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Thursday, 28th February 2019

Fed Policy Turns in Favor of Gold  

On January 30th, 2019, the Federal Reserve issued a statement confirming an abrupt about face. After five years of promising 'normalization' of monetary policy and a pre-set path that included eight rate hikes and the sale of hundreds of billions of dollars in assets, the Fed paused in mid stride, thereby opening the door for a new gold bull market. The Fed's path to monetary normalization reverted to flexible data-dependency almost overnight. Suddenly, rates could now go up or down and the balance sheet could shrink or grow.

In early October of last year, Fed Chairman Powell had made it clear that the Fed Funds Rate was a long way from a neutral interest rate, that their policy was still far too accommodative and that they might have to overshoot before they were done raising rates. But on December 19, with the stock market in free fall, Powell claimed that we were suddenly at the low end of the neutral range. He also said that the Fed's sale of assets known as Quantitative Tightening or QT, which was designed to unwind Quantitative Easing or QE, would continue on 'autopilot'. The autopilot was cancelled by way of a leak to the WSJ in early January and its demise was confirmed on January 30th.

In late 2018, investors learned that the Fed's emergency policy interventions after the Great Recession...ultra-low interest rates and massive QE...cannot be withdrawn without markets collapsing. This is a major development. Why can't the Fed remove its stimulus? The Fed's unparalleled intervention may have saved the financial system but it did not generate a real economic recovery. The Fed inflated speculative bubbles that masqueraded as an economic recovery while adding an enormous amount of new debt. That promises to be this year's discovery.

The Fed's surrender accomplished two things: it began to bring down short-term interest rates and it likely brought a halt to the rising dollar, reversing two powerful headwinds for gold. Gold trades inversely to the dollar about 75% of the time. The dollar entered an uptrend when QE ended in late 2014 and the Fed began signaling that rate hikes were coming, which they did in late 2015. QT strengthened the dollar and weakened gold just as QE drove the dollar down during gold's bull market of 2009-12.

As Jim Grant of Grant's Interest Rate Observer has often noted, the gold price has another inverse relationship even more important than the one with the dollar...confidence in the Federal Reserve. The abrupt change in direction at the Fed over the past several months has shaken some of the market's confidence in the Fed. But there is more to come.

What happens when the debt has risen much faster than the economy needed to service and repay it? That's likely to be this year's discovery, one which could devastate Fed credibility and cancel the market's confidence in the so-called Fed Put which supposedly back-stops the markets.

Understanding QE

As you can see from the chart below, the three largest Central Banks in the developed world more than tripled the size of their balance sheets since 2008 in response to the Great Recession. Although the Fed began tapering first, the ECB stayed at the game much longer before announcing it had ceased as of the end of 2018. This enormous $10 trillion expansion was revolutionary when it began but then became normal to markets. The small amount of shrinkage in 2018 turned out to be very eventful.

Assets held by the U.S. Federal Reserve, European Central Bank and Bank of Japan, quarterly

Here's how it worked. The CBs bought assets out of the market with newly created base money consisting of currency and bank reserves. The new base money sported a tiny interest rate if banks kept it on deposit at the Fed, otherwise none at all, while deposits at the ECB were actually charged interest. The incentive was therefore for the sellers to immediately buy riskier assets to gain a return rather than hold the base money.

As Dr. John Hussman writes, someone always had to be holding the new money for as long as it would take to replace it with something better. This became a game of hot potato in which $10 trillion in QE-supplied money circulated through the financial system, searching for yield and driving interest rates down to 5,000 year lows. Not surprisingly, debt soared.

With the benefit of hindsight, we can now see that this stimulus did not go into the economy to provoke either an investment boom or a binge of consumer spending. The money went to the financial system where it was used overwhelmingly for speculation and financial engineering...the focus of Wall Street. It went to activities such as M&A, leveraged buyouts, share buybacks, high yield debt refinancing and interest rate arbitrage.

S&P 500 companies use of cash

North American M&A activity 2008-2018

For many CEOs, M&A is a preferred alternative to investing in innovation and new plant and equipment. Total deal volume reached almost $4.2 trillion globally last year, higher than 2017's $3.7 trillion but still less than the record of over $5 trillion set in 2015. Deals involving U.S. targets totalled over $1.7 trillion, compared to approximately $1.5 trillion in 2017.

Private equity firms also had a banner 2018. As of late December, private equity buyouts had reached almost $384 billion, the highest since before the Great Recession.

Did the Fed's massive QE boost real growth and investment? The overwhelming evidence is that it did not. After a brief recovery following the collapse of 2008-9, Real Gross Private Domestic Investment has been stagnating.

Real Gross Private Domestic Investment 2011-2018

Data prepared by Bloomberg for a report dated November 19, 2018 shows investment as a percent of GDP going sideways to down for nearly 20 years while corporate debt continues to rise. Fed policy has encouraged borrowing more than investing.

Non-financial corporate debt rise has not led to a boom in investments  2001-2018

Not surprisingly, the diversion of capital from investment to financial engineering has resulted in the poorest productivity performance in the history of the U.S. economy. Following a typical bounce back after the Great Recession, U.S. worker productivity has grown less than 1% annually.

Private non-farm business sector: labor productivity 2011-2017

Corporate profits have also suffered from the malaise. The U.S. Bureau of Economic Analysis estimates that pre-tax corporate profits have not increased since 2012 (see below).

Corporate business: profits before tax (without IVA and CCAdj) 2011-2018

The Results of QE

The Fed got it wrong. Yes, it seemed logical to assume that a 10 fold increase in the Fed balance sheet would encourage investment, productivity and real growth. Instead, the U.S. got the poorest economic recovery since the Second World War.

The extra $10 trillion of money creation by Central Banks seems to have depreciated the value of capital. Easy money encouraged short-term thinking. The average holding time for an 'investment' on the NYSE fell to four months.

Ultra low interest rates kept alive zombie companies whose continued existence acted as a disincentive for better companies to invest in building new. It was easier, faster and cheaper to borrow and speculate or merge rather than accept the extra risk and the years of planning required to innovate and build.

The quantity of debt soared while the quality fell. Never has the percentage of U.S. investment grade bonds just one step above junk been this high (52%). The system has become increasingly fragile but few have noticed...after all, the stock market was soaring so the economy must be strong. If only the yield on the U.S. long bond would rise to confirm the bull narrative.

In effect, Fed monetary policy after the Great Recession restructured the economy around cheap money, driving down expected average returns to levels that supported millions of otherwise uneconomic transactions and wasting valuable capital. No wonder markets rejected the Fed's plan to take back its stimulus last year.

It is hard to escape the conclusion that higher interest rates and a significant rate of default are needed to clear out inefficient companies and excessive debt in order to get back to a more healthy economy based on savings and real investment that are rewarded with higher rates of return.

One blessing is that QE did not drive consumer inflation the way many had expected, a fact that ultimately ended gold's last bull market in 2012. The stimulus ignited financial inflation instead. The excess dollars therefore did not undercut confidence in the currency.

The Second Fed Shoe

This year we expect the second Fed shoe to drop. Not only can the Fed not normalize policy by taking the stimulus back. We are now also going to learn that QE and zero interest rates mortally weakened the economy, having promoted speculation and mal-investment rather than real growth.

Debt has grown much faster than the economy. As Ray Dalio of Bridgewater fame points out, every dollar of debt is a claim on the future goods and services of the real economy. Holders of that debt have complacently assumed that these claims will be honored in the future and that the dollar's worth will be maintained. This cannot be so, as the below chart shows. Either the claims must be devalued to align with the real economy (default), or the dollar must fall (inflation). Both are extremely gold friendly developments.

The argument against inflation is that it hasn't happened yet. But inflation is largely psychological. When does the flood of new claims against a slow- growing economy begin to frighten investors? During the next recession? When an avowedly socialist government is on the verge of being elected? When too many baby boomers decide to cash out and retire?

A limit has always been reached in the credit booms of the past, when people woke up and suddenly tried to crowd into the real economy before the currency devalued, thereby devaluing the currency. Confidence in a currency is lost slowly and then all at once. Remember that the emission of extra dollars to pay simultaneously for U.S. wars against poverty and communism triggered the inflation of the 70s. Today's soaring Federal Government fiscal deficit could easily have the same impact.

Gross domestic product / All sectors; debt securities and loans; liability, level

What happens when the red line wants to have more of the blue line?

One way or another, we are going to see a realignment of the real economy and the financial system. As for predictions, we agree with Dalio: the Fed will once again fight economic slowdowns and defaults with more QE and the dollar will implode. For the year ahead, we cannot imagine financial safety without a measure of gold in the portfolio.