Submitted by Adam Hamilton:
Silver has been selling off relentlessly since the Federal Reserve expanded its third quantitative-easing campaign last week. As that decision was highly inflationary, silver’s subsequent weakness has really vexed traders. But its counter-intuitive selloff had nothing to do with fundamentals. As the Fed’s past QE campaigns demonstrated abundantly, QE3 will eventually prove to be very bullish for silver’s fortunes.
Quantitative easing is a pleasant-sounding euphemism for debt monetization. Historically this dangerous practice has been scorned because it ultimately unleashes serious inflation. Monetizing debt is exactly what it sounds like. A central bank chooses to buy bonds, and then conjures up the money to do so out of thin air. This new money is injected into the economy as the bond sellers spend it, igniting inflation.
The rapidly-expanding money supply grows much faster than the underlying economy. So relatively more money chases after relatively less goods and services, which bids up their prices. As more money is poured into the system, each unit has less purchasing power. Inflation is ultimately an oversupply of money, which quantitative easing greatly accelerates. Investors flock to precious metals in such times.
The supply-and-demand dynamics of gold and silver protect and multiply capital when central banks are inflating their money supplies. Since fiat money can be wished into existence instantly in unlimited quantities, its growth vastly outpaces the naturally-constrained growth in global precious-metals supplies from mining. A lot more currency competing for relatively less silver inevitably drives up its price.
So make no mistake, the Fed’s decision to more than double QE3 last week is wildly bullish for silver going forward. The Fed just announced an unprecedented tidal wave of money-supply growth from debt monetization that is going to start hitting our economy’s shores in January. The recent silver selling is the result of unrelated bearish psychology, and such extreme sentiment anomalies never last for long.
Why is QE3 so bullish for the white metal? Because its probable scope dwarfs that of QE1 and QE2, and both of those earlier inflationary campaigns eventually worked wonders for the silver price. This first chart shows silver over the Fed’s QE era of the past four years, along with QE’s growth. The direct injection of new money into our economy from the Fed’s debt monetizations is a great boon for silver.
This chart is updated from a more comprehensive study of the Fed’s QE campaigns I wrote a couple months ago. When the Fed creates new money to buy bonds, these purchases grow its balance sheet which is shown in orange. The yellow and red lines, which are stacked like an area chart, show the types of bonds the Fed buys through QE, mortgage-backed securities and Treasuries respectively.
And it is the red Treasury buying we want to focus on today. Of all the debt a central bank can choose to monetize, its government’s bonds lead to the most direct inflation. Central banks only print money to buy their government’s debt when it is living far beyond its means. Thus all the money created to buy these bonds is spent nearly as rapidly as the issuing government receives it. It flows directly into the economy.
So it shouldn’t be surprising that the Fed’s unprecedented quantitative easing over the past four years corresponds exactly with Obama’s extreme record deficits. As unchecked federal-government spending soared to a quarter of the total US economy, the Fed monetized increasing amounts of the resulting deluge of new Treasuries. And as the government immediately spent all this newly-created money, silver surged.
All three of the Fed’s QE campaigns were introduced in two stages, to blunt their psychological impact on inflation expectations. QE1 was born in November 2008 and expanded in March 2009. Through it the Fed created an epic $1750b out of thin air to buy bonds, but only $300b was allocated for Treasuries. They were gradually monetized over roughly 15 months, working out to buying of about $20b per month.
And how did silver do over this entire QE1 span? Awesome, it rocketed about 80% higher! Of course this gain wasn’t just from QE1 and its relatively-small Treasury monetizations. As a hyper-speculative metal extremely sensitive to sentiment, silver was ripped to shreds in the epic fear of the stock panic. So as QE1 was launched, silver started from a very depressed base. Still, the QE1 inflation was very bullish.
Today traders are freaking out because silver hasn’t been skyrocketing since QE3 was born a few months ago. But look at its behavior during QE1. Though silver rose mightily on balance, it still experienced periodic sharp selloffs like in the second quarter of 2009 and first of 2010. Other times it just ground sideways and consolidated. Silver is and always has been volatile, traders have to accept that.
Though the inflation unleashed by quantitative easing is a strong tailwind, many other factors affect short-term silver psychology from time to time. Greed can erupt to catapult silver higher far faster than QE alone warrants, and fear can crush silver much lower than fundamentals merit. But normal sentiment-driven selloffs within a timeframe where the Fed is monetizing certainly don’t make inflation less bullish.
Since QE1 miraculously failed to significantly raise mainstream traders’ inflation expectations, the Fed was greatly emboldened for QE2. It was exclusively Treasury purchases, the purest form of inflation from debt monetization. And it weighed in at a whopping $900b over about 10 months, although the first third of this was from rolling over already-monetized mortgage-backed securities into Treasuries.
So we are talking about a $90b-per-month rate of Treasury monetizations. And as you can see above, during this QE2 span silver skyrocketed. It ultimately blasted a staggering 177% higher in 9 months, its biggest upleg of its secular bull by far! QE, especially the direct inflation that comes from monetizing Treasuries, is very bullish for silver. But like QE1, QE2 didn’t mean silver never experienced weakness.
In August 2010 when the Fed announced the rollover of maturing MBSs into Treasuries, it wasn’t called QE2 at the time. And silver surged dramatically after this, largely for other reasons. It wasn’t until QE2 was tripled in November 2010, to intense global political criticism, that it actually became known as QE2. But right after that QE2 expansion that would ultimately prove wildly bullish, silver consolidated.
This metal had just rocketed 39% higher in less than 3 months, thus it was short-term overbought. So silver climbed a bit higher into late 2010 before selling off sharply in early 2011. Silver lost an eighth of its value in several weeks despite the Fed’s QE2 Treasury monetizations being very bullish. Sound familiar? Later in May 2011 silver plummeted after getting wildly overbought, QE isn’t its only driver.
Nevertheless, over the entire span of QE2 silver still powered 89% higher! This is despite the near-crash after silver euphoria grew far too extreme in that mammoth QE2 upleg. When the Fed is aggressively growing its balance sheet by buying bonds with freshly-conjured money, especially through Treasuries, silver investment demand surges. Silver has always been one of the best assets in inflationary times.
Interestingly after QE2 ended in the middle of 2011, silver continued correcting sharply. Though the Fed was shifting its Treasury allocation from shorter term to longer term through what became known as Operation Twist, it wasn’t growing its balance sheet. The tailwind of new QE inflation was gone, so silver investment demand and prices naturally deflated. But correction sentiment was the dominant factor.
Silver didn’t really start showing some sustained signs of life until QE3 expectations really began to flare late this past summer. Between early July and the day in September the Fed birthed QE3, silver surged 29% in a couple months. So as the next chart illustrates a little later, this metal was definitely short-term overbought. And then the initial stage of QE3 avoided Treasury monetizations for political reasons.
After it expanded QE2 in November 2010, the Fed was shocked by the resulting firestorm of global criticism. World leaders condemned this brazen monetization. And more importantly, here in the States Republican lawmakers accused the Fed of being in cahoots with Obama to “finance” his record deficits. And Congress can kill the Fed with a single vote. So the Fed remained wary of monetizing Treasuries.
But QE3’s first stage was still unprecedented. Instead of a static target like QE1’s $1250b of mortgage-backed-securities monetizations, the Fed announced its first-ever open-ended QE of $40b per month this past September. But the banks and large investors selling MBSs to the Fed don’t spend this new money right away like the federal government does after Treasury sales, so the inflationary impact was muted.
Then after Obama won re-election a couple months later, the Republican political threat to the Fed greatly diminished. It could continue brazenly monetizing Obama’s record deficits without an immediate risk to its survival. So just last week, following the pattern established in QE1, QE2, and even Twist, the Fed expanded QE3. For silver, this new QE3X is the most bullish inflationary campaign of the entire QE era!
The Fed just announced adding $45b per month of Treasury monetizations to QE3’s existing $40b per month of MBS buying, more than doubling the campaign. Now $45b per month might not sound like a lot compared to QE1’s $300b of Treasury buying and QE2’s $900b. But QE3 is open-ended. There is no end date. And based on the Fed’s own targets, QE3 is likely to run for a long time. We are talking years!
Last week the Fed said it plans to continue manipulating interest rates to levels near zero “at least as long as the unemployment rate remains above 6-1/2 percent”. The last time we saw a 6.5% unemployment rate was over four years ago in late 2008 as the stock panic started to unfold. Even the economic optimists figure it will take several more years before unemployment heads decisively below 6.5% again!
$45b per month of Treasury monetizations for one year works out to $540b, already dwarfing QE1’s and nearly as large as the new component of QE2. After two years it grows to $1080b, and three years would take QE3 to a staggering $1620b of new Treasury monetizations! Not including the rollovers of MBSs and other already-monetized Treasuries, QE1 and QE2 only saw $900b in total Treasury monetizations.
So QE3 is going to utterly dwarf QE1 and QE2 combined in its inflationary impact! The Fed has effectively committed to monetize half of Obama’s record deficits, which are expected to average $1100b annually in his second term. And if silver surged 80% during QE1 and 89% in QE2, which were much less inflationary than QE3 is looking to be, why would silver not fare at least as well in this latest QE?
The Fed monetizing Treasuries, with the government then immediately spending this new money and injecting it into the economy, is highly inflationary. Despite silver’s day-to-day volatility, investors eventually realized this and drove massive silver uplegs during QE1 and QE2. Mark my words, the same phenomenon is going to happen again as the crazy inflationary implications of QE3 start to sink in.
So with QE3’s coming Treasury monetizations so massive, why hasn’t silver responded favorably yet? The answer is temporarily bearish sentiment totally unrelated to QE3. Remember that silver fell sharply at times during both QE1’s and QE2’s durations, yet on balance it still soared dramatically. Though QE is a strong tailwind, it is a background driver. Meanwhile greed and fear batter silver around as always.
Last week in an essay on silver’s young upleg, I discussed the lingering correction psychology that is a major reason for silver’s recent weakness. Early in new uplegs few traders believe one is indeed underway, so they figure any new selling means the correction is back. Bullish contrarian sentiment remains rare. But a second reason silver has been weak is because it got too overbought before QE3.
This last chart looks at the 10-trading day, 20d, and 30d returns in silver over its entire secular bull. These metrics measure how fast silver has moved. Naturally when it has surged too far too fast, it is overbought and greed is excessive. So depending on where silver is in its upleg cycles, either a pullback, correction, or consolidation is necessary to rebalance sentiment. And that is what silver has been suffering lately.
Partly due to the anticipation of QE3, partly due to being very oversold, and partly due to strong autumn seasonals, silver surged dramatically in late August and early September. After its massive 14-month correction, this was a lot of fun. But silver got ahead of itself. At best it was up 13.9% in just 10 trading days, 24.6% in 20, and 27.5% in 30. As you can see above, such extreme rallies are rare and short-lived.
If silver happens to be in a mature upleg after such incredible short-term runs, it soon rolls over into a new correction. But following its massive correction that bottomed this past summer, that sure doesn’t describe silver’s state in September 2012. It was early in a new upleg, so the necessary reckoning to rebalance away the excess greed generated by such a fast surge was merely a pullback or consolidation.
Interestingly, short-lived early-upleg surges are not uncommon. Each of silver’s five major uplegs of its secular bull has seen rapid advances early on that were followed by sharp pullbacks. Yet this selling certainly didn’t short-circuit these uplegs. In fact just the opposite was true. These pullbacks and consolidations after silver had advanced too far too fast bled away greed, keeping the uplegs healthy.
Silver’s apparent lack of response to the Fed’s highly-inflationary QE3 expansion has nothing to do with QE3. The QE3 Treasury buying hasn’t even started yet, the Fed isn’t spinning it up until January. Silver simply got overbought early in a new upleg, and selling emerged as always to rebalance sentiment. And it has worked. All the greed that was mushrooming in mid-September has totally yielded to serious fear.
Gold has been a major factor in silver’s recent weakness as well. Silver traders have always looked to gold as their major cue for buying and selling the white metal. Gold is silver’s primary driver. And due to a combination of poor sentiment and fund selling, gold has been much weaker than normal this time of year. This has heavily weighed on silver, and is probably responsible for the great majority of its selloff.
But don’t get too caught up in this temporary weakness. Silver rises and silver falls, but there is no doubt monetizing Treasuries is wildly bullish for this metal. Sooner or later all the distractions keeping investors from buying silver since the QE3 expansion will evaporate, and the urge to get deployed will hit hard. Silver nearly doubled during both QE1 and QE2, and QE3 will almost certainly prove much larger!
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The bottom line is the Fed’s new QE3 campaign is wildly bullish for silver. Monetizing Treasuries leads to direct inflation, which drives investors into the precious metals. And QE3’s Treasury buying is going to utterly dwarf that seen in QE1 and QE2. Yet silver still nearly doubled during each of those earlier monetizations. The longer QE3’s monthly Treasury buying lasts, the more capital will flood into silver.
It’s true, silver has plunged since this unprecedented QE3 expansion was announced. But that selling had nothing to do with QE3’s Treasury buying, which hasn’t even started yet. While QE provides a strong tailwind for silver prices over time, this metal’s trademark volatility remains intact. The fearful sentiment that drove this recent selloff will soon dissipate, and silver’s young QE3 upleg will resume.
Adam Hamilton, CPA
December 21, 2012
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