Silver has once again stolen the investment market spotlight. Margin requirements for silver trading rose 84 percent last week, which prompted a major sell-off. Silver posted its worst four-day drop since 1980 and was down more than 25% after the CME Group raised the costs for investors to trade the metal four consecutive times within a week.
The impact of these rather drastic increases in margin requirements was decidedly negative on trader psychology. Last weekend when the latest margin increase was announced, one analyst observed, “Many commodities traders in the US cannot trade on the weekend, and when Chicago opens many will instantly be hit with margin calls because of the immediate rise in margin requirements.” The selling pressure was immediately felt on Monday, May 2, at the commencement of trading with selling pressure spilling over into the subsequent trading sessions.
The weakness in silver spilled over into other commodities, including crude oil, which declined almost 10% on Thursday, May 5. Among the many issues the sell-off has provoked, the idea that inflation has made its return is being questioned.
The silver sell-off was by no means a “normal” correction; it could be called a policy-driven crash and it did significant damage to the silver uptrend. While a bottom can occur at any time – the market is certainly “oversold” enough from an immediate-term technical standpoint – it’s questionable that a full retracement of the recent crash will occur quickly. Even if CME Group reverses its policy decision and significantly lowers margins in the coming days (not likely), the psychological damage to silver isn’t likely to be healed so quickly. Traders and investors are spooked and they have good reason for questioning the soundness of the exchange group’s policy decisions as well as its motives.
Some questions should be asked of the CME Group in the wake of last week’s happenings. If CME Group was truly concerned with a silver bubble, why then did it not raise margin requirements on the metal shortly after the commencement of the Fed’s second quantitative easing program (QE2) when it was obvious that the increased monetary liquidity would lead to increased commodity speculation? Why wait until after silver has had a meteoric and is at an all-time high before delivering the hammer blow of not one, but four consecutive margin requirements increases? The CME Group surely knew what the outcome of their decision would be on the silver price.
It’s hard to argue with the basic logic behind CME Group’s decision to raise margins, though. There can be no denying that speculative bubbles are impossible without the significant use of leverage, which is normally accompanied by low margin requirements. This makes it easier for speculators to load up on a commodity trading position with a smaller outlay of capital. What’s questionable in this case is the timing of CME’s decision to raise silver margins. Suffice it to say the CME’s policy decision would have been timely had it been executed a few weeks ago.
What made the recent CME policy debacle even more intriguing is the myriad of demands for a margin requirement increase from financial commentators in the days immediately preceding the event. In an article appearing in the BusinessInsider.com web site datelined May 1, the writer argued that CME should raise margin requirements by 30%, otherwise silver would be setting up for a “record-setting crash, which could impact many other markets in the process of correcting, especially other commodities like Gold and Crude Oil.” The writer went on to say, “We are not talking about a 5% correction setting up at these levels for silver, we are talking in terms of a 20% down day that poses a contagion effect to markets in general.”
It gets better. He further wrote, “As the very real possibility of a 20% two-day correction is moving towards becoming a very real probability, it could bring down a lot of other markets in the process. Remember, we had the flash crash around this time last year? Well, if the Silver market isn’t cooled off [by raising margin requirements], it could potentially be one of the catalysts for another broad flash crash this year.”
How prophetic! Unfortunately, the author didn’t foresee that the very policy he was advocating would in fact lead to the outcome he feared the most, namely a commodities crash. Sometimes, the “cure” is worse than the disease.
Meanwhile the iShares Silver ETF (SLV), our silver proxy, ended up closing at its 90-day moving average on Thursday, May 5. In “normal” market conditions we could expect the SLV to react to the 90-day MA, which we use to identify the market’s dominant interim bias. Often the 90-day MA will act as a strong support and can even reverse a decline. Ultimately, though, the only cure for a sell-off of this magnitude is for the fear of market participants to exhaust itself. This fear appears to have been exhausted on a short-term basis and if silver can establish support above the 90-day MA in the next couple of days we’ll have a good indication of a market bottom.
There are two major lessons that can be learned from the recent silver crash. One is that policy, no matter how well intentioned, can have profound negative consequences on the market. The other lesson is that markets are hyper-sensitive to abrupt changes in policy given where we are in the long-term deflationary cycle. The Federal Reserve has had a relatively easy going in rejuvenating the financial market with its loose money policy in the last year due partly to the fact that the last of the long-term cycles, namely the 6-year cycle, is still up. The 6-year cycle is due to peak this October, after which time the Fed will likely have its work cut out for it in terms of artificially sustaining the inflationary trend in both stock and commodity prices. Once the 6-year cycle has peaked there will be no long-term cycle of consequence (beyond the 4-year cycle) up until after 2014.
Viewed from the standpoint of the yearly cycles, the “flash crash” of last May and the late silver crash could be viewed as a “shot across the bow” warning for the coming arrival of deflation once the final long-term cycle peaks. The ranks of the deflationist camp have bee noticeably thinned in recent months as commodity prices soared and most commentators resigned themselves to the belief that hyper-inflation would be the dominant them in the coming years.
Before we arrive at that path, however, deflation must finish its work before the 120-year cycle bottoms in 2014. The early stages of the final deflationary (or de-leveraging) process commenced in 2007-08 with the credit crisis. We should see signs of the re-emergence of deflation in 2012 with the years 2013 and 2014 being severely deflationary. The next few months should be used by individuals to de-leverage in advance of the Kress Cycle Tsunami.
