Precious Metals Poised for a Historic Rally

Summary

• Multiple fundamental factors are coming together to spark a massive rally in Gold and Silver.
• We look at current conditions, and similarities to previous periods of very strong performance for precious metals, to determine the potential upside.
• We detail two interesting ways to express bullish gold and silver views taking advantage of the attractive levels in vols and skew

Precious metals prices have recovered strongly of late. This is hardly surprising given that commodities generally are seeing their strongest rally since 2011. Everywhere you look, raw material prices have surged, both industrial and non-industrial. Dollar weakness amplifies the picture somewhat, with the benchmark DXY index slipping below 90 this week, a roughly 10% decline over the past year.

Surprisingly in this context, precious metals prices have done poorly relative to other commodity groups. There are three explanations for this, which also help explain the recent reversal and apparent breakout in gold and silver.

First, real rates began rising in the second half of last year and continued to do so until quite recently, when they declined sharply due to a combination of falling Treasury yields but primarily rising inflation breakevens. Second, until only very recently, actual, realised inflation rates had remained low, notwithstanding gathering evidence of pipeline pressures. But now US CPI y/y has surged to over 4%, the highest since before the global financial crisis of 2008.

Those factors are significant. However, it is the third reason that remains a headwind for precious metals: stocks and other risk asset classes have been trading firmly. The VIX has generally remained under 20 in recent months, following a prolonged, elevated period during the Covid scare. As long as investors are willing to take incremental risk in anticipation of an incremental further return, precious metals tend to underperform.

Risk aversion is therefore the key. Real rates are now much lower than they were, whether measured by breakevens or actual, realised CPI. Consequently, should risk aversion begin to rise, it would likely unlock significant precious metals upside. Key technical levels, trendlines and momentum measures have all swung positive over the past week.

Indeed, the previous highs for both gold and silver are easily within reach. If those are breached, then longer-term charts come into play and show a highly bullish picture. But it is the fundamental context which, throughout this entire period of consolidation, is the most bullish factor of all.

All prices are ratios. Normally, the numerator is a base currency and the denominator the good, service or asset being bought, sold or traded. When it comes to precious metals, however, different ratios can apply, as they are established stores of value – alternative monies.

When taking a broad look at relevant ratios, a highly bullish picture emerges. During the past few years, the supply of both base and broad money has exploded. Yes, velocity has declined in tandem, but most recently, velocity has recovered sharply. Compared with the available above-ground stocks of gold and silver, which grow only slowly, the ratios of money supply to gold and silver supply are far higher today than ever before.

Alongside the exploding supply of money has been an explosion in debt. Much of this yields essentially zero or less than either realised inflation or forward breakevens. As gold and silver are widely expected to at least hold their real value in an inflationary environment, this implies that, unusually, there is a positive opportunity cost in switching out of negative-real-yielding debt into gold or silver (Chart 2).

Yes, central banks may eventually begin to raise rates alongside rising inflation. But few expect real yields to rise substantially, as that would rapidly choke off the post-Covid recovery. Debt burdens are extremely high relative to GDP historically – especially excluding wartime periods – and so rising debt-servicing costs would have a much stronger negative impact on growth prospects than was the case back when debt burdens were at more normal levels.

Simply extrapolating these trends and allowing for gold/MS and gold/debt ratios to mean-revert over time, as seems reasonable, the implied gold price soars into five digits. While not a forecast per se, that does provide an order of magnitude for what is fundamentally and historically justified.

Silver might have even greater upside potential from here. Stocks are tight, the market is thin, and silver’s growing medical, photovoltaic and other tech and ‘green’ uses imply strong real demand going forward. Although the gold/silver ratio has declined far from the historically elevated levels of a year ago, it remains well above longer-term historical averages.

The 60 level for the ratio held for many years. Consequently, were gold to rise strongly from here, as discussed above, silver could end up in the triple digits.

While that might sound somewhat aggressive, keep in mind that the fundamental global economic environment of today greatly resembles that of the stagflationary 1970s. Exogenous shocks have led to both fiscal and monetary stimulus. Real rates are now as low as they were during the 1970s, when the US Fed and other central banks accommodated the oil shocks. Today it is the Covid shock, but remember that it arrived in a context of still highly indebted governments and highly leveraged corporations.

Stagflation is a highly challenging economic environment. Businesses with pricing power can still grow real profits. But most profit growth is simply nominal, more or less keeping up with inflation, and in many industries, profit margins get squeezed as firms seek to maintain some portion of market share. P/Es naturally compress in that case, and it is worth observing that the P/Es for the US benchmark indices declined into the single digits by the early 1980s.

Yes, they subsequently rose again, and strongly, once the Volcker Fed addressed the stagflationary conditions. But no investor then would have wanted to just ride that out. Indeed, it was during this time that both gold and silver soared as safe-haven demand rose.

For those who see a significant probability to history at least rhyming this time round, if not repeating exactly, being long gold and silver is an obvious choice. Silver may have more potential, but of course the corresponding volatilities represent that. The six-month ATM vol spread for gold vs silver is trading roughly around its recent averages (Chart 3 and 4).

Focus is on the unprecedented actions of global central banks and governments. Also, we are experiencing some of the most negative real rates in 40 years. Yet despite all that, volatility in gold and silver are both well within recent ranges. For gold, volatility has only recently started moving away from one-year lows.

We are approaching some of the most favourable conditions for precious metals since last century. Considering that, the upside vol and skew look incredibly cheap. We believe this is a time to separate your thinking from the recent lower realized volatility and consider the possibility of very large breakout moves in both, driven by the rapidly changing fundamental dynamics.

In silver, we suggest:

6 Month $38 XAG Call Prem .81 USD Pips Vol 42.75 Delta 20

In gold, we suggest:

6 Month 2100 XAU Call Prem 28.10 USD Pips Vol 17.85 Delta 22