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Metals Still Carry Weight and May Even Point to Bond Rally

The strong metals market reflects economy, not inflation.

Gold and silver. The very words are synonymous with wealth, power, elegance and an ability to attract divorce lawyers' attention in a property settlement. And because they cannot be debauched by reckless governments and always will be accepted by border guards, coins of precious pedigree have been considered safe havens in times of inflation and political turmoil.

The last 20 years, however, have not been kind to metals speculators because inflation from 1970s levels has been tamed and a wealth of other trading vehicles with which we can express our opinions has emerged.

The inexorable truth for any product not consumed -- and gold, for all the lust associated with it, is one of the least intrinsically useful metals around -- is that its nominal price should rise only when the expected rate of inflation exceeds the expected cost of holding it.

In our excitement over the New Economy, though, it is important to remember that the Old Economy still swings a pretty big stick, and many of these sticks use base metals or precious metal catalysts in their manufacturing process. Nearly one-fifth of the goods produced in the world today depend on platinum or palladium catalysts. Steel may dull, but we use an awful lot of it, and many basic and all stainless steels contain nickel.

These are reasons enough to pay attention to the way commodities are trading these days. What's more telling, perhaps, is that the confluence of events in the metals market may point to a bond rally in the offing.

From Russia With Love

Russia, one of four countries that dominate the production of many precious and industrial metals, is to industrial metals what the

Organization of Petroleum Exporting Countries

is to oil. After the fall of communism, the Empire Formerly Known as Evil flooded the world with aluminum ingot in order to raise hard currency.

Who's Precious Now?
Relative metal prices since the Russian default

Source: Bloomberg

The price collapse lasted to late 1993, and made



an underperforming stock. A later price collapse associated with the Asian and Russian crises of 1997-1998 hurt Alcoa as well, and it wasn't until an apparent bottom in aluminum in early 1999 that Alcoa took off and became the best-performing stock in the

Dow Jones Industrial Average

for the year as a whole.

The recent drop in Alcoa's relative performance in light of firmer aluminum prices may be signaling an emerging slowdown in industrial demand as higher interest rates start to bite.

Alcoa Anxiety?
The stock's recent slip may signal a slowdown in aluminum demand

Source: Bloomberg

Buddy, Can You Spare a Nickel?

Every time gold hiccups, it makes the financial headlines, but the price is still nowhere. Nickel, on the other hand, has been trading like As Russia's capital-strapped mining and transport sectors struggle to keep up with world demand, the prices of platinum, palladium and nickel have been soaring. Nickel is more than twice as valuable as it was just prior to the Russian default, and palladium is 70% higher.

Financial markets are continuously paranoid over inflation. The European central banks announced suspension of their gold selling in September 1999.

Placer Dome


recently announced it would stop selling gold forward.

Warren Buffett

still has, to the best of anyone's knowledge, the huge silver position he acquired in 1997 (this guy probably sits in Omaha and gets nagged: "Waarrrenn! You should have bought palladium!").

So how come the action is in the base metals?

The answer, quite simply, is that strong economic growth and increasing inflationary pressures are two very different things. If inflationary expectations were in fact increasing, two observations on market spreads would be true: First, the spread between 30-year and one-year Treasury yields would be increasing, and increasing as a percentage of one-year yields; second, the spread between platinum and gold would be stable or falling, and falling as a percentage of gold prices.

Neither is the case. The Treasury yield curve is in the process of inverting at higher one-year rates as the Fed tightens credit. And the platinum-gold spread is moving strongly in favor of platinum at a flat gold price as industrial demand surges.

Fed Fights Inflation, Platinum Whomps Gold


While we can credit all sorts of special factors to both of these spreads -- the supply uncertainties of long Treasury bonds and Russian production and shipping disruptions -- we come back to one simple reality: Inflation is too much money chasing too few goods. The Treasury spread tells us we are producing less money, and the platinum-gold spread tells us we are producing more goods.

It won't happen tomorrow, or even next week or next month, but this confluence of factors is setting us up for a pretty good bond market once again.

And if November 1994 is any indication, when the bond reversal comes, it will come quickly and powerfully. Hop on board, you'll love the ride.

Howard L. Simons is a professor of finance at the Illinois Institute of Technology, a trading consultant and the author of The Dynamic Option Selection System (John Wiley & Sons, 1999). Under no circumstances does the information in this column represent a recommendation to buy or sell securities. While Simons cannot provide investment advice or recommendations, he invites your feedback at