Many people have asked me to comment on the plunge in gold and silver. First let’s take a look at the wrong answer: Case Closed: CME Hikes Gold, Silver, Copper Margins

And there you have it: CME just hiked gold margins by 21%, silver by 16% and copper by 18%. Mystery solved.

Sorry Tyler, wrong answer.

Four Reasons for Metals Plunge

  1. Fed did far less than expected
  2. Mutual fund redemptions
  3. Margin calls at hedge funds
  4. China growth story fading

1. Fed Did Far Less than Expected

The Fed did not do what everyone thought, which is to say something far more than “Operation Twist”.

As noted in advance, I explained why the Fed wouldn’t do more than Operation Twist, in Six Things the Fed May Announce Tomorrow (But Likely Won’t); Would Any of Them Matter? Gaming the Reaction.

In short, the Fed did not print, or even threaten to print. Moreover the Fed committed to a strategy not through the end of this year, but all the way through June of 2012. Perhaps the Fed does more in the interim, perhaps not.

For those expecting drama, the Fed’s non-action was decidedly bearish for commodities in general, even gold.

2. Mutual Fund Redemptions

Mutual fund cash levels are at or near record lows. In general, mutual funds were not prepared for the market selloff and sell orders came in. Rather than sell garbage like Bank of America at $6, mutual funds unloaded stuff like gold, taking profits.

3. Margin Calls at Hedge Funds

Hedge funds unloaded gold and silver for the same reasons as mutual funds, but also because they mistimed the play and what Bernanke would do. Leverage works both ways.

4. China Growth Story Fading

Commodities in general have been clobbered along with currencies of commodity producing countries because the global economy is slowing rapidly.

As in 2008 there will be no decoupling. China is not a growth engine in any real sense of the word. Instead, China desperately needs demand from the US and Europe. Moreover, China is overheating and has a huge property bubble to boot, at precisely the wrong time. Commodities were set to plunge on the China story alone.

Metals Volatility

In the wake of increased volatility related to the above, the CME hiked margins. That likely added to the volatility but was not a fundamental “cause” of the plunge in precious metals.

What will the Fed do Next?

“Bay of Pigs” asks …

Mish, Any thoughts on what the FED will do next? I doubt they sit there and do nothing.

Thanks Bay. That was a good question. This is why:

1. It is a single question, not five questions
2. It is a question on topic
3. It is a question I have not explained 10 times already
4. It is macro-based, not stock specific
5. It seeks an honest opinion rather than asking for something that may take hours of research

Problems for Bernanke

Market expectations were clearly for the Fed to do more. Goldman Sachs was shocked at the market reaction, I was not. See Goldman Surprised by Reaction to “Operation Twist” for details.

The problem for Bernanke is every action he may take now has serious negative ramifications. Fort example, take Operation Twist: The flattening of the yield curve may (I doubt it) help mortgages by lowering mortgage rates. However, the flattening of the yield curve will without a doubt hurt banks struggling to make profits on spreads.

The flattening of the yield curve also hurts those on fixed income as well as pension plans with 8.5% or so yield assumptions. The irony is pension plans might have gotten big returns had they been in treasuries, but they weren’t because treasury yields were “too low”.

Instead, pension plans all plowed into foreign bonds, commodities, currencies, and global equities to make their 8.5% assumptions.

So what is Bernanke to do?

See Bernanke, a Complete Dunce, “Puzzled by Weak Consumer Spending” for more on how the self-proclaimed student of the great depression is clueless about the current depression.

Bottom line: The Fed is more or less out of bullets. Moreover, Bernanke admitted he does not know why his policies are not working even though it is perfectly obvious.

When backed in a corner, Bernanke may conceivably try nearly anything. However, Bernanke is just not that desperate yet. Right now, European banks are at far greater risk than US banks so Bernanke may easily bide his time.

Silver Daily Chart

Silver, once again, is acting more like a leveraged commodities plaything than a currency.

I traded all my silver for gold on April 27, as noted in Taking Silver Profits – Swapping Silver for Gold.

Gold is still higher than my swap point.

At the time, I commented “I believe the price of silver is highly likely to revisit the low $20’s at some point. Thus, I see no point in chasing silver higher here. Moreover, except for pure speculation, I see little reason to even hold silver in this spike.

I really do not know if silver hits the low 20’s or not, but I was not tempted by that previous decline to near $32. Had I bought it there, I made a mental sell at $40. Silver got all the way to $44 and to be honest I was wondering if it would take out my swap point.

Silver breached $30 today.

As I have commented many times, silver is a far riskier play than gold. I believe this volatility proves my point.

CME margin hikes are not a cause of 40% collapse in silver from the top.

No Hiding Places

On September 19th I wrote No Hiding Spots Except Despised US Dollar: Equities Red, Metals Red, Energy Red, Grains Red

No Hiding Spots Except Despised US Dollar

If you have not done so already done so, please consider the possibility there will be no hiding spots except for US dollars and short-term US treasuries (yielding nothing) in a renewed strong downturn.

I expect gold to hold up in a major decline, but I could easily be wrong. One encouraging sign is the $HUI gold miner index is down less than a percent even though gold is down by 2% and the S&P; and Dow are down by almost 2% as well.

Short-term, I have been wrong about gold holding up. Then again, I really do not concern myself with short-term action. Moreover, gold is higher than it was the day I swapped it. The equity markets in general sure are not.

Bernanke Will React

It’s a safe bet Bernanke will react, we just do not know when. Things may (or may not) get ugly for miners (especially silver) in the meantime.

Those with cash, should be rooting for a selloff in gold and miners. In the meantime, hold a core position in gold. Take profits on big spikes and buy big dips.

At some point that advice will stop working, I just do not think this is the time.

Mike “Mish” Shedlock
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