The Fed Should Ignore Its Critics And Focus On Its Mandate

Includes: GLD, GLL
by: Robert Wagner

Recently the Fed "Tapered" and rates dropped. The Fed cut bond buying by another $10 billion/month on Wed January 29th, 2014. On the same day the headlines are claiming that 10-year rates are hitting 2 month lows. Just prior to the announcement, the 10-year Treasury yield was sitting at 2.71%.

The yield on the benchmark 10-year note fell four basis points, or 0.04 percentage point, to 2.71 percent at 1:15 p.m. New York time.

Currently the 10-year note trades at 2.66%, but has traded at low as 2.58% post "Taper."

Yes there are other factors like the market sell-off and Emerging Market fears that contributed to the fall in rates, but the fact remains that the "Taper" has resulted in lower not higher rates. In fact, when the Fed started the first "Taper" the 10-year was almost 2.90%.

the yield on the 10-year Treasury note used in figuring mortgage rates and other consumer loans rose 3 basis points to 2.87.

Gold trade at $1,235 when the "Taper" began.

Gold futures for February delivery settled at $1,235 an ounce, up $4.90, or 0.4 percent, during the regular trading session, and were volatile in electronic trading after the Fed decision.

Gold was trading below $1,240 just four days ago.

And the recent rally occurred with a spike in the VIX. With gold near $1,260 when I write this, a $25 rally in gold when the markets have been selling-off and the VIX is spiking isn't that impressive. Gold barely moved when compared to the VIX. Gold simply isn't rallying like it should.

While gold is above the level it was at when the "Taper" began, rates are lower and fear as measured by the VIX has spiked. Neither of those are likely to be long-term in nature. The whole purpose of the "Taper" is to stop the market distorting impact of the Fed's bond buying program. The Fed has been buying bonds to lower rates, so when the Fed stops buying bonds, rates should reverse themselves.

That is exactly what happened, only with a twist. While it is true that the rates are lower since the beginning of the "Taper," they aren't down from the real beginning of the program. The real "Taper" began last May when the Fed started talking about the "Taper." The Fed's communications with the markets drove rates from 1.5% to over 3%. So technically the "Taper" has resulted in higher rates if you accept the market as a discounting instrument. Gold is down more than 10% over that same time period.

While I'm usually a big fan of the Fed's actions, some recent comments give me concern. Multiple Fed Presidents have made comment about the need to continue with the "Taper," seemingly unconcerned with the ultimate goal of monetary policy, that being economic growth and job creation.

WINCHESTER, Virginia (Reuters) - The U.S. Federal Reserve will probably keep reducing monthly asset purchases at its current pace and it would be hard to make the case for a pause in the tapering process, a senior Fed official said on Tuesday.

Richmond Federal Reserve President Jeffrey Lacker said U.S. stocks had performed well looking at the last year and recent moves likely reflected a downward adjustment in expectations for growth.

Hello!!! McFly!!! Anyone home!!!? Think McFly, Think!!! If the markets are telling you that they are discounting lower growth in the future why in the world are you continuing the "Taper?" I simply don't get it? Slowing economies with high unemployment aren't inflationary? What good could possibly come from continuing the "Taper" other than silence critics of the Fed's programs that have been wrong since the start of TARP back in 2008? Now is not the time for the Fed to start playing politics.

Fed President Lacker isn't the only one letting the tail wag the dog, Fed President Plosser thinks the "Taper" should be accelerated.

(Reuters) - The U.S. Federal Reserve should wind down its bond purchases faster than planned and end it before mid-year, a hawkish Fed policymaker said on Wednesday, going a step further in his criticism of the stimulus.

Philadelphia Fed President Charles Plosser warned of looming communications problems if the central bank keeps buying assets while, as he expects, the U.S. unemployment rate falls below 6.5 percent some time in the first half of 2014, from the current 6.7 percent.

It is the second half of that quote that gets me most concerned. You would have to be living on Mars to think the US unemployment rate is actually 6.7%. The labor force participation rate is hitting 35 year lows. If you include discouraged and under-employed workers the unemployment rate would be 13.8%. 1/6th of our Nation's workforce is either un or under-utilized, and some of the Fed Presidents are wanting to accelerate the "Taper?" Why? I just don't get it. What are the benefits? Silence a group of misguided critics? The benefits of TARP and QE-finity were/are the preservation of the global financial system, avoidance of a deep global depression, lower interest rates and a boost in economic growth. A premature end to these programs threatens to reverse all those gains, and pull the supports out from under this fragile recovery. The Fed critics simply don't have a great track record. They should be ignored, not embraced. Just because someone is saying push this economy off a cliff doesn't mean the Fed should.

Ironically, I've been asked to come and speak to a group of gold bugs, and what I tried to do is develop a strategy for people that hold physical gold in their basements.

Anyone that follows my articles knows that I am absolutely no fan of the yellow metal, in fact I am short gold. I think it is an awful investment and is headed much lower before it goes higher. The problem is, very very very few of my friends agree with me. I've been warning them about gold for at least 3 years now, but to no avail. Many of my friends don't trust "paper gold" or what most people call a gold ETF, so they literally own physical gold and stash it in their basements...along with a small arsenal and enough gun powder and lead to sink a battleship. Oh, and you can't forget the MREs, seeds and sterile water. My friends are prepared for the world after the Federal Reserve destroys it with all this fiat money "printed out of thin air."

Recently my friends invited me to speak to their group and give an economic and investment review and to participate in a panel discussion. Preparing for this event I needed to come up with an investment strategy regarding gold that wouldn't get me fitted with a pair of concrete boots and thrown in the local river. I was going to be talking to the hardest of die hard gold bugs, the "you'll have to pry the gold from my cold dead hands" type of gold bugs. To make matters worse, 90% of the audience have CC permits and likely be "packing heat." Bottom line is I'll have to tread lightly when it comes to my gold strategy.

The strategy I plan to discuss at the meeting is income generating and hedging strategies for your basement stashes of gold.

To implement income and hedging strategies, you must first convert 100 shares of the SPDR Gold ETF (NYSEARCA:GLD) into an equivalent amount of gold. Gold closed today at $1,260/oz and GLD closed at $121.24. 100 Shares of GLD therefore is equal to $12,124 or $12,124/$1,260 = 9.6 oz of gold. To keep the math simple, we will assume 100 shares of GLD is the equivalent of 10 oz of gold.

Income Example:

Patrick Henry owns 100 oz of gold and he stashes it in his basement inside the gun safe right next to the 357 hollow point bullets. Mr Henry would never sell his gold, but has been really disappointed with its recent performance, and needs a little extra income so he can diversify into Bitcoins. Unfortunately that scenario isn't that far off from reality.

Mr Henry's 100 oz of gold is the equivalent of 1,000 shares of GLD. Each option contract covers 100 shares, so the strategy would be to sell 10 call options each month. This technically is a "naked" call writing strategy and would require an options account that allows "naked" call writing, but in reality, the call is backed by the physical gold.

Today the $125 Strike March GLD Call options sells for $1.31 (Note: GLD has weekly expirations). Mr Henry would be able to sell 10 contracts for a total of $1.31 x 100 x 10 = $1,310. Mr Henry, by writing technically covered calls $125 - 121.24 = $3.76 or 3.1% out- of-the-money, could make a nice $1,310/mo income off of his 100 oz stash of gold. That amounts to about 1%/mo.

The risk Mr Henry takes is that GLD rallies by more than 3.1% and the options are "in-the-money" at expiration. If that were to happen, Mr Henry would need to sell some of his gold to close out the open position if they are valued by more than the $1,310 they were sold for. That of course assumes that the Bitcoins purchased with the $1,310 didn't lose any money from the time they were purchased.

That is how to generate income off a basement stash of gold. You must first convert your gold holdings into an equivalent number of GLD shares, and then calculate out how many calls to write. This is technically a "naked" call writing strategy, but in reality the call is covered by the physical gold.

Hedging Strategy:

The hedging strategy is simply the income strategy but instead of writing call options, you buy put options. If Mr Henry thinks that gold is about to go through a short-term correction, he would buy 10 $120 Strike GLD March Put options. Today those put options trade for $2.41. It would cost Mr Henry $2.41 x 100 x 10 = $2,410 or 1.9% to hedge the gold stash until the last Friday in March. By doing so he would be protected against losses if GLD fell below $120.

In conclusion;

In conclusion, the ironic twist of the "hawkish" Fed comments is that they are likely inspired and supported by the gold-bug critics of the Fed. People expressing their misguided anger resulted in the Congress failing to pass the TARP program on its first vote. The result was predictable, the markets "plunged."

House Rejects Bailout Package, 228-205; Stocks Plunge

These same misguided people cheered on the Government shut-down last year. Now their voices seem to be influencing the decision makers at the Fed. The Anti-Fed crowd has been consistently wrong since 2008, and it should concern investors to see Fed Presidents taking about continuing or even accelerating the "Taper" without any real solid evidence of economic growth and hope of lower unemployment. Fed policy should lag economic recovery, not lead it. Higher rates now threaten very recovery low rates was intended to trigger. Ironically, higher rates now will not only increase the likelihood of a recession, it will also drive gold prices lower. Gold-bugs should be careful what they wish for, they just might get it.

There is however strategies for those who own gold in their basements. Many people hold physical gold but are unaware of strategies to generate income off of or to hedge those physical gold holdings. Each strategy has its own risks, costs and benefits that need to be understood, but if someone wants their gold to do more than take up space in a gun safe, the above strategies may be worth considering. Also if you found this article entertaining and educational and know someone in a Tea Party, please forward them a link to it. They may want to use it as a topic for one of their meetings. I'm sure they will appreciate the self deprecating humor.

Disclaimer: This article is not an investment recommendation or solicitation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. Full Disclaimer and Disclosure Click Here.

Disclosure: I am long GLL. 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.

Additional disclosure: I also own calls on GLL