insurance costs. Luckily, closed-end funds with a physical redemption option, such as the Sprott Physical Gold Trust ( PHYS ) and the Sprott Physical Silver Trust ( PSLV ), offer a compelling alternative.
Both PHYS and SLV are closed-end funds ("CEFs"), so at any given time there is a fixed number of units available. Units can only be issued via an IPO and follow-on offerings and can be redeemed through buybacks.
The key point is that each unit is fully backed via physical gold and silver bullion. To guarantee that this condition is satisfied at all times, there are two mechanisms in place. First, the fund is legally required by its own prospectus to be fully backed, which is subject to audit control. Second, the trust offers a physical redemption option (above a certain minimum amount).
This redemption feature is crucial and distinguishes physical bullion trusts from exchange-traded bullion funds. Take for instance the case of the iShares Silver Trust ( SLV ), the largest silver ETF. Its stated purpose is to track the price of physical silver, but it offers no option for redemption (unless you are a registered broker-dealer trading in blocks of 50,000 ounces). It claims to be backed by physical silver, but: 1) the custodian is JPMorgan (whereas for the Sprott funds it is the Royal Canadian Mint, which has a lower counterparty risk, being outside the financial system); and 2) there is no constraint to hold only unallocated metal (whereas such a constraint exists for the Sprott funds).
But there is another important feature to be kept in mind for U.S. investors: physical bullion trusts offer significant tax advantages. Unfortunately, most governments worldwide do not treat precious metals as money but subject them to capital gain taxes. For instance, the IRS classifies precious metals as collectibles, which are subject to a 28% long-term capital gain tax (if the holding period is longer than 1 year; otherwise, the proceeds are taxed as regular income). However, the Sprott physical trusts are recognized as Passive Foreign Investment Corporations (PFICs) by the IRS, which means that capital gains are taxed at either 15% or 20% (depending on the holder's income). This is a big advantage for a U.S. investor (provided of course he/she remembers to file the proper IRS Form 8621 with their federal income tax return).
In conclusion, for all the above-mentioned reasons, I consider PSLV a better choice than SLV. Interestingly enough, as of September 9, PSLV is also trading at a discount of around 2.2% compared to NAV, while SLV is trading at a small premium. This is quite odd, considering that the two funds have similar expense ratios (50 bps for SLV vs 60 bps for PSLV).
PSLV Historical Premium/Discount: Market Price to Net Asset Value (Sprott's website)
Conclusion
While the precious metals bull market has recently stalled because of monetary tightening, the long-term fundamentals remain intact. Negative real interest rates, i.e., financial repression, represent a bullish tailwind for all monetary metals.
Silver is particularly interesting at the moment, due to a unique combination of short-term and long-term catalysts. Apart from physical bullion, the best way to hold silver is via the Sprott Physical Silver Trust, because of tax advantages and, above all, the physical redemption feature.
For further details see:
Get Ready For The Fed's Pivot By Going Long PSLV