by Stefan Wieler, GoldMoney:
Silver price framework: Both money and a commodity
In this paper, we introduce a framework for understanding the formation of silver prices. Silver is both money (store of value) and an input commodity and thus the impact of both industrial and monetary demand need to be taken into consideration. We also introduce a silver price model that captures the relative price drivers under this framework, including the Goldmoney “energy proof of value” addition to the standard real-interest rate price model for precious metals. Silver prices are currently about 10% below predicted values, but more importantly, the model indicates that we are still near the bottom of this price cycle.
While market analysts, financial media, and commodity investors often regard silver as gold’s temperamental cousin, simply viewing silver as a more volatile version of gold fails to give the metal due consideration. Just as the physical properties of gold destined it to become an ideal store of value, silver’s properties make the metal special in its own right.
As explained in our Gold Price Framework, gold is not a flow commodity. Historical currency correlations and rate-driven volatility indicate that gold trades as a money stock; however, silver is special because it’s similarly well-suited to be money1 as well as an input commodity consumed in a variety of industrial processes.
Thus, silver prices are driven by monetary demand as well as supply and demand for industrial purposes, the latter of which is an important differentiator. Above ground gold stocks have always grown at the same pace as new gold is mined, dampening the effects of inventory-determined price volatility; however, silver stocks grew much more slowly as industrial demand absorbed a large part of what is mined.
These findings provide insight into the factors that drive silver prices:
1. Silver is, like gold, a commodity store of value and free of counterparty risk, with energy-intensive replacement costs setting the lower boundary for prices (the same energy proof of value that underlies gold prices). As such, silver should be impacted by the same monetary drivers as gold prices: real-interest rate expectations, central bank policy, and longer-dated energy prices.
2. As silver is a commodity with extensive industrial applications, changes in industrial drivers (i.e. changes in available inventories) should impact the price of the metal.
We find that that a large part of the changes in the price of silver can be explained in a regression analysis using just a few drivers: Gold prices, TIPS yields, and changes in silver ETF holdings (representing the monetary demand for silver) as well as U.S. industrial production and the ISM manufacturing PMI (the industrial demand for silver). Indeed, these drivers explain close to 80% of the year-over-year changes in silver prices in a multi-variate regression analysis.
Further, we find that the impact of changes in real-interest rates on silver prices is larger than on gold prices. We believe there are two reasons for this:
1. The value of global silver stocks is much smaller than that of global gold stocks, which is the result of silver being used in industrial applications, and thus a change in monetary demand for silver has a disproportionate effect.
2. Because much silver is mined as a by-product of non-silver mining operations, the silver cost curve has a discontinuous shape; base production is relatively cheap, but more costly “pure” silver projects need to become economically viable in order to meaningfully ramp up supply. Accordingly, when an increase in monetary demand leads to a shift on the cost curve, prices tend to increase disproportionately.
The model framework presented in this report should not be construed as a day-to- day trading tool. We aimed to demonstrate (and validate with our statistical analysis) that silver is both money and a commodity, and silver prices should therefore follow a certain behaviour. The silver price model we have developed confirms our hypothesis that silver tends to outperform gold when falling real interest rates create monetary demand for metals. 2016 was a textbook example: Real interest rates had peaked by the end of 2015 after the Fed’s first hike in December. Real interest rates then started to decline again as the market began to reassess the likelihood of further hikes. By the summer, real interest rates had again dropped into negative territory. This move in real-interest rates pushed gold prices higher, while silver prices moved nearly twice as much; however, the market began to price in that the Fed would likely only raise rates one more time, which meant that real-interest rates reversed. The election of President Trump led to a sharp upward move in real rates as the market was suddenly expecting higher economic growth. Gold prices were pushed lower again, and silver declined even more as a result. At the end of the year, gold was still up 8% and silver was up 15%. Going into 2017, the rally in nominal yields has stalled, though in inflation expectations have continued to move higher. This implies that real-interest rates have been moving lower – and as a result, gold prices have risen 5% while silver prices have increased 10%.
In addition to changes in monetary demand, changes in the economic cycle lead to shifts in industrial demand for silver (which overlays monetary demand).
As a result, while gold may be better-suited for steady long-term savings, silver can be more efficient for gaining exposure to changes in monetary policy, particularly around industrial cycles. Changes in central bank policies have a 1:1 impact on the price of gold over the long run, meaning that the loss in purchasing power of the base currency of measurement is offset by the price increase. Therefore, gold can maintain its purchasing power in the long term, something no at currency has ever been able to do throughout history.
When it comes to silver, changes in central bank policy act like a combustive agent on the price, making silver more efficient for someone with a view on the direction of policy-driven impact on currencies who aims for maximum exposure.
However, savers typically do not have (and do not want to have) a view on the “direction” of their money. What they seek is stability, meaning they want to protect their wealth and ensure that the purchasing power of their savings is the same over long periods of time. Gold and silver are the only monies that have ever reliably done so notwithstanding the historical, political, or economic context.
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