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Fed fails to taper – implications for gold and silver

Federal Reserve announcement

Last week the Federal Reserve announced to a surprised financial community that there would be no reduction in money printing this month. The markets had priced in a 5 to 10 billion reduction in the Fed’s 85 billion USD a month of QE which has been channelled into mortgage backed securities and US treasuries to support the US housing and government debt markets and thus keep interest rates at abnormally low levels. Since there has been such a strong drum roll of media commentary about the apparently improving prospects for the US economy and Bernanke has been talking about reducing QE for the last few months there was a consensus on wall street that the the Federal Reserve would act to taper in September.

This didn’t happen as Bernanke acknowledged that economic data was not firm enough to suggest the US economy could move forward without its sugar high of 85 billion every month. Bernanke is dead right in his assessment. Without the 85 billion, interest rates would accelerate their move higher – a trend which began as soon as the taper talk began to emanate from the Fed. This would quickly cause cracks and a new more spectacular collapse in the housing sector as mortgages become completely unaffordable for new buyers and house owners with large mortgages are forced to default on their loans. Given the already bad data on loan defaults for homeowners it’s clear that housing is one of the most vulnerable sectors when interest rates start to rise. And rise they will – nothing goes on forever and the lowest rates in history will not continue indefinitely.

More worrying than this is the effect on the US debt market – rates in the bond market started to rise as soon as the taper began to be mentioned. No private buyers want to be in the train wreck that is the US debt market if the biggest buyer in town, the Federal Reserve is trying to pull out – without their monthly purchases keeping bond prices up and rates down the private market will act as all markets should and try to find the correct price for US debt – that means much lower bond prices and much higher yields until private buyers are satisfied they are being adequately compensated for purchasing US debt – which contrary to popular comment, is not risk free. If the US government has to go cap in hand to the private debt markets the US government will quickly be exposed as being insolvent – never mind the US housing market, this is the elephant in the room and Fed needs to keep him hidden as long as possible.

Housing and US government debt alone are two issues enough to make any taper from the Federal Reserve extremely unlikely – once a government or central bank starts down this money printing track they quickly find there is almost no way out. But there are other problems too – the employment situation in the US appears to paint a far too rosy picture, something Bernanke himself admitted when he pointed out that huge numbers of people seem to have dropped out of the workforce entirely in the last year, meaning they are no longer counted in the unemployment numbers thus the 7.4% unemployment percentage is unrealistically low. Even with those jobs which were created the majority were part time service industry jobs (thank you Obamacare!) rather than high quality well paid full time positions in manufacturing etc.

The stock markets have had a great year, but if the Feds actions this month tell us anything, it’s that the general economy, 5 years after the crash of 2008 is still in a precarious position. Without the Federal Reserve’s intervention in the mortgage backed security market there would be no housing recovery and without that who would really consider the US to be on the way back? But if stocks and housing keep going up while nothing else in the economy suggests they should be, it’s evidence that these two sectors are again going into dangerous territory and without ongoing QE from the Fed they would again be heading for burst bubble territory. The debt collector came knocking on the Feds door in 2008 and Bernanke shut the door and told everyone to keep quiet so maybe he’d go away – this week Bernanke risked a peek out side that same door again and found the debt collector was still sitting there waiting for his payment. The spectre of a deflationary depression looms large in the Fed’s thinking even as Bernanke approaches the end of his term – this is the biggest guarantee that we are on the road to endless QE.

Although both gold and silver have been in a correction since September last year and the stock market has moved forward strongly in this last year, the shaky foundation on which the stock market has advanced suggests that when the stock market falters gold and silver could be set for a strong rebound as the investment market realises it has overestimated the strength of the US economy by a wide margin. At the moment everyone, including the Fed, seems to have forgotten that it is not possible to re-inflate old bubbles and keep them inflated. I would expect that everyone is going to get a good dose of economic realism on this same topic. The only way real estate and stocks are going to avoid a nasty pullback at this point is an ever increasing commitment to QE (never mind an actual taper) and an acceleration in inflation – but even in that scenario both real estate and stocks will lose comparative value to other asset classes such as gold and silver. The parallels between this period and the pullback in gold and silver in 1975 and 1976 are illuminating – gold was off 50% in that 2 year period but from the end of 1976 to 1980 it went up a further 500%. History doesn’t necessarily repeat but if often rhymes.

Bond yields up, gold and silver up and stocks down…

Bond yields up, gold and silver up and stocks down

Exciting price moves for silver and gold

Both silver and gold pushed up strongly in the last few days with Thursday the 15th August being notable as silver moved up 70 cents from 16.50 euro to the 17.20 area. This is hugely interesting because the silver price has been anchored down around the 15.00 euro area for most of the summer and just 2 weeks ago it was down to 14.80 as the Fed issued new commentary regarding tapering. In our opinion this is just an opening salvo from stocks bonds and metals as all three asset classes flash red warning lights over the strength of the US economy and its trajectory minus massive bond purchases from the Federal Reserve.

With positive new jobs data yesterday in the US the market hammered stocks and bonds downward as yields on US treasuries continued to rise. All this while gold and particularly silver had one of their best days of the year in terms of price movement. The talking heads on CNBC and Bloomberg attributed the metals strong performance to disturbances in Egypt where they bothered to note it at all. But it is our belief that the metals strong showing yesterday had nothing do with the middle east and everything to do with the market warning the Federal Reserve not to get off the QE tightrope. If the Fed allows the free market to set the proper interest rates for US debt there is a crisis looming that will make the issues in the Eurozone look like a cakewalk!

Strong evidence is emerging that both China and Japan are backing away from US debt in advance of any tapering from the Federal Reserve. The simple truth here is that without the Federal Reserve persevering in its purchases of mortgage backed securities and money printing there will be scant support for US treasuries at current yields. If the Federal Reserve does taper it risks allowing yields to explode and pushing the US government into a Greek style crisis within 6 months. With yields rising and stocks falling while metals rose this is the market sending out yet another early warning to Bernanke – the US economy, housing, stocks and bonds all depend totally on easy money and near zero interest rates. Without the Fed’s MBS purchases over the last year where would the property market be now in the US? And without a stabilisation in housing who would think there was any strength in the American economy?