Last week’s rally in gold and silver prices might well be short-lived, but it is a good sign that reality is starting to catch up to the paper gold and silver markets. The surge happened thanks to the good old fundamentals driving physical gold and silver.
Those fundamentals have been sidelined for far too long. Although there is very strong evidence of government manipulation of prices, the nature of futures trade has as much or more to do with the widening gap between the actual value of gold and silver and their current market prices.
Both parties in a futures trade must put up collateral to cover potential losses that is held by the exchange. The difference between the settlement price and current prices is called the margin, and the minimum required to enter a contract is set by the exchange.
The exchange moves assets from one party’s account to the other’s to account to balance out changes in daily prices. If an account falls below the established minimum the exchange issues a margin call requiring the account holder to add more assets to the account. When liquidity is as strained as it is today, it is often necessary to sell the contract instead, which drives prices even lower.
When prices are falling buyers buy short, betting that prices will continue to fall. In isolation that would create the self-fulfilling situation that the pro-currency camp bandies about as proof that gold and silver prices will keep dropping. What they neglect to consider, however, is the role of the underlying physical assets.
As we saw last week, new buying of physical gold and silver has changed the game. That erodes the supply of physical assets in the market, which are needed to accommodate the growing number of deliveries. Futures prices must rise to get that physical gold and silver back into the market, eventually bringing prices into balance with those dictated by the fundamentals of the physical market. If it should fail to do so, a reduction in supply become inevitable.
If too great a gap exists between current prices and the true value of physical gold and silver for very long, the profitability of new production falls dramatically. Low prices in the face of growing demand simply cannot be sustained in any functioning market, and will therefore eventually force producers to cut back on supply.
One way or another basic economics will see to it that prices get realigned with the true value of gold and silver .