The Federal Reserve is about to raise the discount rate and the dollar will probably fall.
As the dollar falls, silver and gold will rally.
Silver tends to rally at greater magnitudes than gold and the gold to silver ratio is at a multi-year high.
The best reward per unit of risk will probably be found by shorting gold and buying silver.
The past 3 years have been quite brutal for holders of silver, with the average position down around 50%. In fact, over the past 4 years, silver has only increased on a year-over-year basis in 5 months!
With such a merciless sell-off many are doubtless tossing in the towel or considering exiting all remaining positions. While this is totally understandable, I believe selling now is a mistake. In fact, I think now is an excellent time to buy silver.
Recent changes in Federal Reserve policy indicate that in the very near future, the discount rate will be increased. The discount rate is the bedrock rate of the United States economy against which nearly all other interest rates are evaluated. When the Federal Reserve raises interest rates, ramifications are felt across the entire economy. Specifically, for the past 42 years, every timethe Federal Reserve has raised the discount rate following a lengthy period of low stability, the dollar falls at some point by 10-12% over the next 2 years.
The economic significance of this change is profound. As the dollar weakens, basic economic theory teaches that it will take a greater amount of dollars to purchase the same amount of silver – leading to a higher price of silver. I only tend to believe economic theory if it can be quantified and proven through data.
As you can see, economic theory is substantiated by reality – as the dollar falls, silver tends to rise. Over the past 42 years, every single time that the Federal Reserve has increased the discount rate, the dollar has declined by 10-12%. Historically, when the dollar falls by 10-12%, silver has risen by 40-60%. In other words, the data strongly suggests that it is time to buy silver.
The Gold Trade
Not only does the dollar suggest that silver is in for a strong gain, but also, the gold-to-silver ratio strongly suggests that we are at the end of a strong gold, weak silver cycle. You see, from a financial standpoint, gold and silver are very, very similar. Don’t believe me? Here’s the data.
Gold and silver returns have historically exhibited fairly strong correlation. In other words, if gold increases over a time period, silver increases as well – but only in direction, not necessarily in magnitude.
As you can see from the chart above, silver tends to experience stronger moves than gold, even though the direction is almost identical. I believe this is due to the heightened volatility associated with a less liquid instrument. A fund selling $1 billion of gold futures will not cause the same impact as selling $1 billion of silver futures – silver will move substantially more.
Since silver and gold are quite similar from a financial standpoint, we are afforded the ability to trade one instrument against the other.
We are at the cusp of an excellent investing opportunity. Over the past 4 years, silver has witnessed a 50% sell-off while gold has only experienced a sell-off around 30%. This has driven the ratio of the gold price to silver price to the highest level since 2008. Since gold and silver are similar financial assets, their prices will eventually revert to a mean. In other words, the current ratio of gold price to silver price is too high and will tighten. As you can see in the chart above, this type of opportunity only occurs every 5 years on average. And in each of the previous occasions, silver has historically rallied against gold over the next 3-4 years. For an investor seeking the maximum reward for risk taken, I believe shorting gold (NYSEARCA:GLD) and buying silver (NYSEARCA:SLV) represents an excellent investment.
Don’t get me wrong, I’m also bullish gold. I believe anyone purchasing either gold or silver is due for strong returns over the next 12-24 months. However, if you want to get the best Sharpe ratio, short gold, long silver is an excellent value proposition. Silver historically moves at greater magnitudes than gold, so as both gold and silver strengthen, the ratio of gold to silver will tighten.
Whichever way you decide to play it, the short of it is this – the Federal Reserve is increasing rates very soon. When rates rise, the dollar has fallen every single time. When the dollar falls, gold and silver rise.