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Bernanke was Wrong!

Markets Misinterpret Bernanke's Statement

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All Federal Reserve Chairman Ben Bernanke said at last week’s FOMC press conference was that the Committee will soon be “letting up a bit on the gas pedal” in regards the Fed’s monthly bond purchases.

bernanke 1110Immediately, the passengers riding the markets from stocks to bonds to commodities started jumping out of their seats screaming, “The Fed is bailing out!”

The 10-year Treasury’s yield rose 20 basis points within minutes of last week’s press conference and a total of 50 basis points in just three trading days.

The S&P 500 index fell 5.45% and gold fell over 7% across that same short period. Since then, gold has continued falling for a total of 12.78% in just the past six trading days.

Several members of the Federal Reserve banking system have spoken out to ease the market’s jitters. They are telling everyone to just calm down and relax. Monetary accommodation is not going away.

In fact, some are saying accommodation could even pick-up. Wouldn’t that turn the gold rout on its head!

A Big Misunderstanding

What worries the Fed most is the bond market’s massive retreat and rising mortgage rates. Even before the bond market’s sell-off last week, yields have been on the rise for a year now. Banks have raised their mortgage rates from 3.9% to over 4.6%. And corporate speculative-grade bonds have jumped two percent in two months.

The Fed’s entire path of monetary policy has been built along keeping interest rates down, as the Fed’s latest June statement revealed:

“Taken together, these actions should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.”

The markets have been undoing everything the Fed has been trying to achieve! So Fed members came out to whip the markets back into alignment.

Jerome H. Powell, member of the Federal Reserve’s Board of Governors, stressed that “market adjustments since May have been larger than would be justified by any reasonable reassessment of the path of policy,” the New York Times quotes.

William C. Dudley, president of the Bank of New York and Vice-Chair of the FOMC (not to be confused with the Vice-Chair of the Federal Reserve Board of Governors, which post is occupied by Janet Yellen) emphasized, “A rise in short-term rates is very likely to be a long way off,” Reuters transcribed.

Using a smoking analogy, Federal Reserve Bank of Atlanta president Dennis P. Lockhart added, “It seems to me the [FOMC] chairman said we’ll use the patch - and use it flexibly - and some in the markets reacted as if he said ‘cold turkey,’” the New York Times cites.

Stimulus May Even Increase

That ‘flexibility’ has been in the FOMC’s statements for a few months already:

“The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.”

So what is the status of those two key drivers of Fed policy – employment and inflation? Both are far short of their targets for reducing stimulus, and they could even prompt the Fed to push the gas pedal right back down again.

Unemployment at 7.6% is much too high and not improving. “Not only will it likely take considerable time to reach the FOMC's 6.5 percent unemployment rate threshold,” Dudley expounded, “but also the FOMC could wait considerably longer before raising short-term rates.”

As for inflation, yesterday’s Core PCE index came in at just 1.1%, well below the Fed’s target of 2%. The Fed wants more inflation, and it will not stop stimulus until it gets it.

“Economic circumstances could diverge significantly from the FOMC's expectations,” Dudley continued. “If labor market conditions and the economy's growth momentum were to be less favorable than in the FOMC's outlook - and this is what has happened in recent years - I would expect that the asset purchases would continue at a higher pace for longer.”

Beneficiaries

So now that we have a clearer picture of the Fed’s intentions – really, the message had always been right there in front of us, if only market over-reactions didn’t confuse it – what will benefit from continued Fed stimulus consisting of a few more quarters of monthly bond purchases and a few more years of low interest rates?

Bonds, for starters. Many analysts have been calling the bond market’s sell-off overdone, including Jeffrey Gundlach, founder, CEO and CIO of investment management firm DoubleLine Capital LP, who last week predicted, “I think that what we are looking at is a bond market rally that’s going to start fairly quickly.”

Once traders realize how slight bond tapering will be, and that it may be postponed well past their September expectations, bonds’ wider yields should attract investments back in. Bond ETFs should as well, with more attractive NAV prices as of late.

Equities, too, should win here. Four years of ongoing stimulus has conditioned markets to follow the Fed’s lead more than economic reports. Bad economic news has become good trading news, strengthening the case for continued Fed assistance with each poor number that comes out. Bad unemployment number? No worries; keep buying. Low inflation? Not a problem; keep buying. The Fed has our ‘ass’ets covered.

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Gold May Shoot Skyward

But don’t leave gold off the list of beneficiaries. Fed stimulus has had a direct impact on the gold price since day one. As each Q.E. package was announced, gold soared. And with each whisper or announcement of Q.E. tapering, gold plunged. Should this time be any different?

In fact, given its recent meltdown, gold is likely to be the one asset that should respond the most favorably to Fed reassurances of continuing stimulus. Tocqueville Asset Management’s John Hathaway sees gold poised for a dramatic upward correction back to where it should have stayed all along.

Here are some highlights from his June 14th interview with GoldIRA Investments:

  • “I am focused on some very key markets. Japan obviously is making the headlines, but the U.S. stock market is also giving all of the appearances of being at the beginning stages of a substantial correction. I think we will see gold ignite in the second half of this year if not sooner.”
  • “I firmly believe we are reaching the point at which this notion that the central banks have everything under control … is going to be severely challenged as we go into the second half of this year.”
  • “Ultimately, this will … translate into a loss of confidence in paper currencies. My belief is this will happen much more quickly than anyone guesses.”
  • “It could be a grind in gold for a bit more time as rallies will be met with (paper) supply from people who still want to get out.”
  • “But … let’s not be surprised if this thing turns on a dime. That’s why when I read all of this technical stuff I firmly believe that it’s a big mistake … trying to market time an event which is ‘transformational’ in the capital markets.”
  • “You really have to focus on the big picture and … this enormous liquidity that’s been placed into the system … whether these central bankers can actually start withdrawing it. My firm answer is no… I just wonder if they can ever exit.”
  • “The idea that a person can wait for just the right moment for the markets to perceive that these public policies are bankrupt and hopeless, that’s a flash point that I don’t think anybody can predict.”
  • “The bottom line, and my message, is that investors have to be positioned, despite the pain, in order to capture the repricing of gold, which could be very, very sudden. And I’m not talking about $100. I’m talking about another $1,000 on the upside.”

Hathaway stresses, “investors have to be positioned, despite the pain”. Even portfolio managers insist on a 5 to 10% gold allocation in every portfolio, periodically rebalanced as the price changes. This rebalancing means buying a little more on the dips to restore that percentage allocation.

And remember 2008. Most of the price drop that year took place within the last few weeks of the correction. One year later, by December 2009, gold had reached a new all-time high.

Capitulation – we could be seeing it now. Who likes gold these days? No one. That’s a bullish sign. And with Fed stimulus to continue at least until 2015, the sun has not yet set on gold.

gld 2004-2013 6-28-13 small(Click to enlarge) Source: BigCharts.com

The chart above shows the SPDR Gold Trust (NYSE: GLD) since its inception in late 2004. The worst part of the 2008 correction occurred in its final few weeks (red circle; capitulation).

Also, in each of the last eight years, gold enjoyed a year-end rally (green lines), usually beginning the late 2nd or early 3rd quarter and usually extending into the 4th or following 1st quarter.

The chart below shows how the July-August months (blue arrows) figure prominently as the end of pull-backs and the start of rallies (click to enlarge):

gold pullback chart 6-28-13 smallSource: BigCharts.com

Joseph Cafariello

 

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