Based on our latest gold Market Overview report.

In the previous articles and in the previous Market Overview report we discussed the unique macroeconomic position of gold (gold is a system hedge). The main conclusion was that gold is something else than its highly touted reputation as an inflation-hedge. This realization is crucial for any gold investment decisions. Actually, there is a lot of chaos and many conflicting arguments when it comes to gold and the case for it or against it. On one hand we hear stories about the threat of inflation and a sharp rise of overall prices just waiting around the corner, therefore one should invest in this shiny asset. We also hear about credit deflation, banks in trouble, financial markets that are not in great shape, making gold a good alternative. Having been fed with all kinds of information, one can have trouble inferring what to do in various scenarios. Suppose you hear that the rate of inflation is significantly higher. Does that mean and you should increase your position in gold? Or, what if you hear that we have reached very low levels of inflation. Should we then increase our position too? Wait… invest in gold when inflation is spiking and invest in gold when inflation is being lowered? It’s no wonder that investing in precious metals can be confusing.

As always, there are many ways in which the situation can develop and in today’s article (and to a much greater extend in the current Market Overview report) we will focus on what is probably the most important factor that will to a great extent determine what will happen in the coming months, not just in the precious metals market, but also in bonds, stocks and real estate markets.

Yes, you guessed correctly – we are going to discuss the Fed’s possible actions and the probable effects on the markets. Will we actually see any form of tapering or will we just hear about it? If so how will remarks made by the Fed impact actual events? As you know, very often what Bernanke or some other Fed official says can ignite large price moves. So, for the analysis to be complete, we should focus not only on what happens but also on how it is announced.

In the following part of this article we will discuss what’s likely to happen if the Fed does indeed taper the QE program.
Based on the possible combinations we created eight scenarios and we discuss how each of the markets (gold, stocks, bonds, real estate) could perform in each of them. We also explain which are the most and least likely. If they play out in the future you will already know what to expect in the following weeks/months.

The involvement of the Fed in buying assets makes it the most important player in the financial market. Over 3.5 trillion dollars amount to 23% of the American GDP (compare that to “savings”, which are almost two times less than that!). There are “rumors” about the Federal Reserve System’s possible “stepping back” from its policy of quantitative easing. The “rumors” came from Bernanke’s speech, and were slightly present in Fed’s “minutes” from 30^th-31^st of July (the minutes were published on the 21st of August. They register discussions that take place during Federal Open Market Committee meetings).

The so-called “tapering” of the Fed would mean a significant slowdown of the programs (which lead to an increase in the assets holdings). Many observers argued that “tapering” is supposed to start before the end of 2013; September being the likely candidate. The minutes do not confirm this, at least not strongly. We can read that “almost all Committee members agreed that a change in the purchase program was not yet appropriate”. There was only one mildly dissenting voice about some improvement in the labor market as a reason for the Committee to offer an explicit statement about asset purchase reduction in the “near future”. Few members responded that “patience” is needed in order to carefully “evaluate” the economic data. Few others responded that the plan was already articulated (although not very strongly) that the programs will be reduced.

In conclusion the Fed decided to keep the programs floating: they buy 40 billion dollars of Mortgage Backed Securities and 45 billion dollars of Treasuries each month in order to bid the prices of both (and keep the returns low). Moreover, the interest rate is supposed to stay at current low level of 0.25% percent as long as the unemployment rate stays below 6.5%, and the official inflation rate is not half percentage higher than the main policy goal of 2%.

What are the possible scenarios for the Fed? Most importantly the so-called tapering can be significant, negligible, or nonexistent. It can be started because of optimism about the state of affairs, or pessimism because of ineffectiveness of the tools. It can also be done at different times. Moreover the Fed can offer different communications about the program.

We can think of various options.

First scenario: The Fed continues the programs and communicates to the public that not much has changed.

Second scenario: The Fed continues the program and communicates to the people that the program is becoming reduced, because things are going great (economy is improving, unemployment is lower etc.).

Third scenario: The Fed continues the program and communicates to the people that the program is becoming reduced, because of possible threats (e.g. inflation).

Fourth scenario: The Fed freezes the program and communicates to the people that things are going good.

Fifth scenario: The Fed freezes the program and communicates to the people that things are not very good (risk associated with the program are higher than benefits).

Sixth scenario: The Fed decides to reduce its holdings, and communicates that things are going great.

Seventh: The Fed reduces the holdings, and communicates it’s because things are not going well.

In the eighth scenario the Fed will not change anything, but at the same time will think of something “special”, perhaps some other tools. It can start some other programs instead of existing ones.

In today’s article we will feature one of these scenarios in greater detail. Namely, we will discuss what would likely happen if the Fed froze the program and went into “stand by” mode because of positive news. That’s what corresponds to scenario #4 from the above list.

In scenarios four and five the Fed is moving to the stand by position. It freezes its balance sheet, decides to step back from continuous buying of securities, both governmental and mortgage. The communication in this case is the most important factor. In the fourth scenario the program is tapered, and the argument is made that the reason for this is that the economy has improved. The information is: the dollar system is in a better condition. Gold would probably go down under that scenario since it would lose parts of its appeal associated with its anti-dollar nature. The rest three markets would probably react positively, especially Treasuries and the stock market.

It is also the case with real estate, but much less so. If the Fed stopped buying more mortgage securities, then leaving them in the market should lead to a downward pressure, right? True, but we have to accept that there are some small positive movements in the real estate. Probably not that definite, and we should still see a lot of things happening in the market. Nevertheless our decision to put an “upward pressure” comes from the fact that the Fed slowed down in the recent time in buying of commercial assets (at least if one compares the actions to the previous plans).

Therefore there is some paradox in the above table. We see more chances that real estate should grow under the freezing scenario than under the continuation scenario. Why? Simply put, if the Fed officially slows down its operations and communicates the case because of positives, then it may be a sign that there is some life in the real estate market (plus stand by means that government is ready to help at any time if things get worse). Whereas with the continuation program, an additional buying scenario, it will probably mean that there is much less life in the real estate, and the Fed is trying to continue a hopeless fight against market forces.

Summing up, what would likely happen if the Fed does indeed taper the QE program? Gold would likely suffer in the medium term, but other markets would likely thrive (even though no one can rule out a short-term upswing). If you are interested in reading our analysis of the remaining 7 scenarios (including the most probable ones), and staying prepared almost no matter what the Fed does, we invite you to sign up and read today’s Market Overview report.

Thank you.

Matt Machaj, PhD
Sunshine Profits‘ Market Overview Editor