Did the silver bubble burst?

   on May 09 2011 1:46 PM

There are three reasons to believe that the silver bubble has burst.

From a price action perspective, what happened to silver last week was the classic burst-bubble pattern of a parabolic move up followed by a violent and swift decline.

Before 2011, silver climbed steadily. Starting in mid-January 2011, it surged 80 percent in just 14 weeks. Then, in the week of May 2 alone, it crashed 30 percent.

The margin requirement hikes of the silver market are another indication of a burst bubble. 

The margins determine how much you can borrow to buy silver futures – the lower the initial margin, the more you can borrow. Raising the margins of silver futures, in the microcosm of the silver financial market, is therefore similar to a central bank tightening monetary policy.

The CME has steadily raised the margins for silver financial futures from $5,000 in November 2010 to $21,600 last week.  In the process, they crashed the market.     

This is similar to the crashing of other bubbles caused by interest rate hikes, like the dot-com bubble and the subprime mortgage crisis. In all these cases, bubbles were fueled by excessive liquidity, i.e. the ability to borrow too cheaply. Once that liquidity is tightened, the bubble bursts. 

Moreover, because the liquidity is gone, an ensuing bear market takes place.

Still, many silver bulls remain unfazed.They admit that silver prices got ahead of fundamentals and a correction was overdue.  However, fundamentals – namely physical demand from Asia and the Federal Reserve’s loose monetary policy – remain firmly in silver’s favor in the long-term.

The crash of May 2, 2011, then, will just be a blip in silver’s long-term rally.

However, there is a counterargument to the bulls' case that points to the burst and demise of silver: the end of QE2 on June 30, 2011.  When that happens, the US dollar may strengthen and continue to rise in anticipation of an ensuing rate hike. Precious metals, therefore, will likely decline versus the dollar.

Federal Reserve Chairman Ben Bernanke recently noted that he is not inclined to roll out another round of QE. The most recent non-farm payrolls data also points to no further QE. 

June 30, then, may mark a significant turning point in the Fed’s monetary policy to the detriment of silver.

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