The Fed may not have monetary conditions under control after all

The Fed may not have monetary conditions under control after all.

Uncertainty Around Fed Policy and Its Impact on Gold

During 2016, precious metals have carved out technically impressive, stepwise gains. Following strong advances through mid-March, gold and silver consolidated constructively during April and May. Then, after sharp June surges (spot gold +8.79 percent and spot silver +17.02 percent), precious metals once again consolidated in orderly, sidewise fashion during July. By month-end July, year-to-date gains for spot gold rested at 27.28 percent, and for spot silver at 46.75 percent.

As is always the case, recent gains for gold and silver have been driven by a complex array of fundamentals, including negative sovereign yields, collapsing expectations for Fed rate hikes, and investor concerns over faltering global economic performance. We would suggest, however, that one overarching development, to which each of these fundamentals is at least partially related, has been growing concern over the efficacy and credibility of global central bank policies. As it has been observed, the gold price is essentially the reciprocal of confidence in global central bankers. We believe that confidence may be facing significant challenge.

Given the U.S. dollar’s role as global reserve currency, and because gold is generally priced in dollars, no central bank’s policies are more impactful on gold prices than those of the Federal Reserve. Since the financial crisis erupted in 2008, investors have generally viewed Fed policy decisions with a “benefit of the doubt” lens. What we find troubling is that few have questioned why the Fed has been unable to normalize policy in recent years. We have maintained that the Fed cannot tighten meaningfully because it recognizes that it must provide a liquidity bridge to offset insufficient non-financial credit growth in the U.S. economy (an $18.2 trillion economy cannot effectively support total U.S. credit market debt of $64.2 trillion). 

In direct contrast, consensus has incorrectly predicted tightening of Fed policy for over six years! By way of perspective, it is instructive to revisit consensus Fed policy forecasts since 2010:

  • Throughout 2010, consensus projected outright Fed asset sales in late 2010 to unwind asset purchases of QE1. Instead, the Fed launched QE2 in November 2010.
  • Throughout 2011, consensus projected outright asset sales in 2012 to unwind QE2. Instead, in September 2011, the Fed conceded not only that outright sales were too dangerous, but also that even allowing MBS (mortgage-backed securities) to roll off naturally was too risky for financial markets. The Fed developed and launched Operation Twist.
  • Throughout 2012, consensus projected outright asset sales in 2013, to finally unwind QE1 and QE2. Instead, the Fed launched QE3, designed to gobble up MBS and Treasurys at roughly the rate of QE1 and QE2 combined.
  • Throughout 2013, debate over asset sales was replaced by debate over how and when the Fed might begin to taper the pace of additional QE3 asset purchases.
  • Throughout 2014, as QE3 purchases were ratcheted down at the rate of $5 billion-per-month, financial markets obsessed over the month of final taper.
  • Throughout 2015, financial markets turned to handicapping the month of rate liftoff (ultimately December 2015), and consensus coalesced around projections for four rate hikes during 2016.

After financial stress measures of all ilk exploded during January 2016, following the Fed’s December quarter-point rate increase, Fed officials immediately began backtracking on telegraphed 2016 rate increases. As we sit, in mid-August 2016, implied probabilities for the next quarter-point FOMC (Federal Open Market Committee) rate increase do not exceed 60 percent until the November 2017 meeting. After raising rates at 17 consecutive FOMC meetings between June 2004 and June 2006 (more than quintupling the fed funds rate from 1.0 to 5.25 percent), the Fed has now raised rates exactly one-quarter point over the span of 10 years. And it looks increasingly likely that market conditions and perceived financial stress will preclude even a second quarter-point increase for over a full year after the December 2015 “liftoff.” These are patently absurd parameters for responsible central banking.

Because consensus Fed projections have been so wrong for so long, we admit surprise that Fed participants have been able to maintain credibility in financial markets for as long as they have. However, we believe the juncture has arrived at which consensus is beginning to sense the Fed is truly “boxed in.” On the one hand, by the progressively debilitating effects of ZIRP (zero interest rate policy) on capex, productivity, economic growth, pension solvency and the incentive for savings, and on the other hand, by the fact that $64 trillion of U.S. credit market debt still obscures tens of trillions of dollars worth of mal-invested capital, destined to default at first signs of monetary tightening.

We would offer two final observations about the monetary, economic and financial pickle in which the Fed now finds itself. First, important measures of U.S. economic performance generally rest today below levels at which the Fed felt compelled to launch QE2 and QE3.  (Even improvement in the unemployment rate appears a bit pyrrhic in light of a plummeting labor participation rate.) What is so different about 2016 that will permit the Fed to raise rates when they have felt unable to do so amid more robust economic conditions in recent years?

Second, we believe the final tapering of QE3 in November 2014 has bred false perceptions about the Fed’s confidence in prevailing financial market liquidity. Financial media and market participants give little consideration to ongoing Fed purchases of Treasurys and MBS designed to maintain the aggregate size of the Fed’s balance sheet (as maturing assets roll off). Cornerstone’s Roberto Perli calculates that year-to-date (8/12) Fed Treasury purchases under the reinvestment program total $149.6 billion, and year-to-date Fed MBS purchases total $214.03 billion. Wow! Does anyone really believe the Fed is about to tighten significantly when they still feel compelled to purchase over $48 billion worth of Treasurys and MBS each and every month?

In short, we believe gold’s consistent performance during 2016 reflects, at least in part, growing concern that the Fed may not have monetary and financial conditions as “under control” as perceived by consensus. Given the tiny stock of investable gold versus the burgeoning stock of U.S. financial assets, any recalibration between the two, motivated by declining confidence in central bank policies, could prove explosive for precious metal prices in coming months. Stay tuned!

Trey Reik is a senior portfolio manager and precious metals strategist at Sprott Asset Management USA. Trey authors the firm’s Precious Metals Watch, a monthly newsletter produced by Sprott Asset Management LP.

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