What Does Yellen's Appointment Mean For Gold?

 |  Includes: GLD, IAU, PHYS, SGOL, UGL
by: Steven Cochran

What will the policies and monetary theories of Federal Reserve Vice Chairman Janet Yellen mean for the economy, and for gold in particular, as she takes the helm of the world's largest central bank? The Federal Reserve has a twin mandate of controlling inflation and unemployment, and many on Capitol Hill and elsewhere are concerned that she concentrates too much on the latter to the detriment of the former.

A Keynesian who studied at Yale under Nobel Prize-winning economist James Tobin, Yellen has repeatedly stressed the importance of governmental action to reduce unemployment and counter recessions. In April, she said, "I believe progress on reducing employment should take center stage" and inflation should be a secondary concern for the Fed, even if continued bond-buying "might result in inflation slightly and temporarily exceeding 2%." Recent reports by two of the Fed's top economists (which would have been vetted by both Bernanke and Yellen before publication) propose waiting longer than normal economic policy recommends before reacting to inflation over 2%, if unemployment targets haven't been met. Yellen herself, in a written response to questions posed by Senator Elizabeth Warren, said, "monetary policy is likely to remain highly accommodative long after one of the economic thresholds for the federal funds rate has been crossed."

Can Inflation Be Predicted?

This is in marked contrast to earlier Fed Chairmen, such as Paul Volcker, whose fight with stagflation in the 1970s showed that once inflation started rising in an environment of high unemployment and high liquidity, it was almost impossible to control. Today's environment is very similar, but with the added hazard of a velocity of money that is at 50-year lows. Since the velocity of money tends to correct towards the mean, inflation could rapidly get out of control of a Fed that was slow to react.

Yellen believes that the nation is not in danger of falling into stagflation again, but she will have a difficult task selling her view to a market where bond yields spiked and stocks sold off just on the rumor of a reduction of the Fed's monthly $85 billion in bond purchases. This market sensitivity makes it obvious how quickly a safe haven run to gold could happen. Given her prior statements, the market may not trust Yellen to act until inflation has built momentum, making it harder to control.

This could cause a surge in gold demand as a hedge against this sudden inflation. The latest economic report from the World Gold Council measured monthly loss of purchasing power in real terms from 1976 to 2013, and found that having as little as 10% of your "cash" holdings in gold preserved purchasing power in 76% of those months. Since a major inflationary event in the U.S. will roil world markets, gold is even more important as a hedge, as it acts as both an inflation hedge and a currency hedge. Sudden demand for gold will not be limited to the U.S. in this situation, but will be a worldwide phenomenon. Since low bond yields have currently reduced the opportunity cost of holding gold, a prudent investor may want to take advantage of present low gold prices instead of battling for a scarce resource in troubled times.

QE Diminishing Returns

The stock market, which has reached new highs almost every week from the fuel of Fed bond buying, seems addicted to the "free money," but even the Fed knows that they have reached the point of diminishing returns. In her recent testimony before the Senate Banking Committee, Yellen assured the senators that the Federal Open Market Committee "is focused on a variety of risks and recognizes that the longer this program continues, the more we will need to worry about those risks," but claimed that the purchases have "made a meaningful contribution to economic growth," and cautioned "It's important not to remove support, especially when the recovery is fragile."

Bond buying is only one part of the Fed's quantitative easing program. Short-term interest rates have been near zero for five years. Many fear that by artificially suppressing bond yields, the Fed is subsidizing government debt, and is now trapped into continuing easy money policies indefinitely, since rising bond yields increase the interest the government must pay on new debt. This could lead to a devaluation of the dollar, wiping out savings and wealth. Gold is a popular method of hedging against this possibility, and demand may increase as concern builds over the dangers the Fed is exposing itself to. Even if Yellen doesn't decide to raise interest rates, the financial market may do it for her by refusing to make loans due to perceived risk.

The continuation of current Fed policies, even as the Fed itself acknowledges the dangers, point toward a revival of the Fed's old nemesis, gold. At her confirmation hearing, Yellen said: "I don't think anybody has a very good model of what makes gold prices go up or down, but, certainly, it is an asset that people want to hold when they are very fearful about potential financial market catastrophe or economic troubles and tail risks. And, when there is financial market turbulence, often we see gold prices rise as we see people flee into it."

Does the Fed "Look The Other Way" When It Comes to Big Banks?

In other words, the Fed sees gold as a "tattletale" that their policies are failing. This may be why the Fed has dragged its feet over investigating market manipulation in precious metals. LIBOR rates, currencies, and oil have all been proven to have been manipulated by major banks, so when a recent CFTC investigation into silver prices concluded that there wasn't enough evidence to prove manipulation, it was met with widespread skepticism.

When pressed at her Senate hearing, Yellen refused to admit that lax regulation of big banks and derivatives by the Fed contributed to the 2008 financial collapse, and said that as chairman she would not devote special attention to the implementation of Frank-Dodd regulatory rules. The subject may be taken out of her hands by a Congress that is feeling increasing pressure from the public to rein in excesses by the largest banks. When this happens, gold experts believe that the price of gold will better reflect physical demand, rather than short-term bets in the "paper gold" market of futures and options.

Given the third-party risks to ETFs and other financial instruments that seek to emulate gold's safe haven and hedge behavior (commonly called paper gold) we recommend purchasing physical gold and either storing it yourself, or for larger amounts, in a fully segregated and allocated account with a non-banking certified and insured storage facility. Storing bullion at a bank, even in allocated accounts, exposes your assets to the risk of being unable to claim them in the event of a bank failure or banking holiday. Comparing physical gold with financial instruments, the World Gold Council notes that such instruments are more expensive and not as flexible as physical gold (see pg. 8).

Are Stock Markets and Real Estate in a Bubble?

An increasing percentage of people are concerned that the Fed's quantitative easing policies are not contributing to a wider economic recovery, but are instead financing stock market and real estate bubbles. Yellen admitted that the Fed's massive bond and mortgage-backed securities purchases have harmed savers, but rejected Senators' claims that the Fed has benefited Wall Street at the expense of ordinary Americans. She asserted that there is no stock market bubble, despite stock indexes hitting all-time highs nearly every week against the backdrop of a stagnant wider economy and persistent unemployment. She also claimed there is no real estate bubble, saying that large funds such as Blackstone Group being major purchasers of single-family homes is "a logical response of the market." Blackstone has spent $5 billion buying 30,000 single-family homes in a chase for yield.

Like all bubbles, these will also collapse, and safe haven demand for gold will once again skyrocket. A safe haven acts like an insurance policy against large systemic shocks, but, like any other insurance policy, it can't protect you if you wait until after the disaster to buy it. Unlike traditional insurance policies, in times of economic turmoil and inflation, gold can not only protect you, its rising value provides a return on investment itself.

We could see gold demand exceed recent records in the event of another 2008-style shock, since the Fed has used up all its weapons except bond purchases, and now has a bloated balance sheet. The markets have already shown that they are at a tipping point regarding quantitative easing and Fed policies. Just the hint of a taper in the bond purchase program this fall sent Treasury yields, mortgage rates, and car loan rates spiking, and caused a sell-off in the stock market. Even Yellen admits that "this program [of bond purchases] cannot continue forever."

Perhaps it is time for all of us to worry about these risks. As the recent "September Taper" scare showed, there may not be much time at all to react after the fact.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.