A Melman Minute — January 18, 2011

When we look forward to the remainder of 2011 in terms of potential major influences on the precious metals, several important themes begin to appear and perhaps the most important of all is the general rise in power of Communist China in comparison with the United States of America. Since the USA has been the dominant economic and military power since the demise of the former Soviet Union, any change in that basic structure could have enormous and perhaps destabilizing implications.

There is an old saying which reads, "He who has the gold makes the rules" and over the past two decades it is China which has been accumulating both gold and unbacked, fiat currencies and it is China which is now putting the USA into the unwelcome position of being "Finlandized" to at least a moderate extent. For those not familiar with the term, it refers to the position of Finland relative to the position of its former much more powerful neighbor, the USSR. Although the USSR did not militarily occupy Finland nor take possession of its political workings, its strong position allowed it to exert a form of domination over its much weaker neighbor and the exercise of such domination by a much stronger nation over a weaker one came to be known as "Finlandization".

China now has obtained a position of advantage over the USA in three vital areas, and this is allowing it to begin exerting an ever-growing influence in internal American political and economic spheres. These three advantages include:

- Ownership of massive amounts of US government debt, the sudden sale of which could collapse the value of the American currency.

- Control of mineral resources, specifically including Rare Earth Elements, which are essential to the manufacture of military weaponry as well as an array of highly technical equipment and consumer goods.

- America's consumer-driven economy is now dependent upon a continuous and enormous inflow of low-cost imported items from China. This situation is made even more perilous because the USA no longer has the ability to manufacture many consumer items such as televisions, computers, clothing, footwear, etc. in the quantities necessary to supply ongoing demand.

The growth of Chinese confidence is now being demonstrated in two ways which we believe might have a substantial influence on the precious metals. In the first case, China is now clearly working toward having their Yuan become a dominant currency for international trade, a role once owned exclusively by the Greenback. In our opinion, any diminishment in the US Dollar's role as the reserve currency of the world could drive the precious metals considerably higher over time. An indication of this trend is Chinese President Hu Jintao's recent comment that the present US-dominated currency system was, "...a product of the past."

Secondly, China is now beginning to overtly display an enhanced military presence, one which could potentially reduce America's present dominance, in military terms, of this planet and we also believe such destabilization, if it occurs, could drive the precious metals higher as well. Among other moves in that direction, China has now unveiled a technologically-advanced Stealth fighter and they have initiated deployment of a new anti-ship ballistic missile capable of targeting US aircraft carriers in the Western Pacific.

Another battleground we see developing in many states of America as well as in several European nations is the conflict between those states and nations' efforts to control spending and impose austerity measures as opposed to the maintenance of tremendously generous arrangements between those governments and the various civil service unions which are loath to give up advantages gained at past bargaining tables.

Unfortunately for those civil service unions, reality is beating down hard upon them. Several European nations are now firmly on the road to either uncontrollable indebtedness or actual insolvency while in America, several states appear to be nearing the end of the road. California is facing a $20 billion deficit this year and has an estimated $500 billion shortfall in under-funding of public service benefits liabilities. In Illinois, the comparable figures are $15 billion in deficits and $208 under-funding while New York and New Jersey are also in similar straits.

The struggle between taxpayers and the benefit recipients seems likely to grow during the year and could perhaps even lead to possible state declarations of bankruptcy. We cannot help but believe that the precious metals would react positively to such developments.

Yet another area of growing concern for 2011 is the specter of growing visible price inflation in several nations, inflation which many are blaming on the United States. In order to support the US currency and maintain the present world economic structure, many nations have engaged in programs of US Dollar purchases. The negative side to that equation is they have done so by increasing the quantities of their home currencies and growing domestic inflation is now on the rise in economically important nations such as Brazil, Indonesia and India, among others.

The threat of rising inflation is also driven by stories of food price inflation which have dominated the world's press for several weeks.

Historically, the threat of rising inflation has been a prime mover for previous precious metals bull markets.

Given the above considerations as well as several others, the importance of keeping tabs on the value of the Greenback becomes clear to us and we are including a five-year chart on the US Dollar Index (DXY) with this Melman Minute. As can be seen, DXY is trading near the middle of a wide range between about 90 on the upside and 75 to the downside. We believe the eventual breakout from this range could be of great importance in our analysis of the precious metals.

As of 9:00 AM PST, financial markets in Canada and the USA are on the rise with the Dow Industrials ahead by about 60 points and the TSX Index has gained just short of 100. Precious metals are also higher with gold up about $9 to near $1,370 while silver has gained 64 cents to just under $29.00 per ounce. Base metals are modestly higher on balance; mining share indexes are up by about one percent; petroleum is close to unchanged and interest rates are moving to the upside. As noted, the US Dollar is lower in currency trading.

All quotes US$ unless otherwise noted.

Next Melman Minute scheduled for Wednesday, January 19, 2011

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