Wednesday's Federal Open Market Committee (FOMC) meeting ushered in yet another round of quantitative easing, with the central bank planning to purchase an additional $45 billion worth of "longer-term Treasury securities" on top of the $40 billion worth of mortgage-backed securities (MBSs) the Fed has been purchasing on a monthly basis since September. The newly adopted measure is meant to fill the gap left by the expiration of Operation Twist this month. Through Operation Twist, the Fed sold short-dated Treasuries from its balance sheet to purchase $45 billion worth of longer-dated Treasuries, on a monthly basis, in an effort to depress long-term borrowing rates.
While Operation Twist was inflation neutral (as the Fed was simply reallocating securities on its balance sheet), the announcement of this new measure gave no indication of plans to sterilize this latest round of quantitative easing, meaning that the Fed will be printing money to accomplish it. Members of the FOMC have basically concluded that the Fed will be printing $85 billion a month to purchase both mortgage-backed securities and longer-dated Treasuries for the foreseeable future.
Besides the major revelation regarding the Fed's next round of debt monetization, the central bank took another unprecedented step in its policy approach by stipulating a definitive, numerical goal for the unemployment rate. According to the Board of Governors of the Federal Reserve System:
"...the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent... the Committee views these thresholds as consistent with its earlier date-based guidance."
This "earlier date-based guidance" is a reference to a statement made at a previous FOMC meeting, wherein they stipulated that interest rates probably wouldn't rise until mid-2015. The challenge with a numerical target for unemployment is that decreases in this rate can be deceiving. Take for instance, the November jobs report, where the unemployment rate dropped to 7.7%. This "reduction" was the result of a decreasing labor force participation rate as opposed to a legitimate rise in overall employment.
The participation rate is the percentage of working-age adults that have jobs or are actively looking for work. A drop in this rate represents discouraged workers basically giving up their job search and dropping out of the labor market. Currently, the U.S. participation rate is hovering near its lowest level since the early '80s. While the perception of transparency is nice, the Fed may not be able to base its monetary policy goals explicitly on a numerical target for the unemployment rate considering the natural distortions that may occur.
Assuming the Fed maintains its monthly bond purchases for the next two years -- at $85 billion a month -- the Fed will have printed and added over $2 trillion to its balance sheet; a balance sheet which already contains approximately $2.8 trillion. With these figures in mind, a two-year continuation of the Fed's current bond purchase program would result in a Fed balance sheet valued at almost (or plausibly more than) $5 trillion dollars. Exiting these positions will be an uncertain endeavor -- we are now in uncharted waters when it comes to central bank open market operations. Divestment from a balance sheet of this magnitude will most likely be a monumental undertaking -- there is no precedent or knowledge base from which to derive guidance.
Neither stocks nor precious metals were immediately responsive to the Fed's revelations, with both markets decidedly stagnant in the aftermath. The Fed's decisions were broadly anticipated by market participants so the typical kneejerk response never materialized. This lack of market response also followed the September FOMC meeting in which the Fed announced QE3. The day after the Fed's statements, equity markets opened marginally higher, but not nearly to the degree one would expect following an announcement of further stimulus. The fact that stocks could not elicit some degree of strength as a result of either of the Fed's QE (in September and December) announcements raises questions as to the sustainability of current equity valuations. In the past, anticipation of stimulus and the Fed's "rising to the occasion" provided momentum to stocks; why now, after two similar announcements haven't equities reacted positively? It seems that macro factors (i.e., fiscal cliff) plaguing investor confidence is sufficient to quell any resultant buoyancy.
The initial lack of response in the metals market is similarly strange, as this complex has historically benefited from accommodative Fed measures. As the Fed's decisions were largely anticipated, it is possible that the central bank's actions were already baked into current metals pricing. Since the beginning of 2012, metals price action has converged with that of the broader risk asset complex, causing metals (most specifically, gold) to sell off when economic developments would intuitively portend higher prices. Thursday's sell-off in precious metals was attributed to profit taking and broader risk aversion. Given the ongoing fiscal cliff concerns and other macro detriments hanging over markets, the prospects of continued political gridlock in the U.S. may have taken precedence in the minds of investors.
In the currency world, while the dollar initially slid lower against its major counterparts (although not nearly to the extent one would expect), dollar losses stalled and in many instances, the dollar actually gained back ground against currencies like the aussie dollar, Canadian dollar, Japanese yen, and others in early morning trade on Thursday. This dollar resilience was probably also a factor in Thursday's weakness in precious metals, and was primarily a result of jitters regarding the budget outlook for the U.S. While there are multiple rationalizations for the relatively counter-intuitive trading patterns prevalent in the aftermath of the FOMC meeting, the implications in the long-term are the same.
It is also possible that muted inflation rates have lulled investors into a false sense of complacency regarding the inflationary implications of the Fed's quantitative easing, thereby limiting any immediate demand for gold as a hedge. After all, the Fed did stipulate that:
"...inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored."
However, the Fed does not address the nature of why inflation rates have been, and in the short-to-medium term will remain, muted. When considering inflation, it is important to address the velocity of money. The velocity of money measures the rate at which money flows through an economy, or in other words, it measures the turnover of money from one transaction to the next. There are a number of different metrics used to measure the money supply, and its associated velocity within an economy. However, within the context of the U.S. economy, many of these metrics display the same phenomenon: The velocity of money is at record lows.
Below is a graph that represents the velocity of money as measured by MZM (money zero maturity). This is a measurement of all liquid money within the economy. It includes money market funds and all money in M2 less time deposits (i.e., certificates of deposit).
(click image to enlarge)Data Source: FRED, Federal Reserve Economic Data, Federal Reserve Bank of St. Louis: Velocity of MZM Money Stock; Federal Reserve Bank of St. Louis; accessed December 12, 2012.
MZM is the preferred measure of liquid money in an economy because it only accounts for money stock readily available for spending and consumption. As displayed in the graph, the velocity of the MZM money stock is at its lowest level in recorded history. Stagnant inflation is directly attributable to weak consumption and the depressed velocity of money within the U.S. economy.
Considering that 70% of the U.S. economy is comprised of domestic consumption, a recovery within this framework is predicated on revitalized consumption. A renaissance in consumer spending will precipitate a rise in the velocity of money and correspondingly initiate rising inflation. So while the Fed's unprecedented monetary dilution may not have ushered in uncomfortably high inflation yet, this anomaly has nothing to do with the central bank's policy acumen and everything to do with the deflationary dynamics at play in our economy. Going forward, a more substantive recovery in the U.S. will be the harbinger of rising inflation rates as consumption naturally drives the velocity of money higher.
While we've addressed the response of stocks, metals, and the dollar as a result of the Fed's announcement, it is also important to monitor price action in the bond world. The Treasury market experienced modest selling pressure Wednesday (after the FOMC meeting), especially in the longer-dated securities like the 10-year and 30-year bonds with their yields rising over 2%. The 10-year Treasury yield touched 1.72% yesterday after languishing below 1.7% for the last month. This is also the case with the 30-year Treasury yield, which hit 2.9% yesterday for the first time in over a month. Rising yields on long-term Treasuries was one of the few, if only, market responses to the inflationary implications of further quantitative easing. When investors expect higher inflation in the long term, they will drive up the yields on long-term debt instruments to ensure they are adequately compensated for rising prices in the future. Intuitively, the yields on these securities should have initially dropped with the prospect of increased demand after the Fed announced it would be purchasing $45 billion worth of these securities on a monthly basis.
As we addressed earlier, the Fed has adopted a numerical target for unemployment. While this added transparency may seem beneficial at first glance, the measure could negatively impact the Fed's ability to scale back its balance sheet holdings in the future. If we can accept that Treasury yields are at record lows, and that we are nearing the end of a multi-decade bull market in Treasuries, we can similarly accept that at some point, there will be a significant reallocation of funds away from U.S. debt in the face an impending Treasury bear market. By providing a definitive target for unemployment, the Fed is providing investors the opportunity to preemptively divest their Treasury positions.
However long it takes, once unemployment nears the Fed's espoused threshold, which will warrant an eventual policy tightening, investors will increasingly sell their Treasury positions as the perceived peak of the Treasury bull market approaches. This selling pressure will push Treasury yields upward and correspondingly increase the U.S. government's borrowing costs. Given the extent of the bull market in Treasuries, and the fact that we are still hovering near record low yields for many of these securities, there are substantial amounts of capital allocated to this space that could ultimately be reoriented in the face of rising employment and the green shoots of economic recovery. Now the question is, will the Fed be able to effectively divest its balance sheet amid an environment of Treasury liquidations? Can the Fed afford for interest rates to rise too high, too quickly, which could compromise both the economic recovery and the U.S. government's ability to refinance its staggering debt load?
The reality is that the Fed is purchasing its way into a corner. The danger is that the aberrant size of the central bank's balance sheet and its openly stated policy targets will effectively hinder its attempts at divestment, as investors now have insight into when the Fed will reverse policy and can prepare accordingly. Who will want to hold Treasuries when the economy is recovering and the Fed is getting ready to sell trillions of dollars worth of the securities? Especially given the common knowledge that the Treasury bull market could peak as a result?
A deluge of Treasury divestment could unilaterally drive Treasury yields into the strata of "unsustainable." With the average maturity of its total outstanding marketable debt at a little over five years, the U.S. government is at great risk to rising debt servicing costs. The government has to refinance trillions of dollars worth of debt over the next few years, and can hardly afford to do so at ever-rising interest rates. As this dynamic comes to fruition, the cost of servicing its debt will commandeer an increasingly disproportionate percentage of the government's annual tax receipts. This development will erode the government's borrower profile, which will in turn push Treasury yields even higher as creditors demand higher remuneration for the credit risk presented by the U.S. government. The cyclical danger of dynamic cannot be overstated, as the confluence of these factors (i.e., the end of the Treasury bull market, substantial Fed divestment, the short average maturity of outstanding marketable U.S. debt, etc.) all act to compound the dangers facing the U.S. government's solvency.
Considering everything discussed in this piece, it is more important than ever that investors have at least a core position in precious metals. The fact that metals are intrinsically valuable and unencumbered by the counter-party risk that is observably pervasive in conventional investments makes them especially attractive. The fact that metals have sold off despite the supportive measures adopted by the Fed means that you can take your positions at an artificially attractive price. With only a small fraction of Americans owning precious metals, there is substantial latent metals demand in the market. While the timeframe in which Americans will be increasingly cognizant of the pernicious implications of monetary debasement and the U.S. government's unsustainable debt load is uncertain, that doesn't change the reality that we have reached an unprecedented point in monetary and fiscal history. Preserving a portion of your wealth via precious metals is just one of the many ways you can take action to insulate your portfolio from the consequences of untested monetary tinkering.