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New Signs of a Supply/Demand Collision for Gold and Silver

David Smith: “The Worm Is Turning” on the Dollar

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Welcome to this week’s Market Wrap Podcast, I’m Mike Gleason.

Coming up later in today’s program, I’ll be joined by mining analyst David Smith who has some important things to report about the Petrodollar and the precious metals mining sector. So be sure to stick around for our exclusive interview.

Well, as I noted last week, the silver market appeared due for a bounce. And this week silver mustered a small rally. Prices got as high as $19.85 an ounce in intraday trading Thursday morning. But by Thursday’s close, silver settled back down to $19.53 -- just 4 cents higher than last Friday’s close.

On this Friday morning, silver trades at $19.60, up a little more than 0.5% on the week. As for gold, the yellow metal is putting on a modest rally. Prices currently come in at $1,287, up less than 0.5% for the week as of this Friday morning recording.

Turning to the Platinum Group Metals, we continue to see a divergent pattern, with platinum showing weakness and palladium showing strength. Palladium hit $900 per ounce on Thursday as the streaky metal eyes new multi-year highs. For the week, palladium is up 1.5% to trade at $901. Meanwhile platinum is unchanged on a weekly basis and trades at $1,426 an ounce.

Metals markets are giving mixed signals about their near-term direction -- perhaps in part because the economic data continues to come in mixed. One week, the reports paint a positive picture for the economy. The next, data releases point toward a weakening economy.

On Monday, the numbers for new home sales came in worse than expected. Sales of newly constructed homes fell by 2.4% in July, the third straight month of slowing sales.

The housing market has been propped up by the Federal Reserve since 2008. The Fed has purchased more than two and a half trillion dollars in mortgage securities since embarking on the first round of Quantitative Easing. And it’s still adding to its holdings, albeit at a slower pace.

All this artificial demand has put downward pressure on mortgage rates, though they did trend higher last year and today remain above the lows of a couple years ago. So will the Fed create another housing crisis if it steps away from the mortgage market? Or will it create a crisis in the dollar if it keeps coming to the rescue of the financial system?

It has been well documented by respected economists that interventions by the Federal Reserve introduce more volatility into markets – rather than stabilize markets as central planners claim. Fed stimulus causes market cycles to stretch further than they otherwise would. By holding short-term interest rates at ultra-low levels and buying trillions of dollars in financial assets, the Fed has blazed a trail for speculators to place one-way bets on rising values for financial assets.

It was 43 years ago this month that President Richard Nixon vowed to chase off the financial speculators and defend the dollar by de-linking it from gold. Since that time, the dollar’s rate of depreciation has accelerated by the reckless actions of Treasury Department officials and Federal Reserve governors who are no longer constrained by gold. And the financial markets have behaved erratically, often wreaking havoc on the real economy.

Nixon: We must protect the position of the American dollar as a pillar of monetary stability around the world. In the past seven years there's been an average of one international monetary crisis every year. Now who gains from these crises? Not the working man, not the investor, not the real producers of wealth. The gainers are the international money speculators. I have directed the Secretary of the Treasury to take the action necessary to defend the dollar against the speculators. I directed Secretary Connelly to suspend temporarily the convertibility of the dollar into gold or other reserve assets.

With the S&P 500 hitting a record high of 2000 this week, many analysts now believe the stock market has entered bubble territory. Financial bubbles used to be extremely rare, once-in-a-generation events. But this would be the third major financial bubble just since 2000. And, of course, bubbles always end badly. There’s no escaping that.

The longer the Fed keeps bubbles inflated, the greater the size of the excesses that will eventually come crashing down. Which will set the Fed in motion again to try to come to the rescue using dollars beamed into existence out of nothing.

The dollar has managed to keep its status as world reserve currency since Nixon ended gold convertibility because of its prominence in international trade. Our oil-producing allies require payment in dollars, so effectively we have a Petrodollar standard – as our columnist David Smith explained on our website last week. But that is slowly coming undone as more nations enter bilateral trade agreements using their own currencies.

On Wednesday, Russia’s Gazprom Neft began its first shipments of oil and gas to China based on terms that completely bypass the use of US dollars. Russia’s central bank, meanwhile, continues to accumulate physical gold at a brisk pace.

Value-oriented investors weary of participating in frothy financial markets are also accumulating physical gold – along with silver. We at Money Metals aim to help as many people as possible do the same. Regardless of whether your budget is big or small, you can boost your resilience to future financial shocks by accumulating precious metals today.

And now, without further delay, let’s get right to our exclusive interview…

Mike: It is my privilege now to be joined by David Smith, Senior Analyst at The Morgan Report and regular contributor to Money Metals' website. David, thanks for coming on again. How are you?

David: Very good, Mike. It's good to speak with you again.

Mike: David, you've written a couple of really informative exclusive articles for us over the last couple of weeks that I want to talk with you about a little bit. First off, you penned a piece called the Petrodollar Spiral, highlighting the growing concerns surrounding the US dollar's long-term status as the world's reserve currency. I want to get to what's happening today and how we may be losing our grip on having the privilege of being the world's reserve currency, but first, just how did the US find itself in this envious position of owning the most sought after currency in the world?

David: At one point, it was envious, but now maybe not so much so, but going back to get to the roots of how we got to where we are today, you need to go back to the end of World War II where a monetary system was put together called the Bretton Woods System named after where it actually took place. The system obligated the participating countries to keep an exchange rate by tying their currencies to the US dollar. They would hold that dollar as the primary reserve currencies. Other countries could redeem those dollars for gold at a fixed price, which at that time was $35 an ounce.

Global commercial transactions were conducted largely in dollars and there were several through the US Banking System. What happened is that over time when you have a situation where you can actually print a lot of extra dollars and think you can get away with it, you will do so. That's always been a tendency with any kind of a paper currency. The US thought that they could print a whole lot more dollars than they might have gold to back it up and they didn't think that a lot of people would notice and that they would maybe even actually ask for so much gold to be redeemed for dollars that it could put them in a pinch, but that's what happened.

So leading up into the late 60s and right up into 1971, the outflow of gold became so pronounced from the US coffers that finally in 1971, President Nixon put a stop to that in what they called “closing the gold window”. Really what it meant is that the dollars could no longer be converted into gold by foreign entities. When this happened, of course it was a pretty big shock and the currencies began to float in value, but the dollar was still a reserve currency, and it was no longer backed by gold.

About the same time, the US and Saudi Arabia decided that we would protect them if they would agree that future oil sales globally would be denominated in dollars. What this did was to give the dollar a new lease on life in terms of being a reserve currency. In fact, it gave it a tremendous shot in the arm. Any country that wanted to purchase oil and Saudi Arabia of course was one of the biggest entities selling it, would have to exchange their currencies for US dollars before they could do that.

These dollars are a little bit different than what you and I have in our pocket. They look the same, but they actually don't circulate inside the country. They circulate globally. These dollars came to be called Petrodollars because of the relationship of the dollar and oil. What really happened there, in so many words, we exchanged the gold standard, which took place during Bretton Woods, for an oil standard. Again, the same thing started happening. The US started printing all these dollars, thinking that almost no matter how many they printed, that would still be okay.

What we've had over the last couple of decades is a fairly severe and sustained decrease in the value of those dollars. So far, it's coming to people's attention, but we haven't had a big clamor outside the country to redeem those dollars and because it's now starting to change and that's what takes us up to where we are today, but it's something that was a long time building and given that we made the same mistakes twice in a row, I don't know if we're going to get a third chance before we strike out.

Mike: Fast forwarding to the present, we are now having a growing movement among some key players internationally and many nations are starting to do major deals outside of the dollar. First off, why are we seeing this, meaning why are those other nations starting to ditch the dollar and what are the implications of the growing use of alternatives?

David: These different reasons intersect with each other. They're political and social and economic. The main situation has to do with our disagreements with some of these other countries, such as Russia and China over geopolitics and to some extent over trade and over actually the value of the US dollar because it has been declining over time for the last couple of decades. They hold large amounts of our debt. They've bought our debt from us and we are then able to buy more things with them and keep inflation rate low inside the country and things like this.

The worm is starting to turn on this and with the rise of the so-called BRIC, which is an acronym for Brazil, Russia, India, and China, these countries are trying to worm their way out of using the dollar for all their transactions. Basically the Petro Dollar is coming under assault. China and Russia have concluded a couple of really big trade deals recently with regard to oil and natural gas. They are actually going to be exchanging the buying and selling of these products with their own currencies rather than with the US dollar. This is fairly significant.

Most of the people watching this are saying they'll never be able to supplant the US dollar, but they don't even have to supplant it. All they have to do is take it down a couple of pegs so that it's only first among equals rather than having almost the playing field. This sort of thing is picking up pretty rapidly now with some of the geopolitical problems with Russia apparently set to invade Ukraine and with all the issues we've had with the European countries in regard to that and then the issues we're having with re-militarization of China and this type of thing.

These issues are coming to a head and I really think the issues that we've seen here and in the Middle East, these three major areas of the world, are moving forward by years if not a decade the question of whether or not the US dollar can remain as a reserve currency. This is going to have profound implications all around the world if we start to see this change continue the way it's been going and become more pronounced.

Mike: In terms of where the rubber meets the road so to speak, why should the average investor care about this and ultimately what should they be doing to protect themselves from a seemingly hopeless situation that is out of their personal control?

David: Probably most people in the country still don't see it as a big problem. They haven't looked into it too deeply and they're involved with other things. Inflation is relatively low even though it's much understated by the government, perhaps as much as two or three hundred percent because of the way they've changed the way in which it's accounted for over the years, but it's going to be a big change and the dollar now has been relatively strong the last few months, but still if you look at a 25-year chart, it still looks pretty sick.

If we start to see a change where less and less Petrodollars are being used for the trade globally, you're going to have a lot of these dollars coming back to this country, which is going to create an inflationary situation. It's going to cause interest rates to rise. It's going to cause a change in the standard of living of all of us in this country, and it's going to have profound effects and of course the question really I think it's when not if, because the subtle change that's been taking place is becoming more pronounced and it's something that really could happen quite rapidly.

In other words, people think I'll have five years to figure this out, but you know what? They might not. They might only have a very short time, maybe not enough time in order to make the changes that are necessary. I would suggest one of the biggest changes that they could make, if they've not already done so, would be to purchase physical precious metals, especially gold, silver, and to a slightly lesser extent, platinum and palladium because these metals are holding their value and they've been in a secular bull market for many years. They've been lower in price the last few years as a cyclical bear market, but that is looking like it's going to be changing fairly rapidly.
If we see the dollar coming under more pressure, you could have a very quick movement upside in these metals, perhaps before people get a chance to really get what they like and not only that, that demand against the relatively increasing demand worldwide and decreasing supply could create some real issues about people getting what they want, let alone paying the price that they'd like to get for it.

Mike: Anyone who follows financial markets, especially gold and silver or currencies, know from history that things can move very, very quickly when they do finally move, so it will be interesting to see how it all plays out. Turning to this week's column about some of the issues we're seeing out there in the mining industry, one thing I really liked about your piece is the thorough explanation of what it takes to actually bring an ounce of gold or silver to the market. Even with all the advancements in technology, it's becoming more and more costly to mine, isn't it?

David: It really is, and you know, Mike, I've been to probably several dozen mining sites in many parts of the globe over the last 10 to 12 years or so, and even the more I learn about it, the more I realize just how really amazing it is that the amount of gold and silver that's available where people can have a chance to hold some in their hand and put it away, if it's anything close to what we have and it's only due to the massive efforts on the part of these mines and miners around the world that we have anything at all because a lot of the gold and silver is hundreds if not thousands of feet below the ground.

Many of these deposits are in politically and socially unstable areas of the globe more and more so. Many of them are at high altitudes where there's questionable amounts of water to an infrastructure to process them and the grades that these different companies have been mining have been going down over the last decade or so. If you look over the last 10, 20 years, the grades of gold ore have declined by about 50%. In other words, they're getting half as much gold per ton on balance out of a ton of ore as they did a few years ago.
The cost for all the implications for doing that, the diesel fuel cost, the rubber tire cost, you name it, the taxing structure. Mexico had a recent big increase in taxing on all the miners. All of these things just make it more and more difficult and more unreliable to count on a certain amount of supply out there. It's David Morgan's view in The Morgan Report and it's my view and all of us that are following this that there's going to come in the relatively near future a collision between supply and demand.

When that happens, it's going to be something that I think is going to be pretty impressive and you're going to be a little on the depressed side if you're sitting there waiting to buy some gold and silver and it turns out either not to be available to you or at much higher prices than we see today.

Mike: As you alluded to, there's an environmental footprint that is inevitable in all mining activities and perhaps even more significant, a political impact. Unfortunately, there have been some recent accidents caused by carelessness, accidents that are going to have an impact on the industry as a whole and the production levels. Talk about what you're seeing there.

David: There really are and I've been speaking and writing about this over the last few weeks. We had just a few weeks ago, there was a major spill in British Columbia and it came from a tailings pond which ruptured and broke and there's still probably maybe a couple of billion gallons of semi-treated refuse from the mining process into a lake and several streams. It was really a high profile situation. I really don't know exactly how toxic it was, but even if it wasn't toxic at all because it is treated, to have that much sludge and whatnot being placed into streams and rivers is not a good thing for spawning fish or for people that live along these areas.
It was really bad timing on the part of this that had to happen because environmental groups are becoming more and more concerned about the mining process even though regulations today are much more strict than they were even five or ten years ago. Most of the places that we visit are very studious about trying to be the best possible stewards of the environment that they can, leaving a small footprint, which basically means leaving as little disruption as possible when they are mining. In fact, to open a mine today in most areas of the world, you have to post a bond of money that will enable you to restore that mine when you're done.

If it's 20 or 30 years out, that money is going to sit there so you have to take care of that. The restrictions are there, but no matter how many restrictions you have, you're going to have accidents. There's nothing that I can think of where humankind has been flawless in the execution of any kind of an activity. We balance out the risk and the possible danger that we saw there to the environment with the fact that as David Morgan has so famously said, "Everything that you and I eat, everything that you and I use is either grown or mined."
If we're going to have anything even close to a semblance of the modern life that we've come to depend on, we're going to have to continue mining and the question is how can we do this in a way that leaves as small a footprint as possible and contains, but does not eliminate the risk, because you just can't eliminate those.

Mike: I would think that given all of the scrutiny and hoops and costs that the mining industry now faces, we're going to be seeing growing repercussions on production costs and thus the prices of metals. Is that fair to assume?

David: I think it's almost a given. You're going to see more restrictions. You're going to see more players in making those decisions. There was a major decision in the Canadian Supreme Court just about a month ago giving the First Nations there, the indigenous people's basically right of refusal on any development on their tribal lands or historic hunting grounds or any kind of mining activity if it didn't meet their criteria.

This is one more lever that the mining companies exploration and production are going to have to make sure that they address successfully, not only to even develop a property which there's already a couple of them have been put on hold indefinitely, but to continue operating where productions have already been going on. It's just going to become more and more complicated, more problematic, and at The Morgan Report, we do annual analyses on what we think the amount of silver that's going to be produced each year is going to be and we try to take all these factors into consideration.

The things like you and I are talking about are really, really almost impossible to quantify in any way out very far. You combine this situation with the declining ore grades and for example, Peru this year in the last six months is down 400,000 ounces in gold production from where they were at this time last year. That's a pretty big dent. All of these things coming in really makes me become more and more concerned about just how much supply is going to be out there.

It does not take much of a tipping of demand from the players even in a couple of places in the world as David Morgan says, it's the demand on the margin, to really turn things around quickly and catch people that have been waiting to think that they can figure when that's going to be by surprise and leave them standing at the gate while the last train leaves without them.

Mike: The old adage about how shortages begat more shortages, that's something that we certainly could see come to fruition at some point here. Well David, before we let you go, we'd be remiss if we didn't get your take on what we're looking at here in the metals markets for the rest of the year and as we start to look towards 2015, are we nearing the end of the consolidation period finally or will it be more of the same?

David: I think we're in that end stage and it's been discouraging for people watching this even though we're in the slow part of the year now, we're moving into the next month, which is usually traditionally the strongest month for gold and silver prices. I think you're going to see a firming up and what the metals, especially silver, likes to do, people looks at the charts and it looks like it wants to go lower and it breaks support levels and then all of a sudden, it turns around and catches people off, surprising, you have the darn thing up a dollar or a dollar and a half a day on silver.

I think it's setting up for something like that again. I can't tell you that it's going to be tomorrow or a couple of weeks from now, but I think it will surprise all of us when it happens. When that finally takes places, if it does it on large volume and we see the mining stocks continue to strengthen, which they have been holding their ground pretty well lately, then I think you'll see that next leg going up and I think 2015 has the potential to be a very strong year in your metals. It will reward people that have had the patience either to hold on or to buy more and I think they will be rewarded for that kind of patience.

Mike: Great stuff as usual, David. Have a great weekend and we'll catch up with you again real soon.

David: You too, Mike. It's been great speaking with you.

Mike: For those who haven't yet signed up for The Morgan Report, we have a special offer for our Market Wrap Podcast listeners, the ability to get a no-risk trial of The Morgan Report newsletter plus free silver. For any listener that signs up for one of these refundable subscriptions today, we will ship you a 1-ounce Silver Eagle. The information in The Morgan Report is quite literally second to none among anyone investing in or just thinking about investing in the precious metals sector. To take advantage of this special deal, please look below today's podcast.

Before signing off, I want to encourage our listeners to keep their eyes peeled for a very important announcement from our company on Labor Day, Monday morning. That's all I can say right now other than I want to emphasize that you don't want to miss the news we plan to share with you.

Well that will do it for this week. Thanks again to David Smith. Check back next Friday for our next weekly Market Wrap Podcast. Thanks for listening and have a great holiday weekend everybody.

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