Why Is the Fed Not Listening to the Markets

A common view of the Federal Reserve is that it is some sort of a nearly omnipotent being standing on guard of healthy economic expansion maintaining a delicate balance between growth and inflation in the way of regulating money supply and the cost of borrowing. This view may be correct, but only theoretically so.

In reality, the Federal Reserve is a private, not a public, institution representing the interests of the US banks through its 12 regional branches. Therefore, the nature of the Fed is that it is a banking system insider; the Fed first and foremost defends the banking system and only secondarily represents broad economic interests as mandated by the US Congress. These two objectives are not necessarily always in harmony with each other. For example, the most profitable cycle for the banks started during the 2001 recession as a result of the Fed's super loose monetary policy eventually leading to today's disaster in the housing market.

Today, we are in the midst of a worldwide financial system crisis. That is why, even more so than before, the greatest priority for the Fed is an immediate rescue of the banking sector. The most pressing need for the Fed now is to buy more time, (much more than just several months) which is desperately needed by the banks in order to continue their delevereging process.

To date, this delevereging process has been happening way too slowly and with huge losses for the banks. In April/May, many banks recapitalized their balance sheets by writing off bad loans and issuing long term noncumulative preferred stock (at 7.75% - 8.50%) to bolster their cash positions and support their diminishing lending ability. As a result of this attempted recapitalization, the financial sector temporarily rebounded. By the end of June, the situation reversed. Most of the preferred shares are now underwater with some equities losing up to 40% in just a couple of months.

Since the banking situation is not getting any better, how does one raise more capital to allow for more write-downs and delevereging to occur? And how harsh will the terms of the new financing be? It is not pretty! There is much more pain to come and our financial troubles are far from being resolved.

Many blame the Fed for not raising interest rates and letting the inflation genie out of the bottle. Others are concerned that such actions or lack thereof, are causing the Fed to lose credibility in the eyes of the public. But we believe that the Fed has simply been caught in its own trap and US equity markets are falling for reasons which are now outside of Fed's control. If the Fed were to raise rates, it would be blamed for devastating the failing banking sector. The equity market would still have continued its downward spiral anyway.

Major Driver behind the Gold Bull

The main result of the Fed's "inaction" last week is the failure of the so-called multi-month dollar rally. Technically, the US dollar is on a verge of another downward slide with a reasonable target of 65-68 in the US Dollar Index ($USD). While nothing can be ruled out, we doubt this will happen in the next 1-2 months.

This is because there is an unprecedented pressure being exerted on the Fed to stabilize the USD. Having switched from blaming major oil companies and the so-called speculators, the media is now designating the Federal Reserve as one of the main culprits for high oil prices.

We think that the Fed will try to maintain dollar stability in the next few months and attempt to prevent it from falling to new lows. Short term stabilization of the exchange rate through a concerted effort by central banks can surely be accomplished, but only for the short term. Therefore, we cannot rule out intervention especially if the US dollar continues to slide. Again, such an intervention can help the US dollar but only temporarily.

How does this relate to the current situation in gold? We do not share a widespread perception that the main driver of the gold bull market is the decline in the US dollar. Although gold and the US dollar have strong inverse correlation, this has been the case in the past and is not necessarily a good proxy for the future. This correlation in fact, tells us that the real bull market has not even begun in gold; to date, it has mostly been a bear market in the US dollar. Gold is still way below its inflation adjusted peak set in 1980 and is also one of the weakest performers among hard assets. All this leads us to believe that the most powerful run in gold is still ahead.

Gold's entrance into a new steep phase of the bull market will be caused not by further decline in the dollar exchange rate but by a widespread distrust in all fiat currencies, especially the euro (since it is currently viewed as the main alternative to the USD). It is important to note that a major buy signal for gold will come when the Gold/Euro ratio breaks out from its three month base. In light of this, the coming ECB meeting on Thursday July 3rd will be very informative for investors in precious metals.

Distrust in fiat currencies when translated into politically correct economic language is called a high level of inflation expectations. In such environment, long term yields (which are uncontrolled by the Fed) will explode, yield spreads will widen as the Fed is unable to keep up with rising inflation expectations and investment demand for gold will skyrocket.

Another common misconception is that traditional supply/demand relationship observed in commodity markets governs gold market behavior. In reality, the main factor in a gold bull market is investment demand which soars when investors seek safe haven in gold against inflation and uncertainty.

We are not aware of any universal indicator of worldwide investment demand for gold. In our opinion, the best such indicator is the change in Net Assets (in tonnes) by SPDR Gold Shares (GLD).

Investment demand typically leads gold price. As shown on the chart, the number of tonnes owned by GLD has spiked over the past few weeks - a bullish signal for gold going forward.

This is an excerpt from a Resource Stock Guide Newsletter dated June 29, 2008.