Thursday, May 5, 2011

Silver Nosedives. Is the CME Doing Better Than the Federal Reserve?

In the past week, silver has dropped more than 25% in price, from close to $50 to around $35 or so in overnight trading this evening (May 5-6, 2011). Other commodities have done their own recent swan dives, with oil falling about 10%, gold falling around 5% and copper 3%. These are big and very big price drops for a week's worth of trading. The plunge in the silver market is a crash, to be precise.

Silver prices began their swan dive after the CME (formerly known as the Chicago Mercantile Exchange or the "Merc") started to raise margin requirements on April 25, 2011. Since then, margin requirements have risen about 84%. In other words, contract holders who maintained just the minimum amount of margin required would have had to add 84 cents per dollar down to their accounts in order to avoid liquidation (and that's not counting losses from the market drop, which would have increased their margin requirements). Those contract holders who bought a while ago at much lower prices may still have enough equity in their accounts to avoid having to send in more cash or acceptable collateral. But contract holders who bought recently at or near the peak are likely to be facing margin calls and the potential loss of their holdings. The price swoon in the silver market indicates that a lot of players have been cleaned out of the poker game.

The CME apparently raised margin requirements in order to quell the speculative frenzy that more than doubled silver prices over the past year, with most of the increase in the past six months. By taking this action, the CME implicitly acknowledged that markets can be irrational, and that speculators can do stupid and potentially destructive things. By stopping the insanity now, before prices popped up to, say, $75 or $100 an ounce, the trading losses incurred by a return of prices to a not completely gonzo level may be relatively confined. This is very important, since limiting losses reduces the potential for systemic impact. Some gamblers may have lost their shirts. But as long as taxpayers don't have to lose theirs bailing out market insiders who risked so much as to become a systemic threat, things aren't so bad. Indeed, a stern woodshedding by the CME may be just the sort of character building experience that the wilder market players need to acquire an appropriate appreciation of the virtues of prudence. And, as the sell off spreads to other commodities, the growth in market wisdom may be well worth the short term losses sustained (as long as taxpayers aren't selected for service as bailers again).

Students of monetary theory will not avoid wondering if the Fed's easy money policies contributed to the speculative lunacy in commodities. After all, if you're one of the Wall Street pros who has access to the zero or near zero interest rates imposed by the Fed (retail credit card customers need not apply), borrowing cheaply and using your almost free money to speculate in commodities is a pretty obvious play. There aren't many other places for cash to go, so a little spark in this market could produce some nice price action. And the traditionally lax rules of leverage in the commodities market made speculation a breeze. Fed officials have acknowledged that they'd like money to move into risk assets. Indeed, they've admitted to hoping to foster consumer spending by boosting asset values in order to trigger a wealth effect. This is a most dangerous game, because if the Fed boosts asset values too far, too fast, it creates a bubble. And, as we know from repeated experience with tech stocks, real estate, and financial assets, bubbles eventually burst. If those bubbles get really big before they burst, taxpayer assets are seized by the government and turned over to the well-off and well-connected. Quite a few Americans seem to think this is bad policy.

The CME made the right move by popping the silver bubble before it became a hydra that would spawn numerous painful consequences in the financial markets. It's a shame the Fed has never had the gumption to pop an asset bubble before it rendered huge amounts of collateral damage. The Fed's rules of engagement seem to require massive casualties among innocent civilian and taxpaying bystanders before the central bank will intervene. Maybe there's no elegant economic proposition, statistically established to the 99% confidence level, that allows unequivocal identification of an asset bubble. But a little bit of common sense might go a long way.

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