From TDV’s Senior Analyst...

Confidence in the precious metals trade has ebbed going into the fall, and our bottom hypothesis is about to be tested.  It is an irony in light of what many of the central banks are doing to their currencies these days.  But you have to remember that most investors are sheep, chasing yesterday’s returns.

A confluence of factors has nevertheless conjoined to make me potentially wrong about a few things: stocks, bonds and the dollar.  If I turn out to be wrong about these things I may be wrong about gold.

What We’re Wrong About So Far

I’ve been advocating a limited short against US government bonds (at least as a hedge) since gold prices first crossed over $1500 in 2011.

I tried very hard to avoid that trade for many years, but with the price of gold in parabolic mode it began to look appealing.  An initial allocation of 5% was recommended in August 2011, only a month before the Fed launched “operation twist,” driving bond values to record postwar highs.

I doubled up on that short (through the proshares ETF, TBT) on the idea that the rally on Wall Street would undermine bond values just before the Fed was going to taper.

Nevertheless, my timing is still clearly early.

This trade is down 40% after averaging out the two purchase prices, and continues to look weak.

My call on stocks is half right.  I withdrew my remaining short-term bullish calls on US equities, as of the end of 2013, but have avoided recommending a short.  I don’t know if equities have peaked out yet or not but I am confident that ‘US’ equities have peaked in performance relative to the foreign equities.

I am pretty confident that the Bull Run on Wall Street is close to exhaustion, but I can’t be sure if that means one month or ten more months higher before the collapse, though I really think it is stretched.

Meanwhile, my bearish call on the US dollar, and one of my premises for an upturn in the precious metals at the current juncture, is vulnerable to an upset if dollar bulls keep the USD index above 81.5.

With stocks, bonds and the US currency refusing to give in to the bears, the precious metals trade is at risk.  So the question is why is that happening, and how will all this affect our investment strategy.

What We’re Not Wrong About

Before shedding light on the factors working against us, let me tell you what I know that we are and will be right about.  In the first place, all western governments are fundamentally insolvent.  What this means is not that they can’t pay their bills day to day, per se, but that they wouldn’t be able to if they were not engaged in a ponzi scheme with the help of their central banks.  If governments allowed the free market to “dictate” the rate of interest, you would see just how insolvent they are –as well as the government supported banking cartels and many other uneconomic enterprises they also support.

They are putting off the default through the inflation of the money supply and manipulation of interest rates (lower), which just encourages the accumulation of ever-greater amounts of public debt.

Some people think that it is a good thing to save governments and the banking cartels they support on the grounds that these things are fundamentally vital to a functioning economy.

But they are not.

We are also not wrong about the nature of the boom.  It is unsound.  That means it will not last.  It is supported by false incentives producing an imbalance between saving and investment that will have to ultimately result in a financial crisis and bust once the inflation policy that produced it is withdrawn or we get runaway cost inflation (hyperinflation) that drives up interest rates and squeezes profit margins.

Usually the central bank tries to withdraw the policy to prevent runaway inflation, and produces a bust.

In the absence of the planners’ manipulation of these monetary variables the primary source of financial instability and our recessions would disappear.  We are not wrong about the fact that these “policies” cannot create wealth or growth, but that they can definitely reduce and harm these things.

We are not wrong that the inflation policy harms capital, and hollows the economy out in the long run.

We are not wrong that the vast majority of sheeples have conflated economic growth with changes in the monetary variables (both demand and supply) brought about by central planners in order to create the illusion of growth while redirecting the great proportion of purchasing power to their crony friends.

We are not wrong about the fact that money growth (as opposed to economic growth) has inflated profits and asset prices, and that goldilocks is nothing but that phony calm between financial crises.

Ultimately we are not going to be wrong about interest rates –that is an accident waiting to happen!

And we will not be wrong about the collapse of the western USD centric fiat currencies, including the Euro, Pound, and Canadian dollars in particular.  These governments are insolvent, as mentioned above, and have little choice but to continue to abuse and debase their way to gradual default.

We just happen to be in a period where certain factors have worked to promote confidence in the opposite story – the one promoted by the establishment on Wall Street and the Fed – i.e., that they have saved capitalism, again, and have produced a genuine recovery by waving a magic wand.

What Are the Headwinds?

The story for practically a year has been the poker game that ECB president Draghi has played with the markets over a prospective decision to launch another quantitative easing program in order to give the banks another boost of liquidity.  The ECB has done everything except what the bulls have wanted it to: purchase sovereign government debt and expand the money supply brute force.  Consequently, bond yields in Europe have plummeted across the board even though the banks haven’t been lending.

The yield on 10yr German bunds is at 1% today.  It is 1.3% on French bonds.

[The two-year yield in these countries is practically near zero…it is negative in Austria and Finland.]

The equivalent 10yr US Treasury yields 2.4%.

The substantial decline in Euro bond yields occurred throughout the back up in US yields during 2013, and has resulted in a situation where the US yield is more attractive, especially in light of inflation risk.

This is one of the factors I believe is supporting the US dollar.

I do not think it will last, but while it does it may continue to pressure gold prices.

Another source of strength for the US dollar and for Treasuries at the same time is weakness in the commodity complex across the board, including in oil and wheat prices, copper, and silver (bulls can’t refute the 14-month descending triangle in the chart), which continues to weigh on the inflation trade.

The Fed’s tapering is not the cause of USD strength in my opinion because US money growth is still higher than in both Europe and Japan.  Moreover, in light of the continued acceleration in bank credit in the US, the tapering might become moot, particularly if it continues and expands in overall breadth.

At the moment, markets may be attaching a higher inflation risk to Euro assets and they may see the European economy as weaker –despite the fact that so far the Fed has run a more aggressive policy.

This too may be adding support to the US dollar, as is the retrenching Chinese monetary policy (i.e., the relatively less easy Chinese policy has contributed to the weakness in world commodity prices).

Prognosis and Outlook

Here is the bearish case for the precious metals.  The status quo.  Stocks, bonds, and the US dollar continue to rise.  This would obviously continue to hinder bullish sentiment in gold & silver regardless of what Bugos says about its fundamental valuation or the economics of monetary intervention.  Since we are ruling out actual economic growth as driving these trends, in order for them to continue, the monetary aggregates are going to have to continue to grow, quicker, without spreading price inflation.

They don’t have control over the latter effects of the policy, but at the moment money growth has been slowing everywhere this year.  The US, Canada and UK are expanding money at about the same rate (7-8 percent year over year) while the ECB is at roughly 6%, and the BOJ is back below 5% y-o-y.

See Mike Pollaro’s work for details: http://blogs.forbes.com/michaelpollaro/austrian-money-supply/

I have been warning for some time that US banks are expanding credit again, even though a lot of the expansion still involves the purchase of securities rather than commercial loans.  Nevertheless, there’s scope for more, in my opinion, even as the Fed stops printing.  Combined with an upturn in the growth of euro area money aggregates it could provide the impetus required to extend the unsound boom.

But not only am I skeptical that an ECB driven QE policy will have the same effects as a commercial bank driven expansion in money, the window for a continuation of these policies without stirring price inflation seems rather small.  Technically, the USD index has not fully rejected the bearish hypothesis until it breaks to new highs, but I have to warn precious metals investors that they are vulnerable while it remains above the 82 level.  Maybe, I should just point it out as another coming buying opportunity.

At any rate, the equity markets may be getting ahead of the ECB’s decision, and excessive valuations in both stocks and bonds present a risk/reward proposition that favors gold and silver in my opinion.

The big question in my mind continues to be whether the crash happens in stocks or bonds, first.

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Follow My Calls…

Why not follow my calls more closely by subscribing to the premium letter where I recommend a portfolio of up to 20 precious metals equities.  Two of our junior picks have recently been taken out by a major, and one of our exploration companies (Merrex Gold MXI:TSXV) has made a discovery that may potentially rival the one made by Papillon Resources (which was taken over by B2gold this year).

Things are happening regardless of the gold price.  I have been toiling for over a year to build a portfolio of precious metal growth stocks that would benefit from higher gold prices but don’t depend on them.  Most of our picks have strong balance sheets, growth potential, operate in mining friendly regions, and relatively modest capital needs in order to execute on their business plans and goals.