On Wednesday, the Federal Reserve released its long-awaited and much-anticipated decision on its federal funds target rate. As expected on Wall Street, the Fed chose to raise its federal funds target rate by 25 basis points to a new range of 1% to 1.25%, marking the third time in six months that the U.S. central bank has lifted interest rates, and the fourth time since December 2015. The Fed retained its longer-term target of a 3% federal funds target rate.
The Fed also laid out a plan to unwind its roughly $4.5 trillion balance sheet of Treasuries and mortgage-backed securities that it acquired during its numerous quantitative-easing measures following the Great Recession. Initially, the central bank plans to allow $6 billion in Treasury bonds and $4 billion in mortgage-backed securities (MBSes) to roll off its balance sheet on a monthly basis, with these caps raised every three months until they reach $30 billion for Treasury notes and $20 billion for MBSes a month. However, the Fed didn't indicate when the unwinding of its balance sheet would begin.
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The Fed's decision yields carnage among gold and silver stocks
The reaction in the market was swift, but it was especially harsh for gold and silver mining stocks. Every single gold and silver stock with a market cap of $200 million or higher fell during Wednesday's trading session. Physical gold and silver had been up as much as a respective 1.2% and 2.5% before the Fed decision but had careened to a loss of 0.6% and gain of just 0.1%, respectively, by the time the U.S. stock markets closed at 4 p.m. ET.
Why the carnage? To begin with, physical gold and silver have no dividend yield. This means that as the Fed raises its fed funds target rate and corresponding yields on interest-bearing assets rise, the opportunity cost of owning gold and silver, as opposed to a nearly guaranteed yielding asset, like a Treasury bond, increases.
Secondly, the Fed's outlining of its balance-sheet wind-down isn't good news for physical gold and silver prices. Since bond prices and bond yields have an inverse relationship, the Fed's selling Treasury bonds and driving down their price is expected to increase the yields on T-bonds. Once again, higher yields act as a deterrent to investing in gold since the opportunity cost of choosing gold or silver over a T-bond is on the rise.
Finally, the Fed's press release noted that inflation has declined in recent months and is trailing its longer-term 2% target rate. Inflation often acts as a counterbalance to rising interest rates and opportunity cost, meaning a low-inflation environment with rising rates is a worst-case scenario for gold and silver stocks.
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Relax: This isn't as big a deal as it seems
While the Fed's rate increase may have shaken gold and silver investors to the core, it's not as big a deal as it appears.
To begin with, the recent decline in inflation is probably going to be temporary. Expanding economies typically exhibit some degree of healthy inflation. For example, the U.S. central bank expands the monetary supply to meet growing demand for goods and services from consumers, thus making each currently circulating bill worth less, and making it more expensive to buy an ounce of gold or silver. Rising inflation has the ability to cancel out the negative affect of higher interest rates for physical gold and silver.
On the flipside, if inflation is falling, it could signal that economic activity isn't as robust as the Fed would like to see. That could slow or stall the pace of future interest-rate increases, as well as the Fed's balance-sheet unwinding. In effect, gold and silver can win either way.
Also, today's Fed decision does nothing to remove a number of global uncertainties. For instance, the recent elections in the U.K. have made Britain's exit from the European Union murkier than ever. We're also seeing plenty of safe-haven investing in the U.S., given the unconventional Trump presidency. The potential for conflict with another country aside, the Republicans' inability to pass healthcare and tax reform thus far suggests that economic growth may not be as robust as Trump had pledged during his presidential campaign. In other words, uncertainty begets opportunity for precious metals.
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Demand for precious metals could also be a surprising driver of spot prices. Don't forget that supply and demand still matter in the metals market despite the focus on opportunity costs, inflation, and uncertainty.
During the first quarter, the World Gold Council pointed to an 18% decline in gold demand. However, it must be remembered that gold demand hit a record in Q1 2016 amid the yellow metal's best quarter, in terms of spot-price appreciation, in 30 years. Remove this anomalous quarter and we'd see that gold demand is still quite strong, despite weaker demand from central banks. Investment demand grew by 9% year over year in Q1 2017, and jewelry demand was up marginally. Combine this steady demand with relatively tepid supply growth caused by lower capital expenditures from the miners themselves, and we have what looks to be a formula for higher long-term spot prices.
An industry of bargains
The end result is that the weakness in precious-metal stocks, along with the ongoing concern caused by the expectation of higher interest rates, has created a veritable sea of bargains amid the gold and silver stock industries.
Take Yamana Gold (AUY) as a good example. Since nearly touching $6 per share in mid-July 2016, shares of Yamana have shed 58% of their value. But take a closer look at its expected production and cost improvements over the next two to three years, and there's little reason to be pessimistic.
Next year, both the Cerro Moro and C1 Santa Luz mines should be coming online, with Cerro Moro expected to deliver an average of 150,000 ounces of gold and 7.2 million ounces of silver over its first three years, and C1 Santa Luz an average of 114,000 ounces of gold over its 10-year mine life. By 2019, the Suruca development in the Chapada mine should yield another 45,000 to 60,000 ounces of gold annually for about five years. The result is Yamana is expected to generate $0.27 in annual EPS by 2019 and $0.88 in cash flow per share, yet it's trading at a mere $2.51 per share. That's exceptionally cheap.
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Silver Standard Resources (NASDAQ: SSRI), which is a holding of mine, has also positioned itself for long-term success. Its acquisition of Claude Resources last year brought the low-cost, high ore-grade Seabee mine into its production portfolio, which compliments its Nevada-based Marigold mine well.
More recently, it worked out a joint venture with Golden Arrow Resources for the development of the Chinchillas Project. With open-pit mining having wound down at Silver Standard's San Miguel mine, this joint venture will provide a new, steady source of silver, once commissioned in 2018, for the next decade. If smart investors wait a year while Silver Standard and Golden Arrow ready the mine for production, they'll be rewarded with a company that could produce $1.38 in cash flow per share (CFPS) by 2020. With Silver Standard Resources near $9 a share and down more than a third from its 2016 high, and most mining stocks valued near 10 times their CFPS, it would appear to be inexpensive at its current levels.
Chances are you can find some great gold and silver stock deals if you're -- excuse the pun -- willing to dig around a bit. My suggestion would be to mostly ignore today's Fed rate increase and focus on the longer-term positives offered by gold and silver stocks.
