Gold prices embarked on a massive rally recently, rising from around $1210 to $1380 in just two months. Simultaneously the US index, which has a traditional inverse relationship with gold, has fallen from 83.5 to 76.5 as America puts a nose ahead in the current currency devaluation wars. The fundamental factor that is driving both gold and equities higher, and the USD lower is the expectation of a second dose of quantitative easing (dubbed QE2) by the US Federal Reserve.

Two months ago, whilst we were signalling to our subscribers to purchase 'out of the money' GLD calls (on which we have doubled our money in a few weeks), there was a mixture of opinions of whether or not the Fed would announce more quantitative easing measures in 2010. Now it appears the consensus is that we will most certainly get an announcement of additional quantitative easing by the Fed at their meeting on November 2nd, the debate has moved from not if there will be more quantitative easing, nor when, but how much it will be.

The way the markets have behaved recently suggests that the expectation is that QE2 will be in the hundreds of billions, perhaps even a trillion, as the stocks have rallied, the US dollar is in a nosedive, US treasury yields continue to fall and gold prices are soaring. This puts the Federal Reserve in a precarious situation, since the markets have jumped the gun and probably already priced in around $500 billion of quantitative easing, perhaps more.

Whether or not the Federal Reserve previously intended to announce QE2 this November is now irrelevant. The fact that the financial markets have priced in hundreds of billions of dollars in more quantitative easing for this November effectively means that the Fed has been backed into a corner and the decision has now been made for them. Not announcing more quantitative easing means that the markets have anticipated and priced in, will be rapidly priced out. Stocks, treasuries and gold would sell off and the resulting increase in demand for greenbacks would cause a surge in the US dollar. The sell off would be particularly rapid and ruthless due to the large number of speculative positions taken in anticipation of QE2. The S&P hasn't rallied 130 points in 50 days due to retail investors becoming more optimistic, improvements in the economy or company fundamentals. Those gains have been established by speculative buying by proprietary trading desks, hedge funds, and other trading operations all chasing the beta effect of a much anticipated QE2. In addition to this, of course the quant traders, which account for up to 70% of daily trading volume in US stocks and simply use computer algorithms to trade statistical relationships on a second to second basis, have jumped on the pattern and played their part to keep the markets ticking up nicely.

The Federal Reserve is not about disappoint and will certainly deliver QE2. Even if they were going to do it anyway, the accumulation of speculative positions betting on QE2 is now so large that they will not risk having those market players reverse their positions in an instant, sending stock plummeting and causing interest rates to jump, and therefore QE2 is now a certainty.

For similar reasons to those detailed above the Fed must also announce quantitative easing measures that live up to market expectations, since if they fall significantly short of the $500 billion or so that financial markets are currently pricing in, we would see similar severe selling pressures and this is another headache that Ben Bernanke does not want. Therefore the size of the quantitative easing package must be equal to or in excess of market expectations.

In fact it could be argued that QE2 in excess of market expectation is what is actually required, since many traders will have taken positions specifically for this announcement, and will close these trades shortly after, with the time old adage of buying the rumour and selling the news comes into play. Therefore perhaps a QE2 figure above what is currently priced into the market is needed in order to stimulate some buying after the announcement, to counteract the selling that will undoubtedly comes as traders take profits.

In additional to this there is a fair chance that the Fed will go too large for the fear of going too small. For the same reason that central banks generally do not set a target inflation range of 0% to X% for fear of deflation, it is probable that the Federal Reserve will err on the side of caution and lean towards announcing a number larger than market expectations than trying to target the precise level the market needs and risk coming up short.

Although many may believe that it is the market that must pay heed to what the Fed says, this is one of the cases where is it the market that is calling the shots. The situation between the Federal Reserve and financial markets is that what the market wants, the market gets; zero interest rates, multibillion dollar capital injections, insurance bailouts of 100 cents in the dollar, the market is indeed calling the shots down to the price of a paper clip. In just a few months Wall Street has picked the QE rabbit out of the Fed's hat while Main Street sits out there wondering how the hell we got here, (to paraphrase Mr Gordon Gekko), when not long ago the recession was over and we were going to have a great recovery.

In conclusion, although QE2 may be a given, what is not certain is how much is already priced in, and how the market will perceive whatever figure we get in November. We have decided to maintain stop orders on our open positions in gold and silver, moving the stops up to lock in more profits as the market continues play in our favour. This keeps us exposed to further upside in the precious metals whilst limiting our downside risk. We actually think that some form of pull back in gold would be good to see, as it would make an assault on $1500 in the next few months a lot more probably from a technical perspective. On any such correction we would be aggressive buyers, however we are keeping our discipline and will not buy any additional positions whilst gold and silver are so drastically overbought.

Our premium option trading service OptionTrader is banking great gains in this rally, closing 5 positions on Friday with gains of 81% to 101% on trades opened just last month.

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