Gold and silver prices have fallen considerably from their 2011 highs. Silver peaked at nearly $50 per ounce and now trades below $20. Gold topped out at about $1,900 anounce and is currently close to $1,200. Both metals are not only trading far below their peaks, but also their inflation-adjusted highs set in 1980 (Figures 1 and 2). This gives asense of the scale of their downside and upside potential.

At least five factors may have contributed to their decline:

1)  The steady recovery of the US economy has allowed the US Federal Reserve to end quantitative easing and begin considering rate hikes, possibly as soon as June.

2) The European Central Bank (ECB) has succeeded in containing the European debt crisis (at least excluding Greece) by promising to act as a buyer of last resort of the debt of Italy, Spain and other financially-challenged Eurozone countries, vastly reducing intra-European spreads.

3) The value of the US Dollar (USD), the currency of choice in the global commodities trade including gold and silver, has soared versus other currencies.

4) The prices of many other commodities including industrial metals, crude oil, natural gas and agricultural goods, have fallen in USD terms.

5) The crisis in the Middle East has not spread, at the moment, to the largest oil producing nations in the Persian Gulf.

Let’s look at how gold and silver prices might trend basedon these possible drivers of market returns.

Since 2009, the Fed has found itself in the unusual position of holding its policy rate (Fed Funds) below the rate of core inflation. This is something that has only occurred on a few occasions (Figure 3).

1)  1969-1970: Rates were lowered to fight a mild recession. The Nixon Administration attempted to contain inflation afterwards with wage and price controls.

2) 1974-1977: When the Fed mistakenly thought that inflation from the first oil crisis would be temporary. This resulted in a massive run up in inflation from 1977-1980 that was reined in by soaring interest rates and a deep recession.

3) Brief periods of slightly negative real rates in 1992- 1993 and 2001-2004 when the economy was healing from recession.

When the Fed holds Fed Funds below the rate of headline inflation, there is a tendency for gold and silver prices to soar (Figures 5 and 6).

The tendency appears to last until the market begins to anticipate that the Fed will hike rates or tighten policy (by ending quantitative easing, for example).

It is our view that the Fed is likely to begin tightening policy in 2015 for a variety of reasons:

1)  A strong recovery in the labor market, with average hourly earnings up by 2.0% year- over-year and average hours worked increasing 0.6%. This makes for a 2.6% gain in average earnings, comparing February 2015 to February 2014 – quite respectable given the low rate of inflation.

2) The number of people working rose by 2.4% between February 2014 and February 2015. This brings the increase in total labor income to 5.0% (2.4% more people working + 2.6% increase in average wages). This should make for robust consumer spending.

3) The Fed sees the recent energy-related dip in inflation as being temporary.

4) Other areas of the economy appear to be robust, including corporate profits near a record high and the housing market continuing to recover slowly. As such, we would not be surprised if the Fed increases rates as soon as this June. Fed Funds futures reflect a rate hike by September and a second one by January 2016 – with the possibility that such rate moves could come sooner.

If the Fed does raise rates as expected, it could pressure gold and silver prices. As such, we would not exclude the possibility of gold dipping below $1,000 per ounce into the triple digits, and silver making a run for below $10 per ounce.

There are risks to this forecast, however. Equity markets have been trading at valuations that look reasonable so long as corporate earnings hold up. If corporate earnings begin to decline in 2015, however, there is a real possibility that the equity market could have its first major correction since 2011. Two previous Fed chairmen, Alan Greenspan and Ben Bernanke, were known for lowering interest rates (or ramping up quantitative easing) in the face of equity market weakness – dubbed the Greenspan and Bernanke puts. Will there be a put by current Fed Chair Janet Yellen as well? We don’t know, but it’s hard to imagine that she and the FOMC would risk exacerbating market volatility by hiking rates in the middle of a steep downturn in stocks. As such, if an equity market correction happens, to the extent that it delays Fed rate hikes, it might give at least a temporary boost to gold and silver prices.

Bottom line, we think that US monetary policy holds more downside risks than upside potential for precious metals in 2015, but if the Fed delays rate hikes for any reason, it could be good for gold and silver.

While gold is denominated in US Dollars and therefore responds more strongly to changes in the Fed’s monetary policy than it does to actions by other central banks, the US isn’t the only game in town. On the other side of the Atlantic, it appears that the ECB’s gambit of promising to buy the debt of Italy, Spain and other financially-challenged Eurozone nations as a last resort has paid off.That promise, along with the announcement of a massive quantitative easing program, has pushed German yields close to zero, while Italian and Spanish yields have fallen below the yields on US Treasuries (Figure 7).

The easing of tensions in the Eurozone has been generally bad news for gold and silver. It eliminated the possibility of any imminent Eurozone break up to the disappointment of gold bugs who see the yellow metal as a store of value in times of inflation and uncertainty.

The good news for investors in precious metals is that the process of calming the European rate markets is probably nearing an end. Simply put, rates might not be able to fall much further. German yields are already negative, below the six year point on the curve, and BBB+ rated Italian debt and BBB rated Spanish debt pay less than AAA (composite) rated debt in the United States. Once the ECB begins its buying program, there is a risk that rates might back up a bit. This won’t necessarily help gold and silver but the harm to gold and silver long position holders from the calming of the situation in Europe over the past few years is almost certainly over.

Greece is the one exception. Its yields are still above 9% and Greece’s possible exit from the Eurozone monetary union, dubbed Grexit, could still happen later this year or in 2016. Even so, the impact of Greece’s withdrawal should be minor -- Europeans have already ring-fenced most of their private sector exposure to Greece, which constitutes less than 2% of the Eurozone economy.

Bottom line: We see Eurozone events as a net neutral for gold and silver going forward.