Fed QE and Gold, Silver
After the Federal Reserve launched QE3 last month, investors and speculators are growing excited about its future impact on gold and silver. Though the Fed's QE3 campaign started out relatively small, its open-ended nature is utterly unprecedented. Thus an unknown amount of future inflation will be spawned. Naturally gold and silver thrive in such environments, as they proved during QE1 and QE2.
Of course QE stands for quantitative easing. Even as a lifelong student of the financial markets, I don't recall hearing this term before late 2008's epic stock panic. Central banks are notorious for trying to cloak their actions. So although "quantitative easing" was universally derided historically, it was known by a different name. Quantitative easing is simply a pleasant-sounding euphemism for debt monetization.
All throughout world history, debt monetization ended in ruin for the countries that foolishly played this dangerous game. And it is exactly what it sounds like. Central banks create new paper money out of thin air to buy bonds, thus monetizing them. The big problem is this grows, or inflates, the money supply. Whoever sold the bonds to the central bank spends this new money, injecting it directly into the economy.
The result is inflation. When the money supply grows faster than the underlying pool of goods and services on which to spend it, their prices are bid up. The more new money the central bank creates to monetize debt, the worse the resulting inflation. Even though its impact on price levels isn't apparent immediately, it is inevitable. Once unleashed, history has proven inflation will fully run its course.
Inflation is devastating, an insidious plague that stealthily impoverishes the great majority of people whose incomes don't rise fast enough to maintain real purchasing power. Inflation slaughters the poor, who already struggle greatly to survive even without rising prices. Inflation crushes everyone on fixed incomes, nearly all retired people. And inflation robs savers blind, stealing their lifetimes' hard-earned surpluses.
Thankfully there is a refuge for the prudent, a safe haven to protect their accumulated wealth from inflation's vile predations. All throughout history, gold and silver have maintained their real purchasing power as money-supply growth lifted prices all around them. They are like battleships on the seas, no matter how high the ocean of paper currencies under them rises they still float commandingly on top.
The Fed's brazen debt monetization in recent years has already created massive inflation. This deluge of new dollars that never existed before is already baked into the pipeline, and its economic impact is just beginning to be felt. Yet gold and silver have already seen fantastic gains during the Fed's initial pair of quantitative-easing campaigns. This new open-ended third one is very bullish for these precious metals.
The best clues as to how gold and silver will perform in this unlimited QE3 era are probably found in how they fared during QE1 and QE2. So let's dig into the entire history of the Fed's post-panic debt-monetization campaigns, and then see how gold and silver did within them. This first chart looks at the Fed's balance sheet, which is where all the debt it has been monetizing ultimately shows up.
Make no mistake, quantitative easing is Fed Chairman Ben Bernanke's response to the once-in-a-century stock panic that slaughtered the markets in late 2008. Prior to that, the Fed's balance sheet looked very different. For the first 8 months of 2008, it averaged $875b. Meanwhile the Fed's holdings of US Treasuries, the most important component of debt monetization, averaged $579b in pre-panic 2008.
The Fed started aggressively buying assets before it launched what later became known as QE1. Note the gargantuan spike in the Fed's balance sheet between late August and late November 2008 in the dark heart of the stock panic. Over that insane 3-month period where the flagship S&P 500 stock index (SPX) plummeted 42.2%, the Fed's balance sheet skyrocketed a mind-boggling 145.5%! QE had begun.
It formally started with a Fed press release on November 25th, 2008. Just three trading days after the stock markets slammed into their primary panic low (SPX 752), the Fed declared it would purchase $500b of mortgage-backed securities and $100b of direct obligations of the government-sponsored enterprises including Fannie Mae and Freddie Mac. With all the other panic turmoil, this was widely overlooked.
In this area chart, the three different bond classes the Fed purchased in its QE campaigns are shown in different colors. Agency (GSE) debt is shown in green, MBS bonds in yellow, and the all-important US Treasuries in red. Note these three classes stack above within the Fed's overall balance sheet in orange (which starts at zero). The red Treasury band doesn't start at zero, but at the top of the yellow MBS band.
Soon after, at the December 16th, 2008 FOMC meeting, the Fed decided to slash its benchmark federal-funds rate by a staggering 100 basis points to zero. At that point the Fed had already expended all its conventional monetary-policy ammunition. Everything it did after that had to be some variation on debt monetization. And the great inflationist mocked as Helicopter Ben didn't hesitate to rise to the occasion.
The stock panic should have ended in late October 2008, as the SPX had soared 18.5% in six trading days ending on Election Day. But the panic frightened half of Americans into voting for Barack Obama, a man who had openly campaigned on a Marxist and Socialist platform. He wanted to divide America with venomous class-warfare rhetoric and envy, and then steal the fruits of the productive to bribe the lazy for votes.
In the two days after Obama's victory, the SPX plummeted 10.0%! It would ultimately plunge 25.2% over the subsequent couple weeks to a new panic low. And that again should have been the bottom, but when the Obama Administration took power in late January 2009 it terrified investors. Many who voted for Obama thought he would be like Clinton and be a centrist leader, but instead he swung sharply left.
As the US economy remained very shaky after that once-in-a-lifetime stock panic, the Obama Administration wasted no time in trumpeting asinine new plans. It wanted to greatly hike already-crushing income taxes on the investors, entrepreneurs, and small businessmen who create most of the private-sector jobs in America. It wanted to radically increase smothering regulations, and wanted Washington to take over health care.
So by early March 2009 in the post-panic period when markets normally soar following such fear super storms, the SPX had slumped 25.1% year-to-date! The Fed was rightfully terrified, as it knows just how important the health of the stock markets is to our entire national psyche. So just over a week after those secondary Obama-fear lows (SPX 677), the Fed vastly expanded its young quantitative-easing campaign.
On March 18th, 2009, the Fed's Federal Open Market Committee released a statement declaring it was nearly tripling its debt monetization. It would purchase another $750b worth of MBSs to attempt to manipulate mortgage rates lower. It would also double its agency debt buys with another $100b. But the shocking part was it announced a direct monetization of $300b worth of Washington's Treasuries!
While the Fed had owned Treasuries before as the red area on this chart indicates, it had never aggressively bought them up with the explicit goal of manipulating general interest rates lower. This was the point when debt monetization and the debasement of the US dollar really started to concern prudent traders. And this ballooned the total size of what became known as QE1 to a staggering $1750b!
You can see above that the Fed's holdings of especially mortgage-backed securities mushroomed dramatically during that QE1 campaign. By the time it started tapering off in late June 2010, the Fed held $1129b worth of mortgage debt at its peak. But with the stock markets' strong post-panic advance stalling out and correcting, the Fed couldn't resist the temptation to expand its monetizations even further.
So shortly after the SPX had corrected 16.0% over a couple months, on August 10th, 2010 the FOMC announced what would later be called QE2. This actually spooked the markets, because the Fed was brazenly reneging on its QE1 promise to let those debt purchases automatically unwind as they matured. It announced it would roll over $300b in maturing MBSs into Treasuries, expanding their monetization.
After that the Fed remained on hold so it wouldn't be seen as political during the crucial 2010 midterm elections. They were amazing, after ramming through Obamacare when the majority of Americans opposed it the Democrats were throttled. They lost 63 House and 6 Senate seats, compared to an average of 30 and 4 in midterm elections. This was the worst midterm defeat for any party since 1938!
The state-level races were even more lopsided. Republicans won 680 state-legislature seats, the most of any party ever even beating the 628 the Democrats won in 1974 after Watergate. The US had never seen a bigger midterm mandate for small government, yet Obama and his party inexplicably decided to ignore it. But the very next day, even this incredible news was overshadowed by the Fed's latest FOMC decision.
On November 3rd, 2010, the FOMC tripled its new QE2 campaign to a total of $900b. It said it would purchase an additional $600b worth of Treasuries by the end of June 2011. This would work out to about $75b per month, a metric to keep in mind later. On the chart above you can see the radical ramp in the Fed's Treasury holdings during that QE2 campaign. They later peaked at a staggering $1684b.
Provocatively QE2 proved a political nightmare for the Fed. World leaders and central bankers, who normally never criticize in public, were openly angry about this brazen monetization. It was called irresponsible debasement. And the newly-elected Republicans attacked the Fed aggressively for this, leading to calls for Congress to revoke the Fed's monetary authority. Bernanke was stunned by this.
QE2 was highly controversial because it directly enabled the profligate Obama Administration's wild overspending. The world's biggest and best bond-fund manager, billionaire Bill Gross, pointed out that a whopping 70% of US Treasuries issued during the QE2 era were purchased by the Fed! If the Fed hadn't created money out of thin air to buy Obama's debt, he couldn't have run such colossal deficits.
So with Obama's unprecedented trillion-dollar deficits and scary debt growth becoming a big political issue, the Fed had to lay low. Any more direct monetizations of US Treasuries would be seized upon by Republican lawmakers as proof Bernanke was in bed with Obama. So even after QE2 ended on schedule in June 2011, the Fed was understandably reluctant to rock the political boat very much.
But again the stock markets, the key to American sentiment as a whole, were flagging. After Obama reneged on his word and blew up a debt-ceiling deal with Congress, Standard & Poor's downgraded Washington's Treasuries in early August 2011. This was the first time the US's AAA rating had ever been downgraded in history! The next trading day the SPX plummeted 6.7%, and fear skyrocketed.
As this selling pressure cascaded into a full-blown correction, the Fed felt compelled to act again. But it was very aware of the growing political risks of its inflation, so it didn't expand its monetization. Instead on September 21st, 2011 the Fed launched what became known as Operation Twist. It sold $400b worth of short-term Treasuries (under 3 years maturity) to buy $400b worth of long-term Treasuries (6y to 30y).
Now since this wasn't new monetization, merely shuffling capital around, it escaped heavy criticism. Stock traders were disappointed it wasn't QE3 though, so their selling hammered the SPX down 8.6% in less than 2 weeks on this decision. And infuriating free-market proponents, the FOMC statement openly said the purpose of this new campaign was to attempt to manipulate long-term interest rates lower.
When Operation Twist had run its course, the Fed decided to extend it to the end of 2012 at the FOMC's June 20th, 2012 meeting. The Fed would maintain the yield-curve twisting rate of around $44b per month. Since this extension would only run for six months compared to the original's nine months, this worked out to $267b. Despite heavy market pressure for QE3, the Fed continued to refuse to expand QE.
But this all changed last month, rather puzzlingly. During previous QE announcements, the SPX had been near major lows after a panic or serious correction. Yet when the FOMC met in mid-September 2012, the SPX was just shy of a new 56-month high! Near the top of its secular trading range, stock-market upside was very limited. Would the Fed actually waste its ammo while the stock markets thrived?
In addition, given the political firestorm QE2 spawned would the Fed risk looking political less than 8 weeks before one of the most-important elections in US history? Somehow the stock markets had managed to survive and thrive in the 15 months since QE2 ended. So why risk the wrath of Republican lawmakers by attempting to goose the stock markets which would greatly benefit Obama's re-election bid?
But apparently the inflationists at the Fed rightly fear a Republican Congress, which could kill the Federal Reserve in a single vote. Instead of waiting a couple more months until after this critical election, the FOMC decided on September 13th, 2012 to launch QE3. And unlike the past debt-monetization campaigns that had specific amounts and timeframes, incredibly QE3 was open-ended with no stated limits!
The Fed was sensitive to the criticisms it is enabling Obama's insane debt growth, so in QE3 it switched back to buying mortgage-backed securities from Treasuries for the first time since QE1. And though QE3 was open-ended, the $40b per month was pretty modest by QE1 and QE2 standards. They weighed in at $1750b and $900b respectively, yet a full year of QE3 would "only" amount to $480b if not expanded.
And it is this new open-ended QE3 campaign that has investors and speculators so excited about gold and silver. How will the precious metals fare with potentially unlimited new inflation about to be unleashed into the economy? One of the best ways to gain some insights is to review how these metals did during the rest of the Fed's QE. So these next charts overlay the QE milestones over gold and silver.
During the time when the Fed's original QE1 buying was underway, from late November 2008 to late June 2010, gold powered 50.8% higher! This is a heck of a run, but it certainly wasn't all due to debt monetization. Gold was beaten down during the stock panic too due to flight capital from elsewhere igniting a monstrous US dollar rally. So gold was due to surge in the post-panic recovery anyway.
QE2, which was smaller but harder-core since it focused purely on monetizing Washington's Treasuries, saw gold gain 24.7% during its lifespan. This is certainly an excellent gain over less than a year. Provocatively, just after QE2 ended gold surged for other reasons. That was summer 2011 when Obama refused to honor a deal with the Congress on reducing spending to secure a US debt-ceiling increase.
The first-ever threat of Washington actually defaulting on its debt drove enormous gold investment demand, but this metal soon grew very overbought. So it started correcting soon before the Fed launched Operation Twist. And the fact that Twist wasn't QE3 really accelerated this gold selling. Over the entire Twist timeframe with no new monetization, gold drifted sideways to lower. But QE3 is new monetization.
Since gold rallied strongly during both QE1 and QE2, there is no reason not to expect it to respond similarly in the Fed's young new QE3 campaign. 25% in a year, especially if QE3 is expanded early next year as Fed officials are already hinting at, seems pretty conservative given gold's QE history. A 25% rally from the day before QE3 was announced would catapult gold up to a record high above $2150!
And being smaller and far more speculative than gold, silver has fared even better in the Fed's debt-monetization era. This metal soared 79.5% during QE1 and a staggering 89.2% during QE2! Realize there was more at play during these times than just quantitative easing though. During QE1 silver was recovering from ludicrous stock-panic lows, and during QE2 this metal experienced surging popularity.
Still though given silver's strong history of surging when gold does in inflationary times, I don't think attributing 50% gains to the Fed's QE is unreasonable. That is also in line with silver's oft-seen leverage to gold of 2 to 1. Again assuming QE3 runs for a year, and gets expanded in early 2013, a 50% gain in silver from the day before QE3 was announced would catapult this metal up near $50 per ounce!
Quantitative easing is pure inflation, the classic debt monetization that has proved so dangerous and ruinous all throughout world history. Gold and silver have always thrived as currencies are being debased, as they've proven abundantly during QE1 and QE2. And despite starting out small, the open-ended nature of QE3 has really ignited inflation expectations like nothing we've seen in a long time.
So the psychology of QE3 is likely to drive big increases in investment and speculation demand for gold and silver as long as the Fed keeps this campaign alive. There is an excellent chance QE3 will ultimately push both these metals to new record highs, perhaps as soon as next spring. And of course as gold and silver power higher, the stocks of the miners bringing these metals to market should amplify their gains.
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The bottom line is the Fed's quantitative-easing campaigns in recent years have been hugely beneficial to gold and silver. No matter how the Fed wants to present it, QE is classic debt monetization. Naturally the precious metals thrive in times of inflation, and QE is as blatant as inflation ever comes. The more dollars created out of thin air, the higher they bid the far-slower-growing gold and silver supplies.
While QE3 started out small, odds are it will be expanded considerably. After its initial launch QE1 was nearly tripled, and QE2 was tripled. For political reasons the Fed is reluctant to fully unleash its inflationary plans all at once. And the open-ended nature of QE3 has reignited inflation expectations like nothing we've seen in many years. It is going to ultimately drive traders to flock into gold and silver.
Adam Hamilton, CPA
October 5, 2012