On Wednesday, the Federal Reserve announced it will begin purchasing $600 billion in Treasury securities through June 2011. In addition, $250 to $300 billion of Treasuries will be purchased, financed through interest payments from its agency and mortgage-backed security assets. These purchases are expected to increase the Fed’s balance sheet by 38% (from $2.34 trillion to $3.24 trillion).
A Perpetual Ponzi Scheme
A Ponzi scheme is a fraudulent investment operation that pays returns to separate investors from their own money or money paid by subsequent investors, rather than from profits. It is named after Charles Ponzi, who became the most famous person to use such an operation in 1920. Bill Gross likens the current Fed strategy to something far worse than Charles Ponzi.
Now, however, with growth in doubt, it seems that the Fed has taken Charles Ponzi one step further. Instead of simply paying for maturing debt with receipts from financial sector creditors – banks, insurance companies, surplus reserve nations and investment managers, to name the most significant – the Fed has joined the party itself. Rather than orchestrating the game from on high, it has jumped into the pond with the other swimmers. One and one-half trillion in checks were written in 2009, and trillions more lie ahead. The Fed, in effect, is telling the markets not to worry about our fiscal deficits, it will be the buyer of first and perhaps last resort. There is no need – as with Charles Ponzi – to find an increasing amount of future gullibles, they will just write the check themselves. I ask you: Has there ever been a Ponzi scheme so brazen? There has not.
Bill Gross, “Run Turkey, Run”, November 2010
As I wrote in my weekly market observation article, “It’s a Federal Reserve Note, Dummy”, the expansion of the Fed balance sheet and the declining quality of assets held as collateral on those reserve notes serve to create declining market forces on the U.S. dollar. There is no question in our minds, the minds of the Chinese and the Germans, as well as in the minds of other technicians, such as Carl Swenlin and Louise Yamada, that the U.S. dollar is headed lower, long-term. The question we pose for ourselves now, however, is how much further down on the current intermediate run in the U.S. dollar?
Since the end of the U.S. dollar rally in June of this year, the dollar has lost 13% of its value relative to a basket of currencies – virtually giving back all of its earlier 2010 gains. Since the announcement of quantitative easing 2.0 on Wednesday, the U.S. dollar has gained 1.7%. So the market is saying, “I’ve already discounted the announcement of QE 2.0 largely before it was made on Wednesday.” Friday, the U.S. dollar index was up to 76.58, up 0.70 or .90% on the jobs report data (I don’t hold much credence in the U.S. jobs data, but most other market participants aren’t as educated on the birth-death model as our readers are). As in 2002, the economists directing our fiscal and monetary policy are hoping to see that a weak dollar stimulates an export-led recovery.
To die – to sleep.
To sleep – perchance to dream: ay there’s the rub!
For in that sleep of death what dreams may come
When we have shuffled off this mortal coil,
Must give us pause.
Shakespeare’s Hamlet “To be or not to be” soliloquy
If QE is successful in causing the U.S. dollar to die and sleep, then perchance by sleeping economists are hoping to dream up an export-led recovery (Obama Shifts to Export-Led Jobs Push) . That is where we find the rub in our current situation and where it must give our politicians pause. Falling interest rates and a falling dollar helped lead our economy back into the black from 2003 to 2004. The economic recovery then caused a 15% dollar rally over the next year from December 2004 to November 2005. For precious metal investors during that time, that was the rub we had to deal with. The HUI Gold Bugs index fell 30% from November 2004 to May 2005—I remember it well—before heading higher again. What should give our politicians and monetary economists pause, is the resulting bubble in housing that was created.
I don’t think any of our politicians or economist running things really fathom that they are essentially playing with fire trying to manage our currency indirectly through massive inflationary measures in QE 1 and QE 2.0. As Hamlet asks, for in that sleep of death what dreams may come…who knows whether this economic dream will be harps and angels on pillow clouds as our exports lead us into the promise land or a real nightmare in Weimar Republic inflationary hell (most likely). The last attempt to manage the inflationary results of low interest rates ended in the housing bubble and credit crisis nightmare. As John Embry mentioned on King World News recently, and paraphrasing, there isn’t an example in history that money printing hasn’t ended awfully. John Embry mentioned that the social implications in Germany after World War I and recently in Zimbabwe were totally hazardous. Many lower income Americans don’t have financial assets to hedge against inflation and will pay out through the nose on cost of living increases. Playing with fire will get you burned and I had hoped would give Bernanke pause – after last week, that doesn’t seem likely.
i believe the end result of QE 2.0 is gold is headed higher; however, I would be doing readers a great disservice to say that the flight is going to be straight up from here. With multiple experiences of 20-30% corrections in precious metals under my wings over the past eight years, it is safe to say there will always be a point at which a dollar rally could emerge, based on stronger economic announcements (as on Friday), or merely as short traders cover their positions. Watching CNBC technicians and other commentators on the web, many are watching the levels the U.S. dollar found support in late 2009 for a bottom. This will likely be a source of profit taking in precious metals and dollar shorts. If we break through the 2009 bottom, it could mean huge bullish momentum for precious metals as traders selling now get back in.
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The long-term outlook on precious metals continues to look solid and very bearishly for the U.S. dollar after last week’s announcement of Quantitative Easing 2.0. Talking about the different investment phases of a mania, we continue to profess that we are near the final stage in which media attention kicks off the advent of mainstream investors jumping into gold. Just last week, Jim Cramer had mentioned that 6/10ths of a percent of portfolios are in precious metals. I’m not sure what his sources are, but if true, that’s room to grow! Since this summer, the best performing stocks in the precious metals mining group have been exploration juniors and silver companies.
In other news…
Today was a (bearish) Shooting Star day in silver and a bearish engulfing pattern day in the GDX as precious metals opened higher and reversed course later in the day. Coincidently, the CME Group raised its margin requirements on commodities (CME Increases Gold, Silver, Palladium Margins). Volume hints at distribution with silver contracts pushing 3x the average volume. Traders are moving to the sidelines after an incredible rally in gold and silver over the past four days.
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And yet in more news, the U.S. bond is breaking down with a developed bearish channel and a 50-day moving average that has rolled over. Support looks to be in the vicinity of the 200-day moving average. It looks like Treasury investors (domestic and foreign) might not be too thrilled with the idea of Quantitative Easing 2.0, regardless of Fed purchases (demand).
As Bill Gross mentioned in “Run Turkey, Run”,
“The Fed’s announcement will likely signify the end of a great 30-year bull market in bonds and the necessity for bond managers and, yes, equity managers to adjust to a new environment.”
