Was that sharp crack in the silver price yesterday the sound of an asset bubble bursting or just a necessary correction to a metal that has had a remarkable run?

For months there has been an escalating debate about whether the run-up in the silver price — it has more than doubled in the past six months and is up about 170% over the past year, far out-pacing the rise in the gold price — is driven by fundamentals or speculative activity. It recently reached its highest level in more than 30 years.

The immediate explanation for the 13% dive in the price, before a modest recovery, was Friday’s decision by CME Group (which owns the major US commodity exchanges) to increase the margin requirement on gold and silver positions by 50%, the latest in a succession of increases in the amount of cash required to be deposited against positions in the metals.

Subsequently the news of the killing of Osama bin Laden caused more turmoil in commodities markets, with gold, silver and oil affected, but that came after the decisive move.

Silver has been the subject of an aggressive war of words between silver bulls and bears, given the accelerating rate of its run-up and the extent to which it has out-performed gold in the past year.

Like gold, silver is regarded as a safe haven and a hedge against the vulnerability of fiat currencies and so there is has been an element of logic underpinning its run, even though it isn’t as dense a store of value as gold and is used as much for industrial purposes as it is as a form of currency.

The weakness of the US dollar and the extent of the US’s debt problems has provided an obvious reason for silver to be sought after, albeit perhaps not quite as desperately as it appears to have been.

An apparent lack of depth in the derivatives markets may, however, have helped exaggerate the increase, along with the emergence of exchange traded commodity funds that are required to hold the physical metal.

The conspiracy theorists have had more than one theory.

The biggest is that a couple of the big US investment banks had long held massive short positions in silver and were caught out when the price started to move, creating in effect a short squeeze that has forced them to try to cover their positions.

Another is that China has been buying precious metals to try to diversify away from its exposure to US Treasuries, and yet another that Chinese traders are replicating a strategy they adopted with copper and using imports and stockpiles of silver as a way of circumventing China’s restrictions on credit as it attempts to keep inflation under control. The traders can borrow against their commodity holdings.

At a more prosaic level, apart from the exchange-traded funds, there has been plenty of hedge fund and carry trade activity generally in all the key commodities, which may have helped fuel the price rise and that would unwind rapidly at the first hint of the price cracking.

In any event, there were fundamental and speculative reasons for the price to rise significantly. The question, unanswered and unanswerable at this moment, is whether the price has become too disconnected with the fundamentals and therefore whether the crack in the price represents the warning bell for something worse to come rather than an understandable correction within a bull run.

The safe haven issue hasn’t changed, despite Ben Bernanke’s disclosure last month that the US Federal Reserve Board has no plans for further quantitative easing.

He also said that rates would remain at their current extraordinarily low levels for an extended period, essentially signalling that while the Fed won’t be structurally expanding its balance sheet further neither is it about to start tightening monetary policy settings any time soon. The dollar is likely to remain weak and gold relatively strong in those circumstances.

If, however, the run-up in the silver price was grossly over-done and reflected more speculative activity than rational demand from those looking for refuge from debased currencies, the bears might be proven right and silver could be in for a trashing.

*This first appeared on Business Spectator.

Peter Fray

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