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A Shifty Federal Reserve Backs Away from Interest Rate Hikes

Fund Manager Frank Holmes on Gold, the Dollar, and Collapsing Gold/Silver Production

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

Coming up we’ll hear from CEO of US Global Investors, Frank Holmes. Frank tells us why the metals have been struggling, the prospects for a supply shortage developing, and what he sees ahead for the global economy and gold and silver. Don’t miss my interview with Frank Holmes, one of the most respected resource analysts in America… coming up in just a moment.

Well, as markets close out the month on this final day of July, investors will have the weekend to mull over the recent tumult. And what a tumultuous month it’s been for the precious metals.

This week’s market action has been less dramatic than in recent weeks. No midnight flash crashes or new price breakdowns. But institutional sellers in the futures markets are still ganging up on the bulls, trying to drive the monetary metals even lower. Insiders say hedge funds are more heavily positioned on the short side of the gold and silver futures markets than they’ve ever been. But that’s one of many signs that precious metals markets have reached an extreme that historically marks turning points.

Now we don’t want to get ahead of ourselves and call this a turning point. The bottom callers have all been proven wrong up to now by what some believe to be free market forces. We’ll only know in retrospect when the final bottom of this grueling downturn is in. However, one encouraging take away from this week’s market action is that silver once again held up better than gold.

Through Thursday’s close, gold showed a weekly decline of 1%. Silver came in essentially flat. As of this Friday morning the metals are trending higher so far today as we near the weekly close. Gold is down just a fraction of a percent now for the week to trade at $1,098 an ounce. Silver is up now by 1.3% thanks mostly to this morning’s modest advance to trade at $14.92.

Neither the metals nor most markets were much affected by the Federal Reserve’s announcement on Wednesday. There was no real suspense leading up to it or drama following it. Policymakers stood pat on interest rates as expected, while stoking investor expectations of a forthcoming rate hike.

Scott Gamm, The Street: The Federal Reserve wrapping up its two day policy meeting Wednesday, leaving short term interest rates unchanged, but it says that it'll be appropriate to raise rates when the Fed has seen some, "some improvement," in the labor market. For more analysis, Lindsey Piegza is here. She's the Chief Economist at Stifel Fixed Income. And Lindsey, “some improvement in the labor market,” what does that mean to you?

Lindsey Piegza: I think this reflects the fact that the Fed consistently lowers their bar of expectations. Now we know that the Fed has lowered their forecast for growth twice now this year, but they're no longer looking for robust further improvement. Now they're looking for some further improvement.

Will the Fed’s shifty language on the economy give Janet Yellen and company the rationale they’ll need to raise rates? Or will the economy prove to be too weak even by the Fed’s low standards? Investors will be weighing the economic data that comes out in August with an eye on how the Fed officials will interpret it for their September meeting.

The economic numbers continue to come in mixed. But careening stock markets in China and elsewhere overseas, plus plummeting commodity prices, are flashing warning signs of a potential recession on the way.

For the beleaguered mining industry, it’s been far worse than a mere cyclical downturn. It’s now more like a Great Depression. Mining giant Anglo American PLC recently announced it would lay off 53,000 employees. It’s all the miners can do at this point to stop the bleeding from operating losses. Whether it’s gold, silver, copper, platinum, or other metals, spot prices are below average all-in production costs – meaning few players in the industry can turn a profit at these levels. All they can do to survive this downturn is shrink – which means output will also shrink.

It will take years for the mining industry to repair itself. In the meantime, even if metals prices jump to levels that make mining profitable, new supply growth will not be immediately forthcoming. Mines that have been abandoned can’t simply be reopened overnight. And new mines can take years of planning, permitting, and capital investment before they actually go into production

From extreme cost-cutting in the mining industry, to extreme selling in the futures markets, to extremely high levels of retail demand for coins, the metals markets are being pushed and pulled from multiple sources. Something will break. And that something could be the lid on prices as physical demand begins to outstrip supply.

Demand for Gold Eagles exploded this month. Demand for Silver Eagles was so high, the U.S. Mint literally couldn’t keep up with it. Private wholesalers and mints, including the Sunshine Mint, ran out of capacity to meet demand for bullion products. Premiums on pre-1965 90% silver coins are up as they become difficult to come by. Some dealers are struggling to cope with these dynamics.

Here at Money Metals Exchange, we are seeing a surge in customer orders over the past 6 weeks. We still have availability of most popular bullion products, but we can’t guarantee future availability amidst these extreme market dynamics.

Something has to break. And if something has to break, then something will break. Whether next week or next year, a new trend will emerge from the currently overstretched and unsustainable market conditions.

Well now for more on the exciting action in the markets, as well as the state of the mining industry reeling from depressed spot prices, let’s get right to this week’s exclusive interview.

Mike Gleason: It is my privilege now to be joined by Frank Holmes, CEO and Chief Investment Officer at US Global Investors. In 2006 Mr. Holmes was named Mining Fund Manager of the year by the Mining Journal. He is the co-author of the book The Gold Watcher: Demystifying Gold Investing, and a frequent guest on CNBC, Bloomberg, and FOX Business. You can find his company as well as his Frank Talk Blog at USFunds.com.

Frank, welcome back. It's good to have you on and get your insights during what has been an extraordinary month in the precious metals markets. How are you?

Frank Holmes: I'm great and thanks Mike for giving me the opportunity to talk about global travels and markets with your listeners. I'm very proud of in addition to winning 24 Lipper awards for best of breed for emerging markets, funds, resource funds and gold funds in the past 15 years. We've also won 65 awards for education. So investors please feel free to go to USFunds.com and sign up for Frank Talk or Invest Alert and you can see the visuals and comments that we're going to make today, you can actually get the slide presentations on our website.

Mike Gleason Yeah it is great stuff there, I can certainly vouch for that. Well I know time is limited today so let's get right into it now. Lots of gold and silver investors entering the month were, had expectations of higher prices given that Greece had defaulted on its IMF loan, but despite all the turmoil in Europe and heavy selling in Chinese equities, the metals could not catch a bid in the futures market. Why do you think Safe Haven buying has failed to materialize?

Frank Holmes: Well I think it's been so much talked up that the US is going to raise interest rates. That's the great debate. When you look at the bond market, say the 10-year government bond, it says rates aren't going up in the fall. When you look at equities and the price of gold, it says no rates are going to go up. I think the bond market wins. I think the world is very different post 2008. The drivers for gold are both, I like to characterize as the “love trade” and the “fear trade.”

The “fear trade” dominates the psyche of North Americans. The two factors that drive that Fear Trade are money supply growth, and real interest rates. Whenever America has negative real interest rates, gold starts to rise in dollar terms. Whenever we have positive real rates of return, gold starts to decline. Positive real rates return makes gold decline, negative makes it rise. If you go back to 2011 at this time, we had negative real interest rates off 3% on a 10 year government bond. Now it's positive two percent. That's a big factor for the fear of trade, that gold is declined because gold at the fear trade is deemed as money.

Mike Gleason I can definitely say that the demand for physical coins and rounds and bars have been extraordinary this month. The US Mint was overwhelmed early in July and completely stopped taking orders for Silver Eagles, as many people know, and they report a huge increase in sales figures for Gold Eagles. Here at Money Metals Exchange we'll see nearly a double our previous all-time monthly high in terms of ounces sold. That's across products.

Frank Holmes: You know Mike, that's very fascinating because that means the wisdom of Crowds Model, where that person that votes, that person that saves and invests is buying gold when it falls on sale. Whereas, the rest of the world is playing a game of trading in and out. I think that was really dramatic to see that five tons of gold was dumped in the Shanghai Market in a two minute window. Knowing that the Japanese are on a holiday. It was not a normal market of buyers and a typical trading volume when they're there is 25 tons. So psychologically break the gold. I share this with your listeners because this happened 18 months ago, that there was a fat finger was characterized. Then as the Chicago Mercantile Exchange, I believe, did an investigation. They slapped some people's hands for having high frequency trading and flashing big sell orders to knock the price down.

What happens, it appears to me, at asymmetrical regulations. If we see gold get knocked down in a sort of aggressive way, then it's looked upon and frowned upon. It it's moved higher, moved up, then by alleged manipulation, then the regulators jump all over it.

It's very deflationary, that cycle of looking at capital markets.

Mike Gleason Yeah, traders have been selling relentlessly. There is a massive disconnect between the physical market and the futures market. What are your thoughts there? Do we have healthy markets and functioning price discovery or is something broken here?

Frank Holmes: I think price discovery is a big issue. It can be manipulated with the futures market. There's no doubt. But I will bet on the smart money, that is the wise person out there that is buying gold when it comes off at a discount. It's very refreshing. I'd also share with your listeners that's a very crowded trade. That is, short positions are the second all-time highest. There's a lot of people that put on short positions. I can see where it's being established. I've written about this many times. What's called global PMI.

PMI is Purchasing Manufacturers Index. It is forward looking. GDP are backwards looking. If you're trying to get an idea what's going to happen in the next six months, it's important to look at PMI. Because you canvass the purchasing manufacturers, and they're going to use a lot of energy to manufacture metal products. Usually there's strong demand for metal, and strong demand for energy, when the one month is above the three months, and they're both above the magic level of 50.

What happened two weeks ago, was the global PMI turned negative. Immediately oil dropped four dollars. That week the World Bank came out and said the global economy is going to slow down. You saw that all the commodities started to take it on the chin. Countries' currencies which are pgged to exporting oil, like the Canadian dollar, it started decline. Columbia, the Peso declined with that. That's another factor we've got to take a look at short term. So that guys that are established in a gold position in the futures market, and then they knock it to become self-fulfilling.

Mike Gleason I want to get more of your thoughts here on the inflation versus deflation debate, which is certainly getting more and more talk these days in the financial world. Right now it looks like investors are preparing for deflation. The dollar is moving higher and commodities are selling off. It seems to us that higher spot prices in the metals are probably going to have to come with some weakness in the US dollar. What do you see on the horizon that might derail this epic run in the dollar and then turn expectations back towards inflation again?

Frank Holmes: Durable goods. If you look at durable goods, which is looking back, they peaked last fall. If you looked at the US as a country alone, its Purchasing Manufacturers Index they call ISM, it peaked six months ago. That strong dollar started impacting America's ability to manufacture products and export. Industrial production reflects that. I think that's a real key factor that makes the Fed sensitive to raising rates. But where we've seen inflation, I see it as a businessperson, is in my regulatory costs. It just doesn't stop. I talk to other businesses, etc., and they're all commenting on different forms of fashions of regulatory cost. Major financial organizations are being treated with this thing called SIFI.

There's big inflation which you've got to pay for that. Then the processing paper to turn that around. We see that inflation. Legal bills for it have gone up every year, for the past five years. We see the audit bills have gone up dramatically. It's interesting that the commodity deflation we're seeing, and its particular energy, which will trickle into the economy. It takes about 12 months according to analyses, that you start to see the big boom for that ability to help the economy.

Mike Gleason Let's change gears here a bit and talk about the mining sector, an area you focus on a lot. We see various estimates with regards to average all in production costs for gold and silver. We know every project has its own economics and costs will vary wildly based on ore grade and a long list of other factors. But for many producers, current prices are below their cost of production… particularly when you include exploration costs associated costs associated with finding new deposits. Today's low prices are having an impact on production. How significant do you expect that to be moving forward?

Frank Holmes: I think that this is going to be the bottom trough year for mining companies where they're going to cut and slash everything they can to survive in this troubled market. I wrote about this when I was in, earlier this year, in South Africa speaking at the Indaba Conference. I was commenting that we're going to see throughout this year a trough year. Guess what? Anglo American laying off, restructuring. 53,000 jobs going to go, as they streamline. What that will do longer term is create a shortage of supply. The world's seven billion people out there will continue to have babies. Now they are all wired and hooked up and they all want the American Dream. So I think that there will be a snap up in commodities two years from now. I think commodities like gold, copper.

Interesting presentation, Mike, that was made. I thought it was a fascinating analysis by Macquarie. They went back over 15 years of data points and they said over a trillion dollars was invested in mining from 2001. Three hundred billion went into iron ore, and three hundred billion went into coal. Most of it metallurgical coal because you need metallurgical coal and iron ore to make steel. That's six hundred billion dollars that's gone into that. We have buckets of supply for iron ore prices, and for iron, and for met coal, and coal. Those commodities are going to be amply supplied for the next decade.

There was a lot less money spent on copper, a hundred and fifty billion. In gold a hundred and fifty billion. There's been no major discoveries. It's been basically going into existing reserves and creeping out the strike zones they have to have production. I think that a lot of these mines will be depleted. You're going to see Pac-man with mining companies buying other mining companies.

So I think that you're going to see that you know, want to have these good companies that have lots of reserves per share. They've passed through all the environmental feasibility studies. All they need is capital to go into production. There's very few, very few. They're going to get bought up. So that supply, still of these commodities for copper and gold and silver, they're actually going to shrink.

Mike Gleason Keith Neumeyer, CEO of First Majestic Silver, has had plenty to say about the Futures markets in a letter to the CFTC he expressed just outright disgust over what he sees as blatant manipulation of silver prices. He's also issued a call for other producers to withhold some their production. Now it doesn't appear his appeal is getting much traction though. Can you envision producers working together in this way at any sort of a broad or meaningful level?

Frank Holmes: No, I don't think so. I think one of the smartest investors out there, Rob McEwen, who I have great admiration and respect for, he had the highest quality gold mine. Goldcorp had the highest grade per ton of rock. It was unbelievable. When gold went from $200-300 and away to $400 he said "We're making so much money we're going to stop selling the gold because we think the gold is cheap. We think the gold is worth $800 dollars not $350." The other gold mining companies all thought he was crazy. He ended up being right. But from that example here's a very successful person. He banked the gold and the rest of the industry said no.

Mike Gleason Well as we begin to close here I wanted to get your take on what you think the Fed's likely to do coming up later this year. Obviously kicking the can down the road has been the plan of choice now for quite a while. Yesterday they came out and looks like they may delay those rate hikes even further. What are looking for there in terms of upcoming Fed policy?

Frank Holmes: I think the G20 was very different prior to 2008. Their real mandate was global trade. Dropping tariffs, streamlining process to move products, create jobs globally. Today it's regulations and taxation. They want synchronized global taxation and regulations. That means to do that, they have to keep interest rates low. Any spike in interest rates will derail any economy. Even Bernanke when he left and had to go and redo his mortgage, it was covered in the Wall Street Journal, it was complicated for him to be able to do that.

The world’s changed. I don't see them raising interest rates. A quick halt to economic turn that the US is enjoying right now on a relative basis. I see the IMF inspiring Japan to devalue their country's currency again to stimulate economic growth. I see Mexico's currency today is taking it on the chin. With that, I think you're going to see continuous currency devaluations. When you look at gold mining companies now, say out of Canada, lower oil price is a big cost to them. They're paying their people Canadian dollars, they're getting US dollars. Canadian gold companies are doing exceptionally well. We love Osisko Royalty as one of our key royalty companies. We love Franco-Nevada. So we think these companies would do well. We've advocated that a five percent in bullion and gold coins, or beautiful estate gold jewelry, and another five percent in gold stocks. Unhedged, high returns on capital gold stocks.

Mike Gleason Lastly here, the last time we had you on you were talking about the importance of re-balancing ones portfolio. Obviously the portfolio for the precious metals investor is looked kind of rough here the last couple of years. What do you have to say to the gold and silver investor who recognizes that something's not quite right in the world, yet they continue to see metals prices fall? What kind of advice would you have for them? Also what are you looking for going forward in the metals?

Frank Holmes: That's a great question. Thank you for giving me the opportunity to share that with your listeners. I've always advocate that ten percent of re balance each year because there's going to be imbalances with government policies. Monitoring fiscal levers. Gold performs exceptionally well when there's mismatch in the imbalance. Then that's put in context globally. I've also always said you should be long stocks and you should be long short term bonds. You should re balance those three categories each year. So your stock market done well. It had a great year last year. You're taking some of those profits and you're buying gold. You're buying some gold stocks. If you look at those royalty companies I've been recommending, even though they're off here they still have performed over gold indexes. It's a very high margin business. They are still in our portfolio, but we have to have many stocks for a diversified mutual fund. The reason why we like them is their high margin business.

Being long, re balancing, and we have a short term tax refund that's been up for 20 years every year. It's a five star. Only 25 out of 25,000 funds have been able to deliver 20 years of consistent performance. That's why we say you take some of that cash, which I do, and I re balance into gold. So my gold taking it on the chin this year, I will take some of the profits from over there in the income and from my capital markets and I'll average down on my gold.

Mike Gleason Wonderful insights as usual Frank. It was great talking to you again. We really appreciate your time and hope we can catch up with you down the road. Now before we let you go, tell our listeners a little about your firm and your services and also some info about the fantastic and renowned Frank Talk Blog.

Frank Holmes: Well thank you so much, you're so kind. I work hard at it with my wonderful team. What the thought process is that every week we print publish an investor alert, and we do a SWOT analysis. It's like in pro sports we look at the strengths and weaknesses that impacted the portfolios in gold. Last week it's always only three key factors of strength, three of weaknesses, and then we say what economic data points coming out next week. What could be an opportunity for gold. Or the stock market. Or a short term fixed income. Or it could be a threat to those in the short term so that life is about managing expectations. As Warren Buffet said, "If you want to have a long lasting marriage, have low expectations so everything is on the upside."

Mike Gleason Well great advice form him and from you there. Thanks a lot Frank, enjoy your weekend. I look forward to doing it again soon.

Frank Holmes: Alright, take care.

Mike Gleason Well that will do it for this week. Thanks again to Frank Holmes, CEO of US Global Investors. The site is USFunds.com and be sure to check out the previously mentioned Frank Talk Blog which you can find there at USFunds.com.

Check back here next Friday for our next weekly market wrap podcast. Until then this has been Mike Gleason with Money Metals Exchange. Thanks for listening, and have a great weekend everybody.

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