Monetary Metals (Commodities)
I figured I’d follow up the post on cyclical commodities with a few notes on the monetary metals, namely silver and gold, and what causes price action in these two metals. Yesterday I posted about the cyclical commodities, or those that would rise and fall with changes in economic output so today’s post on the commodities that rise and fall with monetary policy seemed to be a good fit.
What Makes a Monetary Metal
Silver and gold are commonly referred to as monetary metals because they have been used for trade for virtually the entire history of civilization. Such characteristic, some believe, makes gold and silver attractive as a store of wealth, since they are said to have “intrinsic value.”
This label of “intrinsic value” is usually meant as a comparison to other currencies, especially paper or fiat currencies. By definition, fiat means by order of government. The US dollar, for example, is an example of a fiat currency, since its value exists by order of government. While a $100 bill is worth $100 of goods by law, the processes and materials used to create that $100 bill could be had for less than .03.
Proponents for monetary metals argue that it is the cost of production that makes these metals valuable for use in currency. Silver, for example, costs resources to mine and refine, making the output only slightly more valuable than all the inputs. Each new $100 bill, however, could be used to make roughly 3333 more $100 bills.
Silver has emerged as a monetary metal and attracted quite the following since its post-millenium price explosion. Compared to gold, silver is seen as a smaller item currency unit, since a single ounce of silver is worth roughly one-fiftieth of a unit of gold. A half ounce silver round is valued at only $15, and smaller units, particularly pre-1964 dimes, open up the possibility of easy exchange in silver.
According to coinflation a pre-1965 US dime is worth roughly $2 in silver.
Unlike other metals, silver enjoys rising investment demand. Jewelry demand is also growing as more and more jewelers are mixing silver into gold pieces to keep them affordable, especially in this economic downturn.
Gold has long been considered the counter-cyclical investment, with investors pouring cash into gold as the markets become less predictable. As seen in the 1970s, a combination of inflation and fear about the traditional financial markets started a virtual gold rush. In the early 1990s, gold plummeted as other financial markets improved.
Recently, however, gold has been on a tear, rising higher and higher on inflation concerns and fear over global economic meltdown. Just like silver, gold is demanded in greater quantities for jewelry and investment, which keeps it from my list of cyclical commodities.
Negative Real Interest Rates
Gold and silver are affected near equally by negative real interest rates, a market phenomenon that happens when the price of borrowing is lower than the actual interest rate. If the cost of borrowing was three percent per year, and the rate of inflation was 5 percent, then the interest rate would be an effective negative two percent per year.
In such conditions, an investor could borrow at three percent and watch as the amount they borrowed lost value at a rate of five percent per year, transferring purchasing power from the lender to the borrower.
Following the 2008 financial crisis, negative real interest rates exist in a number of markets important to gold and silver. China and India, two countries which have recently stepped up their imports of monetary metals, both have negative real interest rates. Negative reals also exist in the United States, and such policy has already been blamed for the boom in commodities.
Physicals and Funds
Also aiding in the rise of gold and silver prices is the growth in investment products related to the metals. While there is always the option of investing in physical metals, there are now a wide swath of funds and depository accounts.
Tax policy on gold and silver has helped to a degree. Gold held through a depositary account is taxed at the capital gains rate, rather than the collectible rate. Silver, however is still considered to be a collectible whether owned as part of a fund, or as physical metal.
On the outer fringe of the investing world are those that believe the commodities markets, and their participants, are actively engaging in price suppression. While these claims have not yet been verified or remotely proven, I’ll say only that stranger things have happened. I would’ve never thought high frequency traders were front-running the market, nor that hedge funds were cleaning up on emergency loans made during the financial crisis.