Shortsighted Fed Policy Fuels the Continued Rise in Gold

“Washington doesn't agree on much these days, with one glaring exception: that the U.S. is facing a long-term fiscal crisis. The federal government's debt is now $13.8 trillion and is projected to hit $20 trillion by the end of the coming decade-when it will be the highest level as a share of the economy that the U.S. has seen in 50 years. In September the International Monetary Fund warned that the U.S. is moving dangerously close to a point at which spooked markets will send interest rates on new borrowing to devastatingly high levels. As it is, the government is on course to spend $1 trillion per year on interest costs alone-about a quarter of all federal spending. ‘We are accumulating debt burdens that will rival a third-world nation within 10 years,’ says David Walker, former chairman of the nonpartisan Congressional Budget Office. ‘Once you end up losing the confidence of the markets, things happen very suddenly-and very dramatically. We've seen that in Greece, we've seen it in Ireland, and we must not see it happen in the United States.’" - Michael Crowley, The New York Times

The Federal Reserve's recent shift to the direct purchase of long-term Treasuries carries far-reaching implications for domestic economic stability, potentially causing systemic fractures that could dwarf any short-term benefits to economic growth. While the Fed’s goal is to avoid the scenario described in the quote above, it has created undeniable moral hazard, simultaneously fueling irrational, unpredictable and unsustainable distortions in the market. The Fed is at risk of causing the very end it seeks to prevent. If investor confidence is permanently eroded by these policies, the United States could follow the path of Ireland and Greece and, as a result, elevate gold ownership from intelligent diversification to practical necessity.

In late 2008, in the wake of the financial crisis, the Federal Reserve elected to embark on an unprecedented (in the United States) stimulus plan known as Quantitative Easing (QE). At first, the Fed focused its purchases on Mortgage Backed Securities (MBS) in an effort to directly reduce mortgage rates and in hopes of reviving the housing market. In March 2009, the Fed expanded QE, allocating an additional .15 trillion in bond purchases. This time, instead of continuing to purchase only MBS, the Fed allocated 0 billion directly to the purchase of long-term Treasuries. At the time, this decision was buried in the rubble of the bailouts, and passed with little notice or worry to its significance.

How a rational, freely trading bond market operates

On November 3, 2010, the Federal Reserve approved a second round of Quantitative Easing, dubbed in the market as “QE2”. In QE2 the Fed will directly purchase 0 billion worth of long-term Treasury Bonds, while reinvesting an additional 0-0 billion by rolling over maturing assets. The Fed also decided against a specific end date to these operations, leaving open the possibility of additional future purchases. In contrast to QE1, which focused on Mortgage Backed Securities, QE2 constitutes a direct intervention in the US Treasury market. This difference is significant.

To understand how intervention in the bond market can have such far-reaching consequences, it’s worth a brief discussion on how a rational, freely trading bond market would operate. When an individual investor buys a 10-yr Treasury note, he is essentially agreeing to lend the US Government his money for ten years, and the government, in turn, agrees to give him more back than he gave them in the first place. The difference the government has to pay is a reflection of the perceived risk associated with lending the government a certain amount of money for a certain length of time. That risk is quantified by the interest rate. In a free market, if the interest rate offered to the market didn’t adequately compensate investors for the risk they felt they were taking on, the government would be unable to sell bonds at that rate. Due to a lack of demand, the US Treasury would have to offer higher interest rates until that risk/yield relationship came into balance and demand returned. This basic interaction of the risk/yield relationship and demand establishes a fair market valuation on an ongoing basis.

Now, consider the impact of direct Fed purchases: The presence of a ready buyer for any Treasury auction forces the yield the US government has to offer to attract buyers of its debt to remain artificially low. Essentially the government need not offer what would otherwise be the real market rate to sell its bonds. Since the Federal Reserve cares little for what interest rate it receives, especially because its goal is to drive the rate down, it skews the natural impact that demand, or lack thereof, has on setting a fair market rate. As this process continues over and over, the risk/yield relationship becomes increasingly distorted. The theory that the Fed adheres to is that this distortion is a net positive, in that it will bring down long-term rates, thereby stimulating the economy by rejuvenating credit markets. Of course, that conclusion is predicated on the hope that the economic growth garnered will fuel increased confidence (lower risk) for the market, thereby preventing a rate explosion after the Fed steps aside. In this perfect scenario, the end achieved would be a rebirth of economic growth, with no functional compromise to the stability of the Treasury market.

It is a slippery slope though, where any number of risks could give way to a whole new set of problems. If, on one hand, the Federal Reserve’s methods prove ineffective or too costly and it is forced to remove its support, the market will naturally recalibrate. Given the litany of fiscal and economic risks associated with our destructively high debt-to-GDP ratios, existing interest payment obligations, and stagnant growth (partially the result of the failure of these policies), the interest rate the government would need to offer to attract buyers of its debt, especially its long-term debt, would soar. This is, in a nutshell, what happened in Ireland and Greece. Interest payments on our debt would go from expensive to oppressive, and could dwarf all other government expenditures. A literal snowball effect would ensue and the scenarios described in the quote at the outset of this article would become a reality. Solutions would include higher taxes and reduced spending, ushering in a prolonged period of low economic growth, just like the austerity measures have caused in Ireland and Greece.

"We’ll do it until it works"

Granted, this is exactly what the Fed seeks to prevent. The greater likelihood is that the Fed will resist stepping away from the Treasury market altogether, employing a “We’ll do it until it works” attitude. But even if the recovery were to suddenly blossom, the Fed would likely continue the quantitative easing program, fearing economic growth may not be sustainable on its own momentum. The last thing the Fed would want is for the US to immediately slide back into a recession upon the discontinuation of its Treasury purchases. This attitude could easily lead to a permanent continuation of Fed open market operations.

The longer the Fed directly purchases Treasuries, the more distorted the market will become, and the more the economy will come to depend on Fed intervention. By skewing the risk/yield relationship, the Fed might ultimately undermine free market demand and eventually position itself as the primary buyer of US Treasuries. In the end, it is unknown whether this policy would even prevent the snowball effect described in the first scenario above and masthead quote. By fueling further distortions, and ultimately undermining the legitimacy of the Treasury market, the transition back to equilibrium might prove only to be substantially more painful.

Regardless of the course of action taken, the Fed and US Government are placing a risky bet on the success of these policies. Other countries have tried to paper over their financial problems, as the United States is now, only to ultimately have the free market expose their financial fractures. This was the fate of Ireland and Greece. For those countries, bailouts eventually prevented the market from imposing an oppressive borrowing rate and helped forestall an outright default. But if the United States were to follow this path, the most important question of all needs to be asked: If the lender of last resort is no longer able to borrow money, who stands ready to bail it out?

The Federal Reserve’s actions over the past two years suggest a sort of hubris, reflecting an apparent belief that its interventions are somehow immune to any negative consequences. To the point, during his interview on “60 Minutes”, Ben Bernanke was asked how confident he was that his policies would yield results and how sure he is in his ability to control the situation. “100 percent,” was his answer.

Paradigm shift in gold’s relevance

Despite the dollar’s role as the world’s reserve currency, the lethal combination of a discredited Treasury market and an ineffective Federal Reserve could cause economic instability and significant erosion in the value of the dollar, potentially igniting runaway inflation. This gives compelling cause to the belief that there is an ongoing paradigm shift in gold’s relevance, both for the individual investor and, within the international monetary system. Consider some of the events and trends seen in the gold market since the initial Fed involvement in the Treasury market in March 2009 (the initial 0bln QE injection mentioned earlier):

1. The price of gold has appreciated dramatically – On March 18, 2009 gold closed at 5 per ounce. The next day (the date the Fed announced it would purchase Treasuries directly) it jumped . Following the November 3, 2010 announcement of QE2, gold jumped in four days, ultimately reaching an all-time high of 30. Gold is currently trading at the 00 level, up 56% from the first announcement of direct Treasury purchases by the Fed – less than two years ago.

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2. World Bank chief Robert Zoellick said in an article in the Financial Times that leading economies should consider “employing gold as an international reference point of market expectations about inflation, deflation and future currency values.” Zoellick said a return to some sort of currency link to gold would be “practical and feasible, not radical.” Zeollick’s comments were made three days after the announcement of QE2.

3. The dollar’s role as the world reserve currency is in question. “The dollar has proved not to be a stable store of value, which is a requisite for a stable reserve currency,’ the U.N. World Economic and Social Survey 2010 said. ‘A new global reserve system could be created, one that no longer relies on the United States dollar as the single major reserve currency.’” (Reuters) Countries have already begun to move away from US Treasuries in favor of gold, with China being the prime example. In the last six years, China has increased its official gold holdings 76%, from 454 metric tons to 1054 metric tons, vaulting them to the 5th largest gold holder in the world. Meanwhile, they’ve drastically curtailed their purchases of US Treasuries, as seen in the graph below:

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4. In the 3rd Quarter filing with the SEC, three of the largest and closely followed hedge funds, Soros Fund Management LLC, Paulson & Co. and Touradji Capital Management LP listed investments in gold as their biggest holdings. David Einhorn of Greenlight Capital made headlines in July 2010 when he transferred his entire position in GLD, the gold paper ETF, to physical gold bullion.

5. Gold investment demand has exploded in the last two years. The large spike in demand in the second quarter of 2009 (seen in the graph below) was in direct response to QE1. It should also be noted in conjunction with this point that, by the end of 2009, combined ownership of gold ETFs, gold stocks, and physical metal still only represented less than 1% of all invested assets globally.

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The gold market has already been profoundly impacted by the early stages of Quantitative Easing. As global investors and countries alike embrace the yellow metal in response to these policies, one can only project what will happen to the price of gold, and its overall role in the international monetary system. At a minimum, it will take some time to unwind what the Fed has already committed to in QE2. Add to it the potential for expanded operations in the future and it’s quite possible that we “ain’t seen nothing yet” in the gold market.

Jonathan Kosares graduated Cum Laude with a degree in Finance from the University of Notre Dame. He has authored numerous articles on the gold market and is the moderator for the USAGOLD Video Series.

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