Silver’s Volatility Is Highly Bearish

Will investors’ nerves get the best of them as the hawkish temperature rises?

Despite little economic news, the silver futures price traded within a nearly 6% range on Jan. 23; and while the white metal was saved by its 50-day moving average, its unprompted volatility should concern the bulls. 

In addition, with silver seemingly forming a peak, while the USD Index attempts to form a bottom, a sharp shift should unfold sooner rather than later.

Please see below:

To explain, while the euro is immensely popular, the fundamentals do not support the bulls’ optimism. Moreover, Goldman Sachs expects the EUR/USD to sink to 1.02 in the months ahead, and a realization is profoundly bullish for the USD Index.

Remember, the EUR/USD accounts for nearly 58% of the dollar basket’s movement, so its behavior is material; and while the crowd thinks otherwise, the Fed should still out-hawk the ECB over the medium term.

Analysts at Danske Bank wrote on Jan. 17:

“We still pencil in Fed hiking policy rates above 5.0% in Q1 and think the inversion embedded into the U.S. curve for H2 2023 is overdone. Markets still price in c. 150bp more of ECB rate hikes, which is more than our base case, although we acknowledge the risk of ECB delivering more. In our view, continued tightening must ensure a re-tightening of financial conditions.

“EUR/USD remains overvalued on a 1-3Y horizon and unless we see global growth persistently accelerate, risks are eventually skewed towards a setback. We lift our profile but still pencil in a lower cross on 3-12M, forecasting the cross at 1.03 in 12M.”

Thus, while bearish bets on the EUR/USD are out-of-consensus once again, we were in the same position in 2021 when the crowd assumed the EUR/USD would hit 1.30; and with a similar setup present now, it’s likely only a matter of time before reality re-emerges.

Please see below:

Source: Commitments of Traders (COT) report

To explain, the blue line above tracks the net EUR/USD positioning of non-commercial (speculative) futures traders. If you analyze the horizontal black line, you can see that the crowd is extremely bullish on the currency pair, as their net-long positions are near the top of the ~10-year range.

However, if you focus your attention on the red circles, you can see that crowded positioning made lower highs in 2020/2021 before the EUR/USD collapsed. Likewise, you can also see how the crowd turned prematurely bullish in early 2022 when they assumed the Fed would pivot.

Therefore, please remember that positioning is contrarian, and outcomes rarely align with consensus expectations; and with the consensus overwhelmingly bullish on the EUR/USD, we expect another positioning unwind to help propel the USD Index to new highs later in 2023. 

On top of that, while the physical silver market has rewarded the bulls in recent years, the futures market trades much differently; and with silver’s drawdowns often occurring alongside S&P 500 sell-offs, a deep dive by the latter could sink the former. 

For example, the silver price made its 2022 lows with the S&P 500 in September and October; and with Morgan Stanley’s Chief U.S. Equity Strategist Mike Wilson sounding the bearish alarm on Jan. 22, he “welcome[s] the sentiment and positioning [shift] over the past few weeks.” He wrote:

“The final stages of the bear market are always the trickiest, and we have been on high alert for such head fakes…. Suffice it to say, we're not biting on this recent rally because our work and process are so convincingly bearish on earnings.”

He noted that the difference between his and Wall Street’s 2023 S&P 500 earnings expectation is “as wide as it’s ever been,” and “The last two times our model was this far below consensus, the S&P 500 fell by 34% and 49%.”

Please see below:

To explain, the blue line above tracks the YoY percentage change in 12-month realized S&P 500 earnings per share (EPS), while the brown dashed line above tracks the 12-month forward YoY EPS change implied by Morgan Stanley’s model.

If you analyze the relationship, you can see that the pair have largely followed in each other’s footsteps. More importantly, the large gap on the right side of the chart shows that Wilson expects a YoY earnings decline (> 20%) that rivals the GFC (the lowest point of the blue line). As a result, if his prediction proves prescient, the silver price should suffer mightily as the drama unfolds. 

Overall, $24 has been silver’s kryptonite, and the white meal briefly fell below $23 on Jan. 23; and while the debt ceiling drama could create more volatility, silver’ recent behavior is an ominous sign for the precious metals market. Consequently, we remain sellers at these inflated levels. 

How will the euro fare over the next few months? Will an S&P 500 sell-off help propel the USD Index higher, or is Wilson wrong? Why is silver so reluctant to hold $24? 

Alex Demolitor
Precious Metals Strategist