The release of January’s FOMC minutes had a fairly substantial impact on precious metals this week as on Wednesday alone we witnessed more than a 2 percent sell off in the price of gold. Some analysts attributed this sell off to investors closing out gold positions as a number of them had been financed with borrowed money. The deleveraging witnessed in gold futures positions could very much be attributed to the downward movement in the price, but there is a bigger picture here in terms of what we are seeing in the markets and that is the expectations of higher interest rates.
The dissent at US Fed revealed by January’s minutes highlights the uncertainty from committee members regarding the costs and benefits of their bond purchasing program known as Quantitative Easing. There is beginning to be a revelation from committee members that by supressing long term interest rates high risk borrowers are able to finance credit at what might be discounted prices. This a direct off-shoot of the actions of the Fed extending the duration of their balance sheet by holding longer term bonds opposed to paper with a shorter period to maturity. As increasing number of committee members now fear, they very well could be setting up another asset bubble in junk bonds and high risk mortgages as these borrowers have been given the potential to overburden themselves with debt. In fact, when borrowers are able to finance debt at a lower than “usual” interest rates, it means that the price of that debt is perhaps overvalued, hence the bubble.
On Wednesday, all markets took this as the Fed could be ending QE a lot sooner than we expected. Not only did commodities take a hit, but as well equities sold off as risk appetite left the market place, which is accompanied by resurgence in the greenback. If it is the US central banks approach to begin scaling back their asset purchases, the Fed would likely take a loss on the long term bonds it holds as they attempt to trade them back into the market. It’s no secret that this is the Fed’s endgame as they look to reduce the same balance sheet representing the US currency that has more than tripled since the onset of the Sub-Prime Crises. However, the doubt amongst investors is still how the Fed plans on doing this, and perhaps at what price will the market absorb this barrage of US government debt?
This alone provides rational for the potential of long term interest rates starting to rise. Simply for the fact that not only will investors require a much higher interest rate as the economy now carries a credible risk of inflation over the longer term, yet also such a sudden bond supply increase discounts prices and in turn create upward pressure on interest rates. Therefore, savings that were sitting in gold could be sold off as these funds could flow back into the market and potentially earn a more attractive yield over time. This has to do with the potential of real interest rates rising and money leaving real assets.
The question we have to ask though surrounds what happens to the hopes of this US economic recovery when the above situation unfolds. Furthermore, when the US Federal Reserve begins to tighten monetary conditions and in turn reduce their bond holdings, with very high probability the market reaction in terms of interest rates will not be quite as theoretical as I have played out. It could be accompanied by some turbulence.
To digress, I find it humorous whenever someone tells me with great certainty that gold will hit 2500 US/oz. or some other ambiguous figure in a certain period of time. I loosely believe in the efficiency of markets, and as always the price of gold is reflected in its current price. If it should be 2500 US/oz., then it would be that price today. Nonetheless, gold closing the week at 1581.19 US/oz., down 2.3 percent hasn’t spooked me from holding it as it still has value as a hedge against that economic uncertainty that will prevail.