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The Fed Turns Dove

Gold was already making nice headway, rising from US$1,280 per oz. on January 24 to get above US$1,300 by January 30…and then Federal Reserve Chairman Jerome Powell poured fuel on the fire.

The Fed left rates on hold, which was totally expected. Having hiked in December, there was almost no chance the Fed was going to hike again. But while the immediate rates decision wasn’t newsworthy, Powell made waves by saying that the Fed would be “flexible” on rates going forward.

The market immediately – and I think rightfully – took that to mean that rate hikes are done until further notice. Then in the post meeting Q&A session Powell gave even more reason to believe the Fed has shifted from tightening to loosening when he said his group was looking at the current rate of balance sheet reduction and would alter the path if ongoing economic conditions necessitated a “looser monetary position that changes in the Federal Fund Rate could achieve on its own.”

Let me take a moment to explain that jargon.

The Fed was hiking rates partly because economic conditions were strong enough to warrant higher rates, but also because nothing good lasts forever so they needed to hike rates to create the ability to cut them again when the next slowdown arrived.

In 2018 they stuck to that plan like glue. They projected four rate hikes and actually followed through, a first since they started hiking in late 2015. They have also been ‘reducing the balance sheet’, which means letting Treasuries expire without buying replacements.

That also requires explanation. To support the economy following the financial crisis the Federal Reserve bought huge amounts of Treasuries and mortgage-backed securities (MBS) and had, until mid-2014, been maintaining that balance. When Treasuries expire the government has to repay them and when MBS expire Fannie Mae and Freddie Mac have to repay them. The Fed had been replacing all its expired Treasuries and MBS with new purchases, keeping its balance sheet level and postponing any actual repayment.

In 2018 that approach shifted: the Fed started not replacing some of its expiring Treasuries and MBS. Half a year in, the approach has reduced the Fed’s balance sheet by about 10%. The goal was to cut it in half.

For the Fed to not replace expired holdings has a similar impact to raising rates: it reduces liquidity, flow of money. And they were doing it for the same reason that they were raising rates: so that they could ramp purchases back up when the next recession hits.

As of only a few months ago, Fed Chair Powell was adamant that both efforts – rate hikes and balance sheet reduction – would continue. But then the markets nosedived in Q4 while economic data deteriorated…and now everything has changed.

Really, Powell’s comments on Wednesday confirmed one thing that the markets had already assumed – that rate hikes are done – and then boosted confidence further with the potential for the Fed to start buying Treasuries again.

It’s all totally ironic, of course.

Quantitative Easing – the policy of interest rates at zero and the Fed boosting money supply through mega purchases of Treasuries and MBS – gets much of the credit for the broad stock bull market of the last nine years. That connection means that investors today equate a supportive Fed with stock market success.

The irony is that the Fed makes these kinds of moves because support is needed – because the markets are not strong enough on their own. That backdrop is, of course, fundamentally bearish. So for stocks to rally on news the Fed is moving to support is ironic, but is the way things now work and likely will remain so until/unless the market die off despite Fed support.

It’s also worth noting that the shutdown in Washington means many of the economic reports we would usually be getting right now for January are unavailable…but Powell will have seen the numbers. If they’re weak, which is likely given the trade war-sparked downward trend of late, it will be interesting to see how much the market cares. 

Investors want a reason to believe that this bull market is going to keep giving and so will see a more supportive Fed in that light…and might ignore data that argues the opposite! That US stocks soared in the latter half of this week suggests as much. (Someone else, writing on the same topic, put it more gently: “The more dovish Fed policy stance is warranted and should soften any market reaction to the slower economic data that is already showing up in the manufacturing, small business, and consumer survey data.”)

The other irony is more mathematical: a looser, more supportive Federal Reserve means we should all expect less from the US dollar and a weaker dollar, in general, supports stocks and metals. The dollar dove on Wednesday as Powell spoke.

Gold remains set to do well. All the reasons I have been outlining since the start of the year remain in place and some are now stronger. Real rates, for instance, are certainly not going any higher in the absence of rate hikes and will decline with any inflation; declining near- or below-zero real rates are the strongest support gold can get.

Economic confidence might go either way, as I just noted, but the data certainly suggests a downward trend. The ISM Manufacturing, Small Business Optimism, and Consumer Confidence surveys all peaked six months ago and are now falling under the weight of trade wars, the December market crash, the shutdown in Washington, Brexit, and global economic weakness. All those forces create exactly the uncertainty that drives safe haven gold buying.

That central banks are buying gold at near record levels is another boost. According to the World Gold Council, in 2018 central banks added 651.5 tonnes of gold, worth some US$28 billion, to their holdings. Not only was that 74% more than what banks bought in 2017 but it’s also the most gold central banks have bought in a year since 1971 when President Nixon ended the gold standard.

The increased demand is mostly from emerging markets; among the biggest purchasers last year were Russia, Turkey, and Kazakhstan. China also officially added to its holdings for the first time since 2016 (though what Beijing buys versus what it reports is always a question) and the central banks of several countries including Hungary, Poland, and India bought gold for the first time this century.

All of the above supports gold and a weaker dollar helps. Paul Renken, an analyst and geologist at VSA Capital, holds the same outlook and summed it up well as follows: 

“Gold investors should be buying. Gold miners should be doing deals in M&A. That means globally, not just here. The price and cost to do this will be higher in H2 2019 and likely 2020 in my view if one waits for further confirmation. The bull run is already underway.” 

Of course, there are always folks betting against gold. And fair enough: gold has failed to break up enough times in the last few years that I understand! But Canaccord Genuity Portfolio Strategist Martin Roberge recently pointed out an interesting result from that: while speculators are unwinding their shorts on gold the metal (which were at record levels not long ago), they are cranking up their short bets on gold stocks. Perhaps speculators are playing both sides of the table, placing short bets against gold miners as a hedge in case gold fails again.

Short bets don’t much matter until they do. If gold breaks up above its next technical barrier at US$1,360 per oz., it would as Roberge puts it “likely trigger the mother of all short-covering rallies in gold stocks.”

Powell officially turning dove was fuel on a simmering fire. Gold looks very good from here. 


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