In short, starting tomorrow, the Fed will begin purchasing Treasury bills to the tune of $60 billion per month. These purchases will continue into the second quarter of 2020, though the Fed hasn’t specified a total targeted amount.
The stated reason for this restart is to avoid a repeat of the strain put on the money markets last month when the repo rate skyrocketed. In a speech to the National Association of Business Economists, Powell said these purchases should be viewed only as an adjustment — different than the asset purchase campaign the Fed initiated in the wake of the financial crisis.
“This is not QE,” Powell said. “In no sense is this QE.”
As part of this non-QE-balance-sheet-expansion, Powell said the Fed would be focused on buying short-term U.S. bills rather than longer-term bonds.
Now, sure, this is an important difference. But at the same time, the fundamental dynamic here is the same — the Fed is back to expanding its balance sheet, which is already massive — $4 trillion to be specific.
And how about that $60 billion per month? Well, sure, it’s focused on short-term bills, but if we look at just the amount itself, it’s greater than QE3, when the Fed began buying $40 billion per month.
And what about the alleged end to this “adjustment” in the second quarter of next year?
Well, if it happens, kudos to Powell. But let’s recall what happened in 2013 when then-Fed-Chair Bernanke announced a QE tapering. If your memory is foggy, that resulted in the infamous “taper tantrum” which saw stocks drop over 4% in three trading days. Little surprise that in the aftermath, Bernanke changed his mind about tapering.
The point is the markets might make it hard for Powell to end this cash-injection program — whatever you want to call it.
By the way, here’s a nice visual of the Fed’s balance sheet over recent years.
***Regardless, these purchases are likely to support two outcomes we’ve been discussing here in the Digest — lower yields and higher gold prices
The intended purpose of the Fed’s balance sheet expansion is added liquidity in the money markets. This will help keep rates low.
Meanwhile, the current expectation is for another rate cut at the end of October. Below, you can see CME’s FedWatch Tool. As I write, it’s putting a 73.2% probability on another quarter-point cut at the end of the month.
As you know, lower rates make gold more attractive to yield-hungry investors. That’s because anemic yields make it less likely these investors will miss out on outsized income-investment returns relative to gold.
***Now, if you’re a gold investor, you’ve been watching the recent pullback in the precious metal’s price
This was to be expected.
In fact, it was back in our August 15th Digest that we said there was a strong case to be made for a pullback in gold. And after a brief surge higher in the days following that issue, gold has, in fact, been taking a breather, as you can see below.
There are a number of things we can point toward to account for this. First, gold was simply an overheated trade. Investors had piled in, pushing the metal’s price very high, very fast.
Look again at the chart above, specifically the massive leg higher in early August. Oftentimes, the market has to pause in order to absorb these catapult leaps before moving higher.
Moving beyond this technical explanation, we can also look at macro factors. Sporadic hopes for trade-war resolution has kept gold’s price in check. Plus, we’ve seen some better-than-expected economic data. While these things are good news in general, remember, much of gold’s appeal is due to its role as a hedge against chaotic markets. So, when there’s good news, it keeps fear of volatility in check, which means investors aren’t as likely to rotate into gold.
***But the long-term case for gold remains strong
Last Friday and this morning, we received news that the U.S and China are close to inking Phase 1 of a trade deal. It centers around intellectual property issues, agricultural purchases, and no new tariff hikes. Now, while this is welcomed news, we’ve been close to deals before only to see them fall through.
Also, remember that, at present, all existing tariffs are expected to remain in place. So, until we get a deal that ends all existing tariffs, earnings in the coming quarters will still reflect this headwind.
Meanwhile, a long-running dispute over aircraft aid is threatening to launch the U.S. into a new trade war with Europe.
Recently, the World Trade Organization (WTO) ruled that Airbus (headquartered in France) had received illegal state aid in Europe. This was allegedly helping it compete against its primary U.S. competitor, Boeing.
Boeing cried “foul play.” The matter went to the WTO, who ruled in favor of Boeing. Now, the U.S. can impose tariffs on roughly $7.5 billion of European exports annually.
Of course, soon after Boeing brought its case against Airbus, Airbus launched its own case against Boeing. If the WTO rules in favor of Airbus, you can expect the EU to retaliate against any tariffs the U.S. might impose.
Perhaps the French Minister of the Economy and Finance put it best: “Do we really want to add a trade war between the U.S. and Europe to the Chinese and American trade war?”
Chances are, you don’t — but if it happens, it’s just another tailwind for gold.
***Let’s return to the big picture view
Below is a chart showing the Dow/Gold ratio.
It’s exactly what it sounds like. It’s a chart that shows the relationship between the price of the Dow Jones index, relative to the price of gold.
Here it is from about 1950 through today (the shaded areas are recessions).
To read this, if the value is getting higher, it means the price of the Dow is climbing relative to that of gold (simplistically, stocks are outperforming).
If the value is getting lower, it means gold’s price is rising relative to that of the Dow (simplistically, gold is outperforming).
The critical question is whether or not we’ve recently hit a new, long-term inflection point, which would mean gold is beginning a multi-year bull run.
Below, we look at the chart since the early 2000s, adding in simple trend lines.
Notice the right side of the chart, where I’ve circled the point at which the ratio has now broken beneath its long-term “Dow outperforming” trend.
Now, it’s still too early to say with certainty that the Dow/Gold Ratio has flipped, but given what we’re seeing with gold’s price — even with its recent breather — it certainly would seem wise to allocate at least some of your portfolio to gold.
After all, the last time the ratio flipped in favor of gold, the precious metal went from about $280 in December 2001 to roughly $1,890 in 2011.
With so many factors suggesting more gains for gold, this seems like a no-brainer. That said, this suggestion is from a long-term perspective. In the near-term, technical indicators suggest gold could still see some selling pressure in coming weeks. So, if you’re looking to buy in, smaller allocations might be wise until gold resumes its climb.
It’s shaping up to be an interesting end to the year — a potential truce with China, the possibility of a new trade war with Europe, an expanding Fed balance sheet, and potentially more gains for gold. Lots to watch.
