Real interest rates, liquidity, risk and gold
The arttcle below is a guest contribution by Cees Bruggemans, Chief Economist of South African-based First National Bank.
Think of a big spinning wheel.
At its centre one does not find Beijing (though one day we will) or London (long surpassed) or Europe (a passing wannabe) or any supra arrangement (UN, G7, G20, BRICs).
Instead, at its centre we find the Fed and its adjunct, the US bond market, that amorphous entity capable of threatening even US Presidents (as Bill Clinton found to his dismay in 1993, as the US Congress discovered to its disgust on that Lehman Monday in September 2008 and as no doubt yet others will one day rediscover all over again).
On being confronted by a failing financial system, a deep recession causing massive labour layoffs, a fragile property market weighing on recovery and a drift towards deflation, the Fed deemed it wise to pull out all props.
In the first instance that meant opening new direct channels of liquidity for those cut off from banks or markets. It meant interest rates down to zero. And as inflation eventually dipped below 1% in the presence of an enormous output gap it meant the need for deeply negative interest rates, the equivalent of which was achieved by buying huge amounts of Treasury bonds in the open market (QE1 & QE2 ultimately more than tripling the Fed’s balance sheet).
These actions created oceans of excessive liquidity, giving moral support to those in trouble, but nearly all of it ultimately ending back on deposit with the Fed.
As a consequence of such Fed-displacement of private portfolio holdings, all asset classes tended to rise in value, eventually reinforced by recovering market confidence and risk appetite.
Some of those effects were observable in the US (long bonds initially drifting towards 2%, Dow Jones recovering to above 12 000, bond spreads narrowing, house prices eventually roughly stabilizing 30% off real peak levels). Much of it also spilled worldwide, boosting commodity prices, EM bonds, equities and currencies.
With uncertainty about the eventual US playout high and deep questions being asked about future inflation, the Dollar has weakened and especially gold and silver prices have done well.
During 2011 so far, various crises (European debt, Middle East and North African oil scares, Japanese quake fallout, questions about Chinese growth sustainability, re-emerging EM inflation, future US debt rating) all further boosted risk, assisting gold through $1500.
Last night’s global televised historic first press conference by Fed chairman Bernanke further reinforced market perceptions of modest growth, debt problems and a late Fed exit, feeding bearish Dollar sentiments, propelling gold to $1530, with benign US policy neglect suggesting yet more Dollar weakness and gold strength potentially ahead.
This does raise the question: Where will it all end? For end it will, thereafter seeing renewed gold price subsidence, as also observable in the 1980s for a decade.
Two forces seem to be pivotal.
One is the Fed playing out its stabilizing role. The other is mankind’s infinite ability to create new shocks, inviting new risk anxiety and inviting ongoing appetite for incorruptible hedges such as gold/silver/PMGs.
The Fed is currently shepherding along a still fragile US economic recovery, with a lot of resource slack remaining and inflation still low though no longer drifting towards the brink with deflation.
The Fed has signaled its intention to stop bond buying when QE2 ends in June, prepared to see how financial markets and economy react to being without this support.
If satisfactory, with the market and economic recoveries self-sustaining, the Fed may also start reducing its balance sheet as bonds held on its books are paid off.
At some point, the inflation revival (towards a more ideal 2% for core inflation) and a shrinking output gap (falling unemployment/rising labour participation) will be advanced enough for the Fed to start a gradual rise in interest rates.
Markets are today discounting its commencement sometime in 2012.
Nearly nobody deigns to mention the pivotal Presidential and Congressional elections in November 2012 influencing this process. But remember the timing of the QE2 start, a day after the mid-term November 2010 elections. With a three-month warning head-start per the August Jackson Hole Bernanke speech (is a repeat coming in 2012?).
Provided inflation and output gap warrant it, the Fed would presumably prefer not to get drawn into that election maelstrom and may prefer to start its rate tightening in November 2012 at the earliest.
Other major central banks also have the power to influence global liquidity levels.
Europe has started its monetary tightening, except that we can’t know whether this process may get interrupted by events (as happened to the ECB in 2H2008 as well).
As things stand, BoJ is currently a major source of global liquidity following quake and Tsunami damage and this remaining a supportive feature this year.
Others, especially China, have turned less accommodating.
There is still the potential of things going fundamentally wrong, such as Middle East events causing oil price shocks much higher than seen so far.
Though the Fed emphasizes its vigilance regarding second-round inflation impacts on inflation expectations, its real fear would be for such oil spiking to simply erode US incomes, causing growth to falter.
Similarly, more fiscal restraint could also mean slower growth.
In either instance, the Fed could PROLONG its support and delay its exit from emergency measures.
Any bond market strains due to developing debt fears might also see more rather than less Fed support.
All these scenarios are seen as Dollar-negative in the short-term.
When it comes to precious metal prospects, a weak Dollar prospect boosts the gold price higher as seen in recent months, gold reaching $1530 so far.
Also, a lot will depend on the main risk sources around the world and how these play out these next 18 months.
Externally, more political strain in North Africa and the Middle East, with or without marginal supply interruptions elsewhere in OPEC space (Nigeria, Gabon?), could see the oil price resume its climb, once above $140 eroding US household spending sufficiently to threaten a US (and world) growth relapse. If so, expect prolonging of US policy support, and even resort to QE3 (in need).
Japanese events are currently suppressing industrial activity, but it should not last as reconstruction starts to come through. Growth loss is not expected out of China or Europe, but these areas warrant monitoring.
More interesting is US fiscal policy.
Already restrictive as its budget deficit no longer adds to US growth, the politics surrounding this issue may yet generate major complications. If into the political season next year US bond yields were to start climbing because not enough is being accomplished to address long term fiscal concerns, this would directly threaten US growth recovery via housing and business outlays.
As with higher priced oil and a subsequent growth relapse, this might incite the Fed to remain accommodative for longer.
For as long as the Fed holds off on raising US rates, the opportunity cost of borrowing cheap and investing speculatively in precious metals may be attractive enough to keep powering these metal prices higher.
In addition, these sources of risk may become more stressful in their own right, further bolstering the attractiveness of precious metals.
Market forecasts look for a $1600 peak for gold. It would seem there remains substantial upside potential for as long as the Fed remains on hold, excess liquidity remains available, and risky events globally keep on bolstering prospects.
At some point, though, US conditions will finally warrant the Fed to start more fully exiting its emergency stance, lifting interest rates back towards more normal levels.
For some, the end of QE2 bond buying could change market conditions enough to be taken as the watershed. But it may not prove decisive to overcome the influence of low interest rates or crisis risk concerns.
The Fed itself appears to feel that once it starts shrinking its balance sheet (no longer reinvesting bond runoff payments), monetary tightening will have commenced and thus gradually change the playing field and prospects for Dollar (and gold and other commodities).
Thus a watershed moment overall will eventually arrive.
When this moment arrives one would expect to be in the proximity of a precious metal peak, as real US rates will finally start rising, and other central banks around the world will feel more comfortable of raising their real rates as well.
This argument suggests the gold run may have potentially another 6-18 months ahead of it before facing renewed subsidence.
This still leaves mankind’s infinite capacity to create more crises and heighten risk perceptions, whether in Europe, the Arab world, in Asia or in the US itself.
If such risk were to periodically intensify anew, it could outweigh the Fed’s gradual tightening stance, maintaining the precious metal bull-run for longer, though probably not indefinitely.
At some point, the major crises would also subside enough and an era of relative stability could resume, in its wake downgrading precious metal prices once again.
But when looking at potential crisis areas (Japanese cleanup and reconstruction, European debt playing out, Arab awakening playing out, US debt playing out) one may not deal in just months or even a year or two, but more likely in many years.
And the intensity of some of these potential shock areas could still surprise to the upside, given what’s playing.
In turn, this could still give surprise upside twists to precious metal prices of unknown intensity, until the next great metal price subsidence presents itself.
Thus there is today still upside potential in precious metal prices, potentially enormously so, but these spikes will eventually subside once again as the world returns to a measure of stability, as it habitually is inclined to do after great crisis interruptions and efforts to address these, until the next dislocation disturbs things all over again.
Source: Cees Bruggemans, First National Bank, April 28, 2011.
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