Easing Stimulus and Gold Prices

Like a tugboat pushing a little here and pulling a little there, the Federal Reserve’s job is to guide the juggernaut that is the U.S. economy through shallow waters, doing its best to keep the American economy moving forward without running aground.

Though the tugboat captain Ben Bernanke is very vocal on his radio, always making the tug’s intentions and moves known, waiting six long weeks between FOMC meetings for Captain Ben’s updates is excruciating for news-starved traders and investors.

While we wait for their next meeting of June 18-19, then, let’s satiate our thirst for insight into the Fed’s possible next moves by checking in with an officer of the crew, San Francisco Federal Reserve Bank President John Williams.

Although Williams is not a voting FOMC member this year, he is an active participant in the committee’s discussions and can have valuable insights for us.

Williams Anticipates Tightening Soon

Speaking at a luncheon sponsored by the Portland Business Journal last week, Williams made clear that an outright end to the Federal Reserve’s easy money policy of near-zero interest rates and monthly bond purchases is not a done deal.

“It will take further [economic] gains to convince me that the ‘substantial improvement’ test for ending our asset purchases has been met,” Reuters quotes him.

However, he does believe that should economic reports continue to be as positive as they have been for the most part over the past 2 or 3 months, slight reductions in Fed stimulus could be forthcoming – and soon.

Williams anticipates quicker-than-expected U.S. GDP growth of 2.5% for this year and 3.25% for the next.  Though he does anticipate a slight rise in inflation, he expects it to remain easily manageable at about 1%, half of the Fed’s 2% target.

After noting what he called the “considerably” better employment picture, Williams concluded that the Federal Reserve “could reduce somewhat the pace of our securities purchases, perhaps as early as this summer.”  “Then, if all goes as hoped, we could end the purchase program sometime late this year.” – Reuters.

Two Separate Stimuli

Hurting Williams’ anticipation of a beginning of the end of Fed stimulus is his own expectation of unemployment finishing this year at slightly below 7.5% and ending 2014 at just under 7%.  This is pretty much where the U.S. unemployment number is now, implying no substantial improvement in jobs growth for the next 1.5 years.

Yet the latest FOMC statement released at the end of its last meeting on May 1^st indicated that the committee “currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent.”  And its stressing “at least” leaves room for low interest rates to continue for a time even when the unemployment falls below 6.5%.

So how could Williams expect stimulus easing to begin this summer and end this year when unemployment requirements are nowhere near being met?

Well, Williams was not referring to an end of all Fed measures but to an end of bond purchases only.  While interest rate changes are dependent upon unemployment falling below 6.5%, changes to bond purchases have no such requisite target.  The two stimuli run independently of each other, so that one can be scaled back without triggering a change in the other.

Williams also noted that ending new bond purchases would not end the positive benefits of all bond purchases to date.  The Fed would simply stop buying bonds and would thus stop pumping new money into the economy.  It wouldn’t start selling bonds or taking money back out.

As the Fed holds on to the trillions of dollars worth of bonds and mortgage securities purchased so far and does not sell them back right away, all that extra liquidity pumped into the system through the bond purchasing program would remain swirling about the economy, forcing long-term borrowing rates to remain low and reducing the cost of getting your hands on that money.

Implications

We know how the markets have adjusted to both measures being applied at full steam – both bond purchasing and low interest rates together.  As it is, bond yields have been squeezed to insignificant scraps, investors have flocked to a hot stock market that just keeps rising, and precious metals like gold and silver have fallen out of favor since they offer no real benefit in an inflation-less climate.

But how will the markets respond to the reduction of bond purchases by the Fed, let alone the end of the purchasing program altogether?  Definitely the first market to move will be the bond market.  When Mr. Government Trillionaire is no longer sitting in the front row at bond auctions, we would expect bond prices to fall and interest yields to improve.

In turn, improving bond yields will cause some of the excess stock buying to reverse, as investors lock in stock profits and redirect some funds back into bonds.  Remember, not everyone invested in stocks really wants to be there to such an extent as this.  Much of the equity investment is there only because bond yields are so putrid.  Improve the bond yield a little, and we can expect some equity money to return to fixed income.

So if Williams is correct that bond purchasing could be tapered as soon as this summer, perhaps this white-hot equities run will finally correct at that time.

Yet it is still unclear how this should affect gold and other precious metals.  Although less bond buying by the Fed means less stimulus – which hurts gold – the ensuing sell-off in equities could see some of that money redirected back into gold and other metals as a safety play together with bonds.

Moreover, a reduction in bond purchases may be viewed as a sign that the Fed is worried about inflation taking hold.  Introduce even the smell of inflation risk, and the precious metals will react.

If gold can hold that low $1300 level, the current correction since the 2011 high will have been contained within that critical 30% retracement area, a depth from which it recovered once before in 2008.  If it can hold above this level throughout the summer, H2 could see a nice upward kick, it being the stronger half of the year traditionally.

The lull between FOMC announcements may be difficult to sit through, as investors debate whether to start getting defensive now or wait a little longer.  One cue that could provide some more insight into the Fed’s next move is the upcoming employment data due out Friday, June 7^th.  A week and a half after that, Captain Ben will show us the course he and his tugboat officers have plotted as they nudge and steer the good ship U.S. Economy along its merry way.

Rotation or Displacement?

As one last thought… the situation described above where both stocks and bonds might fall together for a time may seem counter-intuitive.  Equity and bond markets are supposed to move opposite each other as investments rotate out of one market into the other.

However, looking back at these last four years of Fed stimulus since early 2009 we notice a striking abnormality: both equities and bonds have moved up together.  Not a rotation, this has been more of a displacement, where the government jumping into bonds displaced investors out of bonds into equities.

In a way, we might say that the “great rotation” out of bonds into equities that everyone has been looking for has been happening right under our noses.  We just hadn’t noticed it because we were expecting one market to fall while the other one rose.

As it was, both markets rose together because we didn’t have the ordinary recycling of old money.  There was a new participant in the marketplace – the Fed – bringing in new money, lifting both markets together.

We might expect the reversal of this displacement, then, to create a vacuum as the Fed stops buying bonds.  As bonds fall, we would expect to see some investors rebalance their portfolios, selling some equities to buy more attractive yielding bonds.  As equity money moves into bonds to fill the Fed’s vacuum, we could see both markets moving down together for a time.  This reverse rotation would be just as counter-intuitive as the first because of both equities and bonds falling together.

It is kind of like an elephant jumping in and out of a swimming pool, which would cause the water level to rise and fall.  If both equities and bonds rose together when the Fed jumped in, we might expect them to fall together as the Fed jumps out.  At least for a short time.

And if indeed both equities and bonds do fall together, we might then have a showdown between which safe-haven is turned to for protection… the USD or gold.  It is too early to tell which would win out.

Joseph Cafariello

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