The
Federal Reserve is in a very tough position. Despite unprecedented amounts of
stimulus, GDP growth is anemic, unemployment remains historically high,
durable goods orders have plunged and rising rates are harming the housing
rebound. If this is all that can be accomplished with record low rates and
trillions in quantitative easing, the underlying health of the economy must
be magnitudes worse than believed.
Most analysts are expecting the FED to taper in September, significantly
reducing their $85 billion per month in asset purchases. While it is easy to
throw around dollar amounts such as $85 billion, we should put this number
into context. $85 billion per month is over $1 trillion per year and is
equivalent to over 20 million new jobs paying $50,000 per year. It is enough
to end world hunger 30 times over or send every high school student to a
four-year college.
Yet, despite spending this unfathomable amount of money on quantitative
easing, the economy only grew at 1.7% during the second quarter. Can you
imagine the condition of the economy today if the FED was not buying $85
billion in bonds per month?
Interest rates would skyrocket, the stock market would collapse, the
housing market would collapse, credit markets would freeze up, unemployment
would skyrocket and foreign nations would very well accelerate their dumping
of U.S. debt.
Sound dramatic? I am not the only one that holds such views. The Federal
Reserve essentially hoisted a trial balloon earlier this year by discussing
the possibility of tapering to the media. What transpired was an immediate
and severe sell-off in the stock market at only the hint of the possibility
of future tapering. Imagine the impact when the FED actually confirms the
beginning of tapering!
Employment Data Suggests More QE is Needed, Not Less
The FED has a dual mandate of maximum employment and price stability. They
have discussed not tapering until official unemployment drops to 6.5%, but it
still remains at 7.4%. And even this historically high number of 7.4% does
not paint the total picture of the employment situation in the United States.
The better measure of unemployment, U6, is hovering around 14%. If we use
a more honest measurement, such as the one calculated by Shadowstats
to include long-term discouraged workers that conveniently get defined out of
existence in government models, unemployment is at an all-time high around
23%!
Another good way to get an accurate understanding of the health of the
jobs market is to look at the civilian employment-population ratio. In very
simple terms, it tells us what percent of working-age Americans have a job.
It was around 65% in the year 2000. Following the bursting of the dotcom
bubble in 2001, the ratio dropped three points to 62%. When the 2008
financial crisis hit and the recession took hold (grey area in chart below),
the rate dropped sharply from 63% to below 59%. This drop was nearly twice as
severe as the one that followed the 2001 dotcom recession. But here is the
real kicker… the employment-population ratio has remained below 59% for 4
years now and has failed to recover at all, following the 2008/2009
recession.
This is the first time in modern history that there hasn’t been a strong
bounce back in the employment market following a recession and it is an
ominous sign for the future. Simply put, there has been no real recovery in
the labor market.
Official Measures of Inflation Remain at Historically Low Levels
While you may not feel it when shopping for groceries, pumping gas or
buying health insurance, official indicators are showing that both headline
and core CPI remain below 2%. This is not the type of inflation that would
compel the FED and policymakers to back off stimulus programs. In fact, this
level of inflation is technically lower than desired, suggesting that there
is room to increase stimulus efforts without causing runaway inflation.
This is contrary to what many gold investors had expected following the
trillions in bailouts and money printing in 2009. The main reason all of this
new money has not yet translated into high inflation has to do with the
velocity of money. This term is used to describe the pace at which money is
circulating through the economy and being used to buy goods and services.
The chart below shows that the velocity of money has fallen to the lowest
level ever on record. It went into free fall during the latest recession and
has continued dropping towards the 1.5 level as banks park assets with the
FED in order to collect interest on excess reserves. Corporations are also
sitting on record amounts of cash, as their hiring and spending has slowed in
the face of a tepid economic recovery.
So, with both of the FED’s mandates pointing towards the need for more
quantitative easing, not less, why are so many investors and analysts
convinced that the FED will begin tapering next month?
Perhaps it is because of the subtle hints the FED has been dropping or
maybe central bankers want investors to believe the story of an improving
economy that no longer needs stimulus. Whatever the reason, it is a delicate
balancing act needed to keep confidence high and prevent the house of cards
from collapsing. Investors are getting used to it now, but not long ago the
idea of a centrally-planned economy hinging on the words and whims of a
bearded banker would have been hard to foresee. Sure, Greenspan and others
had incredible sway in the markets, but there was still a sense that the main
driver was the underlying fundamentals, not the amount of stimulus the FED
would inject during any given month.
While the majority are bracing for significant tapering next month, my
analysis of the situation suggests the exact opposite. I believe there is
very little chance of tapering in September or even by year end. I have
always suspected that QE3 was actually “QE to Infinity,” so I would not be
surprised to see an increase in bond buying or the announcement of a new
stimulus program meant to keep the lights on a while longer.
What are the Implications for Gold Investors?
A substantial portion of the recent decline in precious metals was driven
by forecasts for an end or significant tapering to FED bond buying. This
forecast was slowly baked into gold and silver prices during the first half
of 2013, leading to multi-year lows amidst the worst correction of the entire
12-year bull market. But was the sell-off justified?
The recent price action suggests the correction was severely overdone. And
while the move over the last two months has been impressive, the real
fireworks will begin when the FED concludes their September meeting without
an announcement of tapering. Even more explosive would be news that the FED
plans to increase their quantitative easing efforts in order to push rates
back down, increase borrowing and spur hiring in the job market.
But even if the FED does decide to taper this year, it will only be a
token amount aimed at pleasing opponents of QE and those rightfully concerned
about the expanding balance sheet of the FED and deepening national debt
levels. Would the FED buying $70 billion per month instead of $85 billion per
month be cause to turn bearish on precious metals or equities in general?
What about $65 billion? No matter the number, it is still an incredibly large
and absurd amount of economic stimulus required years into the supposed
recovery.
Some may view any degree of tapering as proof of a strengthening economy
and foreshadowing of a rebound in the velocity of money. In such conditions,
inflation indicators are likely to spike higher and spread fear that all of
the money printed in the past 5 years will finally begin flowing into the
markets. This scenario would also be bullish for precious metals, leading me
to believe that prices are headed higher whether or not the Federal Reserve
decides to taper.
Summary and Conclusion
I believe that investors have incorrectly assumed the FED will announce
significant tapering in September. This concern has spread through the
markets over the past several months and is now baked into gold prices.
However, if my hypothesis is correct and the FED does not taper in September
as expected, look for a continued upward revision to gold and silver prices.
In the short term, this upward trajectory will likely be accelerated by
increasing tensions in the Middle East and the potential of a new war with
Syria.
While I advocate holding physical metals in your possession first and
foremost, the value currently being offered by mining stocks is hard to
ignore. If mining equities continue their recent leveraged performance to the
underlying metals, we will see some very explosive moves in quality companies
with high grades and low costs. They will benefit not only from higher gold
prices and recent programs to reduce cash costs, but from a newfound
bullishness in equities overall following the realization that the FED will
not be taking away the easy-money punch bowl anytime soon.
After an uneventful and sometimes painful two years for precious metals
investors, there is now very little downside risk and huge upside potential.
A return to previous highs would mean a 35% gain for gold, 100% gain for
silver and tripling or quadrupling of the share price for many mining stocks.
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