Why Tapering Is Good For Gold

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Includes: GLD
by: Hebba Investments

In spite of the bounce in the gold price, gold has suffered its worst quarter in over 30 years and many hedge funds and retail investors are scrambling for the exits on the gold trade or even increasing their short position. This drop in the gold price has primarily been attributed to fears that the Fed will taper down its Quantitative Easing (QE) program.

The argument goes that by tapering off its purchases the Fed will be printing less money via QE, that means less inflationary new dollars into the system and thus it is bad for gold. The second argument is that Fed tapering will signal that the US recovery is at hand, so investors will no longer need gold as a hedge against financial stress.

The problem is both are just plain wrong. But unfortunately many investors have bought these arguments hook-line-and-sinker and have not really thought out if the argument holds weight, with the consequences being that many of them will miss out on a golden opportunity when the fundamental flaws in the argument are exposed.

Which brings us to an important point - investors need to always question mainstream analysis to arrive at their own conclusions. For investors to be successful long-term, they have to be able to think for themselves and challenge current assumptions. The big money is always made by finding flaws in general assumptions and then taking a contrarian position to that mainstream view. We believe that the current understanding of the gold and silver drop is completely wrong and in future months investors will realize this - which will bring significant returns to those who understand and are willing to take the contrarian side of the trade.

Why is QE tapering is not bad for gold

The arguments we explained earlier are very logical arguments of why tapering should lower the gold price. But investors have it wrong for the following reasons:

1. The latest QE has done nothing positive for gold

When the latest round of QE was announced in September of 2012, the gold price was approaching $1800 per ounce as shown in the table below.

As you can see, the gold price has done nothing but drop since the QE announcement. It has dropped every month save one (registering a measly $3 gain in October 2012) and it has dropped a total of 23%. This strikes to the very heart of the argument that QE tapering would hurt gold - will it hurt an asset it did not help?

Did people really buy tons of gold based on the latest QE announcement? It does not look that way based on the price. In fact it looks quite the opposite - a lot of people sold gold after the QE announcement.

A few reasons come to mind. Maybe it is that the latest QE is not correlated with gold, or other factors with a much stronger effect on gold have negated QE, or many investors are jumping on the financial media bandwagon and selling and shorting gold because of tapering worries.

The first two reasons suggest that QE tapering is not the reason for the gold decline and thus should not have an effect on gold and investors should look elsewhere for the root cause of the decline. While the last reason suggests that a lot of investors are basing their selling and shorting on an incorrect assumption. This would provide for a huge relief rally as the crowd slowly realizes that their assumptions about gold's reaction to QE tapering are wrong and that they have been selling hoping the next guy will sell too.

2. Gold's largest gains have come without QE

It seems that many investors have forgotten that gold's biggest gains have come without any QE. Gold started its current bull market in 2001 at just under $300 per ounce, and proceeded to rise to over $1000 before any QE - which computes to over 300% in gains. That is MORE than gold's gains after the first QE announcement to its 2011 peak.

Nobody anticipated QE then and yet gold still rose. So the argument that tapering or a complete end of QE is bad for gold is just not historically accurate.

3. QE tapering signals a strong economy and less of a need for gold

This argument has a very similar flaw as the previous argument. Over the last decade gold has shown that it can increase even with a recovering economy. Every year from 2001 to 2012 gold rose - which is a period that includes the housing boom and bust, the stock market gains up until 2007, and the commodity peak of 2007. Again, investors who make this argument are forgetting that gold can rise while stock markets rise and economies boom - its performance is not tied to a collapsing stock market.

4. Fed tapering means higher interest rates which is bearish for gold

This argument has some major flaws in it because it makes assumptions that are not necessarily true. Rising interest rates could hurt, help, or not affect gold - one is not necessarily a factor for the other. For example, in the 1970's interest rates were rising right along with gold. The key is rising REAL rates - how much higher (or lower) than inflation are current interest rates. If real rates are high, then gold bears have a strong argument against gold, and if they are not then it is bullish for gold.

So the key to this argument is understating if Fed tapering will lead to rising real rates of interest. We know that nominal interest rates should rise with Fed tapering simply because the largest, non-price sensitive buyer would be leaving the market. But does that mean real rates will rise?

This recent quote by Mr. Bernanke can answer this question:

"Inflation that's too low is a problem. It increases the risk of deflation. It raises real interest rates. It means that debt deleveraging takes place more slowly."

The first take-away from this quote is that low inflation is a problem. That means that rising rates will be accompanied by rising inflation - so if rates rise investors can expect inflation to rise too.

Secondly, and more importantly, real interest rates are a MAJOR CONCERN for the Fed. Read that again - the Fed does not want real interest rates to rise. That completely negates the concern about gold that rising interest rates bring.

Rising real rates are a concern for the Fed (as they should be) because it hurts indebted parties. Anyone needing to refinance or roll-over debt will be hurt significantly by rising rates and if inflation doesn't help deleverage them then there will be serious trouble. The fact is that the largest debtor in the world is the US government, and if real rates rise then that means that the US debt burden will grow in real terms. This will have a significant effect on the dollar and would be a crisis that would shake the whole world's financial system. There is no way the Federal Reserve would allow real interest rates to rise by any significant manner.

Conclusion

Investors have a tremendous opportunity. The financial markets are herding together on the tapering bandwagon and punishing gold and silver based on an assumption that tapering is bad for gold.

As we have discussed earlier, fundamentals remain strong for both gold and silver. But investors and hedge funds have joined together to jump on the bearish trade, with the media declaring the gold market over and forecasting ever lower prices where they expect gold to end up. The stage is set for the real fundamentals to take hold - when they do we will see an epic short covering as investors realize that maybe tapering is not quite the anathema for gold that it was made out to be.

Now is the time for investors to aggressively accumulate physical gold and silver, precious metal ETF's (GLD, SLV, PSLV, and PHYS), and even quality miners like Goldcorp (NYSE:GG), First Majestic (NYSE:AG), and Alamos Gold (NYSE:AGI). Rarely do so many people get a trade so wrong. Opportunity is knocking - which investors will have the courage to answer?

Disclosure: I am long AGI, GG, SGOL, AG, PSLV, SIVR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.