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After the Federal Reserve launched QE3
last month, investors and speculators are growing excited about its future
impact on gold and silver. Though the Fed’s QE3 campaign started out relatively
small, its open-ended nature is utterly unprecedented. Thus an unknown amount
of future inflation will be spawned. Naturally gold and silver thrive in such
environments, as they proved during QE1 and QE2.
Of course QE stands for quantitative
easing. Even as a lifelong student of the financial markets, I
don’t recall hearing this term before late 2008’s epic stock
panic. Central banks are notorious for trying to cloak their actions. So
although “quantitative easing” was universally derided historically,
it was known by a different name. Quantitative easing is simply a
pleasant-sounding euphemism for debt monetization.
All throughout world history, debt
monetization ended in ruin for the countries that foolishly played this
dangerous game. And it is exactly what it sounds like. Central banks create
new paper money out of thin air to buy bonds, thus monetizing
them. The big problem is this grows, or inflates, the money supply. Whoever
sold the bonds to the central bank spends this new money, injecting it
directly into the economy.
The result is inflation. When the money
supply grows faster than the underlying pool of goods and services on which
to spend it, their prices are bid up. The more new money the central bank
creates to monetize debt, the worse the resulting inflation. Even though its
impact on price levels isn’t apparent immediately, it is inevitable.
Once unleashed, history has proven inflation will fully run its
course.
Inflation is devastating, an insidious
plague that stealthily impoverishes the great majority of people whose
incomes don’t rise fast enough to maintain real purchasing power.
Inflation slaughters the poor, who already struggle greatly to survive even
without rising prices. Inflation crushes everyone on fixed incomes, nearly
all retired people. And inflation robs savers blind, stealing their
lifetimes’ hard-earned surpluses.
Thankfully there is a refuge for the
prudent, a safe haven to protect their accumulated wealth from
inflation’s vile predations. All throughout history, gold and silver
have maintained their real purchasing power as money-supply growth lifted
prices all around them. They are like battleships on the seas,
no matter how high the ocean of paper currencies under them rises they still
float commandingly on top.
The Fed’s brazen debt monetization
in recent years has already created massive inflation. This deluge of
new dollars that never existed before is already baked into the pipeline, and
its economic impact is just beginning to be felt. Yet gold and silver have
already seen fantastic gains during the Fed’s initial pair of
quantitative-easing campaigns. This new open-ended third one is very bullish
for these precious metals.
The best clues as to how gold and silver
will perform in this unlimited QE3 era are probably found in how they
fared during QE1 and QE2. So let’s dig into the entire history of the
Fed’s post-panic debt-monetization campaigns, and then see how gold and
silver did within them. This first chart looks at the Fed’s balance
sheet, which is where all the debt it has been monetizing ultimately shows
up.
Make no mistake, quantitative easing is
Fed Chairman Ben Bernanke’s response to the once-in-a-century stock
panic that slaughtered the markets in late 2008. Prior to that, the
Fed’s balance sheet looked very different. For the first 8 months of
2008, it averaged $875b. Meanwhile the Fed’s holdings of US Treasuries,
the most important component of debt monetization, averaged $579b in pre-panic
2008.
The Fed started aggressively buying
assets before it launched what later became known as QE1. Note the gargantuan
spike in the Fed’s balance sheet between late August and late November
2008 in the dark heart of the stock panic. Over that insane 3-month period
where the flagship S&P 500 stock index (SPX) plummeted 42.2%, the
Fed’s balance sheet skyrocketed a mind-boggling 145.5%! QE had begun.
It formally started with a Fed press
release on November 25th, 2008. Just three trading days after the stock
markets slammed into their primary panic low (SPX 752), the Fed declared it
would purchase $500b of mortgage-backed securities and $100b of direct
obligations of the government-sponsored enterprises including Fannie Mae and
Freddie Mac. With all the other panic turmoil, this was widely overlooked.
In this area chart, the three different
bond classes the Fed purchased in its QE campaigns are shown in different
colors. Agency (GSE) debt is shown in green, MBS bonds in yellow, and the
all-important US Treasuries in red. Note these three classes stack
above within the Fed’s overall balance sheet in orange (which starts at
zero). The red Treasury band doesn’t start at zero, but at the top of
the yellow MBS band.
Soon after, at the December 16th, 2008
FOMC meeting, the Fed decided to slash its benchmark federal-funds rate by a
staggering 100 basis points to zero. At that point the Fed had already
expended all its conventional monetary-policy ammunition. Everything it did
after that had to be some variation on debt monetization. And the great
inflationist mocked as Helicopter Ben didn’t hesitate to rise to the
occasion.
The stock panic should have ended in
late October 2008, as the SPX had soared 18.5% in six trading days ending on
Election Day. But the panic frightened half of Americans into voting for
Barack Obama, a man who had openly campaigned on a Marxist and Socialist
platform. He wanted to divide America with venomous class-warfare rhetoric
and envy, and then steal the fruits of the productive to bribe the lazy for votes.
In the two days after Obama’s
victory, the SPX plummeted 10.0%! It would ultimately plunge 25.2% over the
subsequent couple weeks to a new panic low. And that again should have
been the bottom, but when the Obama Administration took power in late January
2009 it terrified investors. Many who voted for Obama thought he would be
like Clinton and be a centrist leader, but instead he swung sharply left.
As the US economy remained very shaky
after that once-in-a-lifetime stock panic, the Obama Administration wasted no
time in trumpeting asinine new plans. It wanted to greatly hike
already-crushing income taxes on the investors, entrepreneurs, and small
businessmen who create most of the private-sector jobs in America. It wanted
to radically increase smothering regulations, and wanted Washington to take
over health care.
So by early March 2009 in the post-panic
period when markets normally soar following such fear super storms,
the SPX had slumped 25.1% year-to-date! The Fed was rightfully terrified, as
it knows just how important the health of the stock markets is to our entire
national psyche. So just over a week after those secondary Obama-fear lows (SPX 677), the Fed vastly expanded its young
quantitative-easing campaign.
On March 18th, 2009, the Fed’s
Federal Open Market Committee released a statement declaring it was nearly
tripling its debt monetization. It would purchase another $750b worth of
MBSs to attempt to manipulate mortgage rates lower. It would also double its
agency debt buys with another $100b. But the shocking part was it announced a
direct monetization of $300b worth of Washington’s Treasuries!
While the Fed had owned Treasuries
before as the red area on this chart indicates, it had never aggressively
bought them up with the explicit goal of manipulating general interest rates
lower. This was the point when debt monetization and the debasement of the US
dollar really started to concern prudent traders. And this ballooned
the total size of what became known as QE1 to a staggering $1750b!
You can see above that the Fed’s
holdings of especially mortgage-backed securities mushroomed dramatically
during that QE1 campaign. By the time it started tapering off in late June
2010, the Fed held $1129b worth of mortgage debt at its peak. But with the
stock markets’ strong post-panic advance stalling out and correcting,
the Fed couldn’t resist the temptation to expand its monetizations even further.
So shortly after the SPX had corrected
16.0% over a couple months, on August 10th, 2010 the FOMC announced what
would later be called QE2. This actually spooked the markets, because the Fed
was brazenly reneging on its QE1 promise to let those debt purchases
automatically unwind as they matured. It announced it would roll over $300b
in maturing MBSs into Treasuries, expanding their monetization.
After that the Fed remained on hold so
it wouldn’t be seen as political during the crucial 2010 midterm
elections. They were amazing, after ramming through Obamacare
when the majority of Americans opposed it the Democrats were throttled. They
lost 63 House and 6 Senate seats, compared to an average of 30 and 4 in
midterm elections. This was the worst midterm defeat for any party since
1938!
The state-level races were even more
lopsided. Republicans won 680 state-legislature seats, the most of any party ever
even beating the 628 the Democrats won in 1974 after Watergate. The US had
never seen a bigger midterm mandate for small government, yet Obama and his
party inexplicably decided to ignore it. But the very next day, even this
incredible news was overshadowed by the Fed’s latest FOMC decision.
On November 3rd, 2010, the FOMC tripled
its new QE2 campaign to a total of $900b. It said it would purchase an
additional $600b worth of Treasuries by the end of June 2011. This would work
out to about $75b per month, a metric to keep in mind later. On the chart
above you can see the radical ramp in the Fed’s Treasury holdings
during that QE2 campaign. They later peaked at a staggering $1684b.
Provocatively QE2 proved a political
nightmare for the Fed. World leaders and central bankers, who normally never
criticize in public, were openly angry about this brazen monetization. It was
called irresponsible debasement. And the newly-elected Republicans
attacked the Fed aggressively for this, leading to calls for Congress to
revoke the Fed’s monetary authority. Bernanke was stunned by this.
QE2 was highly controversial because it
directly enabled the profligate Obama Administration’s wild
overspending. The world’s biggest and best bond-fund manager,
billionaire Bill Gross, pointed out that a whopping 70% of US
Treasuries issued during the QE2 era were purchased by the Fed! If the Fed
hadn’t created money out of thin air to buy Obama’s debt, he
couldn’t have run such colossal deficits.
So with Obama’s unprecedented
trillion-dollar deficits and scary debt growth becoming a big political
issue, the Fed had to lay low. Any more direct monetizations
of US Treasuries would be seized upon by Republican lawmakers as proof
Bernanke was in bed with Obama. So even after QE2 ended on schedule in June
2011, the Fed was understandably reluctant to rock the political boat very
much.
But again the stock markets, the key to
American sentiment as a whole, were flagging. After Obama reneged on his word
and blew up a debt-ceiling deal with Congress, Standard & Poor’s
downgraded Washington’s Treasuries in early August 2011. This was the
first time the US’s AAA rating had ever been downgraded in
history! The next trading day the SPX plummeted 6.7%, and fear skyrocketed.
As this selling pressure cascaded into a
full-blown correction, the Fed felt compelled to act again. But it was very
aware of the growing political risks of its inflation, so it didn’t
expand its monetization. Instead on September 21st, 2011 the Fed launched
what became known as Operation Twist. It sold $400b worth of short-term
Treasuries (under 3 years maturity) to buy $400b
worth of long-term Treasuries (6y to 30y).
Now since this wasn’t new
monetization, merely shuffling capital around, it escaped heavy criticism.
Stock traders were disappointed it wasn’t QE3 though, so their selling
hammered the SPX down 8.6% in less than 2 weeks on this decision. And
infuriating free-market proponents, the FOMC statement openly said the
purpose of this new campaign was to attempt to manipulate long-term interest
rates lower.
When Operation Twist had run its course,
the Fed decided to extend it to the end of 2012 at the FOMC’s June
20th, 2012 meeting. The Fed would maintain the yield-curve twisting rate of
around $44b per month. Since this extension would only run for six months
compared to the original’s nine months, this worked out to $267b.
Despite heavy market pressure for QE3, the Fed continued to refuse to expand
QE.
But this all changed last month, rather
puzzlingly. During previous QE announcements, the SPX had been near major
lows after a panic or serious correction. Yet when the FOMC met in
mid-September 2012, the SPX was just shy of a new 56-month high! Near
the top of its secular trading range, stock-market upside was very limited.
Would the Fed actually waste its ammo while the stock markets thrived?
In addition, given the political
firestorm QE2 spawned would the Fed risk looking political less than 8 weeks
before one of the most-important elections in US history? Somehow the stock
markets had managed to survive and thrive in the 15 months since QE2
ended. So why risk the wrath of Republican lawmakers by attempting to goose
the stock markets which would greatly benefit Obama’s re-election bid?
But apparently the inflationists
at the Fed rightly fear a Republican Congress, which could kill the Federal
Reserve in a single vote. Instead of waiting a couple more months until after
this critical election, the FOMC decided on September 13th, 2012 to launch
QE3. And unlike the past debt-monetization campaigns that had specific
amounts and timeframes, incredibly QE3 was open-ended with no stated limits!
The Fed was sensitive to the criticisms
it is enabling Obama’s insane debt growth, so in QE3 it switched back
to buying mortgage-backed securities from Treasuries for the first time since
QE1. And though QE3 was open-ended, the $40b per month was pretty modest by
QE1 and QE2 standards. They weighed in at $1750b and $900b respectively, yet
a full year of QE3 would “only” amount to $480b if not
expanded.
And it is this new open-ended QE3
campaign that has investors and speculators so excited about gold and silver.
How will the precious metals fare with potentially unlimited new
inflation about to be unleashed into the economy? One of the best ways to
gain some insights is to review how these metals did during the rest of the
Fed’s QE. So these next charts overlay the QE milestones over gold and
silver.
During the time when the Fed’s
original QE1 buying was underway, from late November 2008 to late June 2010,
gold powered 50.8% higher! This is a heck of a run, but it certainly
wasn’t all due to debt monetization. Gold was beaten down during the
stock panic too due to flight capital from elsewhere igniting a monstrous US
dollar rally. So gold was due to surge in the post-panic recovery anyway.
QE2, which was smaller but harder-core
since it focused purely on monetizing Washington’s Treasuries, saw gold
gain 24.7% during its lifespan. This is certainly an excellent gain over less
than a year. Provocatively, just after QE2 ended gold surged for other
reasons. That was summer 2011 when Obama refused to honor a deal with the
Congress on reducing spending to secure a US debt-ceiling increase.
The first-ever threat of Washington
actually defaulting on its debt drove enormous gold investment demand, but
this metal soon grew very overbought. So it started
correcting soon before the Fed launched Operation Twist. And the fact
that Twist wasn’t QE3 really accelerated this gold selling. Over the
entire Twist timeframe with no new monetization, gold drifted sideways to
lower. But QE3 is new monetization.
Since gold rallied strongly during both
QE1 and QE2, there is no reason not to expect it to respond similarly in the
Fed’s young new QE3 campaign. 25% in a year, especially if QE3 is
expanded early next year as Fed officials are already hinting at, seems
pretty conservative given gold’s QE history. A 25% rally from the day
before QE3 was announced would catapult gold up to a record high above $2150!
And being smaller and far more
speculative than gold, silver has fared even better in the Fed’s
debt-monetization era. This metal soared 79.5% during QE1 and a staggering
89.2% during QE2! Realize there was more at play during these times than just
quantitative easing though. During QE1 silver was recovering from ludicrous
stock-panic lows, and during QE2 this metal experienced surging popularity.
Still though given silver’s strong
history of surging when gold does in inflationary times, I don’t think
attributing 50% gains to the Fed’s QE is unreasonable. That is also in
line with silver’s oft-seen leverage to gold of 2 to 1. Again assuming
QE3 runs for a year, and gets expanded in early 2013, a 50% gain in silver
from the day before QE3 was announced would catapult this metal up near $50
per ounce!
Quantitative easing is pure inflation,
the classic debt monetization that has proved so dangerous and ruinous all
throughout world history. Gold and silver have always thrived as currencies
are being debased, as they’ve proven abundantly during QE1 and QE2. And
despite starting out small, the open-ended nature of QE3 has really ignited
inflation expectations like nothing we’ve seen in a long time.
So the psychology of QE3 is likely to
drive big increases in investment and speculation demand for gold and silver
as long as the Fed keeps this campaign alive. There is an excellent chance
QE3 will ultimately push both these metals to new record highs, perhaps as
soon as next spring. And of course as gold and silver power higher, the
stocks of the miners bringing these metals to market should amplify their
gains.
The bottom line is the Fed’s
quantitative-easing campaigns in recent years have been hugely beneficial to
gold and silver. No matter how the Fed wants to present it, QE is classic
debt monetization. Naturally the precious metals thrive in times of
inflation, and QE is as blatant as inflation ever comes. The more dollars
created out of thin air, the higher they bid the far-slower-growing gold and
silver supplies.
While QE3 started out small, odds are it
will be expanded considerably. After its initial launch QE1 was nearly
tripled, and QE2 was tripled. For political reasons the Fed is reluctant to
fully unleash its inflationary plans all at once. And the open-ended nature
of QE3 has reignited inflation expectations like nothing we’ve seen in
many years. It is going to ultimately drive traders to flock into gold and
silver.
Adam Hamilton, CPA
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