Precious metals: The rally is becoming more speculative

Precious metals prices continued their remarkable rally this week as the dollar fell to a record low against the euro. During the course of the week, EUR/USD crossed the psychologically important 1.50 mark which gave the already positive sentiment in precious metals another boost.

Buying by financial investors is additionally fuelled by surging inflation rates, which prompt market participants to consider precious metals investments. At the moment, gold is trading above USD 970. Silver prices stand just above USD 19.60. Platinum and palladium are currently trading at USD 2,150 and USD 565, respectively.

Along with the boost in sentiment, the rally in precious metals is also becoming more speculative. On the fundamental side, the news flow has been rather negative, particularly for gold. For instance, the latest data on physical supply and demand for gold published by the World Gold Council shows that jewelry demand suffered quite a bit during the fourth quarter of 2007 due to the surge in prices. In Q4, jewelry demand for gold declined by more than 18% YoY. While mine production also declined by 10%, the market was still in a surplus of 174 tons in the fourth quarter. Looking at the entire year 2007, the market still exhibits a supply deficit of 78 tons. However, the situation deteriorated significantly during the fourth quarter.

Apart from this, the IMF might sell up to 400 tons of gold to cover its mounting deficit. The plan still needs the approval of the US House of Representatives, but the odds are fairly high that it will be approved. And while the sale is likely to be split over several years, it is nevertheless another source of supply for the market. In our view, the current supply/demand dynamics would rather point toward a consolidation of prices.

However, this is not what’s happening. Indeed, renewed dollar weakness and surging inflation currently leads to significant liquidity inflows into the precious metals complex. Since these liquidity flows tend to be rather short term in nature, the price rally is becoming more speculative and in our view somewhat more unstable. One sign confirming this assessment is the fact that silver and palladium have significantly outperformed gold and platinum over the last two weeks . Silver and palladium both have weak supply/demand fundamentals and are usually far more volatile than their peers, gold and platinum. They tend to benefit most in an environment of speculative inflows of capital into the sector.

It is useful to look at correlations to assess whether the current developments are really mostly a story of the weakening dollar and the search for an inflation hedge. Figure 4 illustrates how the correlation between the various precious metals and the EUR/USD exchange rate has evolved. While the influence of the FX market on precious metals has been rising since August 2007, there has been an upward spike during the past two weeks, particularly for palladium and silver. This confirms our view that the rally is becoming more speculative and probably more unstable.

So what should investors do? In any case, they should expect larger price swings across all precious metals. Platinum and gold prices are still backed by good fundamentals, in our view. Here, the price rally should slow down somewhat following the rapid increases of the last months. Nevertheless, we still expect gold to rise above the USD 1,000 mark later this year. Prices of USD 900 or below are in our view buying levels. We are becoming more cautious on silver and palladium. The risk of a correction for these two metals is very high. Following the recent overshooting, any such a price decline would likely be triggered by an appreciation of the dollar.

source: CS