When a pendulum swings, it does not go from one side to dead vertical, stop and then return. It moves all the way to the other side of an arc, adjusted for the effects of friction.

Many traders feel as if they should duplicate one of these behaviors. There is an extreme compulsion to alternate positions, to always follow a long position with a short position, and to always stay on one side of the market as a permabull or a permabear.

Silver has brought out both of these tendencies in me, and at different times. But as we shall see below, temptation can be resisted. The metal's meteoric rise during the Hunt brothers' ill-fated attempt to corner the market in 1979-80 and its subsequent fall into more than 20 years of torpor produced a bad association for many traders.

Like pork bellies, which recently were at an all-time high in nominal dollars, silver was something for which commodity analysts always found themselves on the defensive: "You deal with that?" In the pre-Internet days, it symbolized price totally unrelated to economic value, and it was associated with the worst peacetime inflation in American history.

One Brief Shining Moment
Source: CRB-Infotech

No Gold Medal for Silver Yet

Unlike gold, with which it is forever and perhaps improperly associated, silver is an industrial metal as well as a store of value. Its principal use, photographic film, is in what appears to be an irreversible decline relative to digital image capture, so much so that the editors of Dow Jones found no reason to keep Eastman Kodak ( EK) in its Industrial Average.

I turned bullish on gold in March 2001 for monetary reasons, with the federal funds rate then at 5%. I figured that further rate cuts would both weaken the dollar and raise expected inflation relative to the financial costs of holding gold. However, I withheld a bullish call on silver on the basis that industrial fabrication, chiefly for electronics, would not rise until the economy improved.

That bullish call came in January 2002 and was apologized for in September 2002 . The bullish call was not followed by a bearish call, but I did not want to stay on the long side of the equation without evidence that it was the right place to be.

By August 2003 , I was talking up the gold/silver ratio, here defined as the bullion price of gold divided by the bullion price of silver, both expressed in dollars per ounce, on the grounds that inflation would be rising and that silver production would be rising as copper and lead-zinc production increased.

Monetary Metals and Monetary Policy

The gold/silver ratio, which had peaked over 80 in June 2003, stayed in the mid-70s until October. Then it began a break that has carried it down below 52 even as commodity prices in general rallied, the dollar weakened and the spread between TIPS (Treasury inflation-protected securities) and normal Treasury bonds grew.

Something was amiss: If gold is better than silver as a barometer of inflation, and if inflation chatter is back on the airwaves, then shouldn't gold be firming relative to silver instead of engaging in one of the sharpest drops in three decades?

Markets should anticipate changes in policy as well as react to past data, a statement that occasionally seems ludicrous following a major government report, or before a major government report, depending on when you get the information. Here the gold/silver ratio may be anticipating the long-awaited flattening of the yield curve with a clarity and a consistency that has eluded many economists in the past year.

Gold/Silver Ratio and Monetary Policy
If the gold/silver ratio continues to rise, the yield curve will be flattening by the end of the year.
Source: CRB-Infotech

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