Here’s the news of the week – and how we see it here at McAlvany Wealth Management:
Blowing the Fed’s Decision Out of Proportion
In anticipation of the Fed’s open market committee meeting next week, the market has undergone a fair bit of posturing – not all of it favorable, depending on the asset in question (see the box scores). A slight majority of traders and economists are expecting the Fed to taper its $85 billion/month bond purchasing program based on the belief that the US economy is strong enough to thrive independent of the Fed. As US interest rates have risen uncontrollably, we’re not sure how anyone with as much as an economics 101 degree can come to that conclusion. Tapering, or any attempt to remove QE altogether, will do more to damage to the US financial system than if the Fed’s bond purchases remain intact for the time being.
This has not prevented the tapering theory from developing into an obsession among traders and economists (66% say Bernanke will taper). This applies to the gold market as well, where the notion has been discounted many times over (in low-volume trade), despite a noticeably weaker dollar this week. So far, there hasn’t been any unusual dumping of gold on the markets. Volumes have picked up by about 10% compared to the average in the last 30 days, but this isn’t saying much since the base volume over the last 30 days has been relatively low. This suggests that a repeat of April events is improbable and that the price action is reflective of exaggerated movements in a low-volume environment in front of the Fed’s decision next Wednesday. Stocks, on the other hand, historically sensitive to the idea of Fed tightening, haven’t budged from all-time high territory. So as far as Wall Street is concerned, Fed tapering is a joke.
As for bonds, the mainstream media have folks conditioned to believe that the sole reason we’re seeing higher rates is due to speculation on Fed tapering. However, an examination of the event timeline would show that rates were on the rise long before the press conference (in late June, 2012) in which Mr. Bernanke discussed tapering. A doubling of private sector leveraged loans (over 2012 levels, up 59.0% or $6.0 trillion since 2007), and an additional $1.0 trillion in public debt (now approaching $17.0 trillion), coupled with zero demand for long-dated debt instruments from our foreign counterparts (collectively net sellers now) are in fact the prime contributors to rising rates. So the tapering exercise may just be a smokescreen to obscure the real problem – that $736 billion (YTD in bond purchases) have been spent in a wasted effort to keep rates low on long-dated maturities. Ben will have some explaining to do, if he doesn’t manage to punt that debate past his retirement in January. In any case, it’s still fairly clear that the bond market will be even worse off without the Fed’s generous subsidies in place.
The markets will need to reconcile these and other inconsistencies in the coming weeks and months. One that is of particular importance to MWM investors is the schism between the growing global (including US) demand for gold and Wall Street’s persistent bashing of the metal. Goldman Sachs in particular has added to gold holdings for its clients while simultaneously reducing its price targets on gold in the near term – as it did this week.
Fed apprehensions aside, the US dollar has yet to fully embrace the Fed tapering hype, and fell below its 200-day moving average yet again this week. Weakness in either the dollar market or the bond market will be the final arbiter for the precious metals – and things are shaping up well in that regard. However, the markets will need to get past the noise surrounding the Fed’s decision next week for this to continue. Therefore, a decent-sized rebound in gold’s price following the Fed decision would not be surprising. We expect minor adjustments to policy, along with a qualifier that grants the Fed license to adjust, “as needed.” An excerpt from previous remarks in which the Fed indicated it would “add to and/or subtract from” QE depending on economic conditions is likely to be retained in its forthcoming statement. Outside of this, risks and evidence of another April-type episode have been greatly diminished (i.e. JP Morgan has exited its commodities business), but not entirely eliminated. An unprovoked spike in gold volumes would cause us to reassess the present conditions, and possibly our expectations.
VP Investment Management