If you read Fed chief Ben Bernanke's speech on the economy in Atlanta in early June, he said the following:
1. "...On the negative side, households are facing some significant headwinds, including increases in food and energy prices, declining home values, continued tightness in some credit markets, and still-high unemployment"
2. "...the rise in commodity prices has directly increased the rate of inflation..."
3. "...Particularly concerning is the very high level of long-term unemployment--nearly half of the unemployed have been jobless for more than six months"
Bernanke has been desperately trying to create inflation across all asset classes. Since commodities are priced and traded in dollars worldwide, inflation in prices of food, oil and gold was achieved. But home price inflation was not achieved, something the Fed desperately wanted. High home prices creates the wealth effect and increased consumer spending. Another failure was lack of significant reduction in unemployment. This further depressed spending. As a result, inflation in non-commodity goods was not achieved. Perhaps non-commodities even saw moderate deflation, as evident by home prices.
So what will the Fed do going forward, and what should we do in such a situation?
Recap of Market Data:
Before answering the questions above, let's look at some real data and analyze the market's performance in the wake of Bernanke's policies.
Click to enlarge
As proxies for various asset classes, plotted above are the performance of physical gold (NYSEARCA:GLD), precious metal mining ETF (NYSEARCA:GDX), energy (NYSEARCA:VDE), S&P500 stocks (NYSEARCA:SPY), and 10 year Treasury Interest rates (^TYX) for the last 5 years. All the asset classes went down in strong correlation with the market crash of Oct 2008 through March 2009, as shown by the down arrow. Physical gold went down the least, perhaps anticipating the Fed's easy monetary policies. Mining shares and energy crashed right along with stocks. During this turmoil, the only asset class that went up in price was treasuries (as interest rates went down, the price of the treasury bonds went up). In other words, one of the best places to be during this turmoil was physical gold and CDs.
As the stock market went up in a straight line since that crash, the other asset classes went up with it, again showing strong correlation. Treasury interest rates stayed largely flat, near the bottom achieved during the fear period of Oct 2008.
For the 5 year period, S&P 500 stocks have been flat, energy and mining shares performed better -- up by about 30% and 35% respectively. But the best class was gold (up by about 140%), and treasuries were also not a bad place to be (with interest rates down by about 40%).
What will the Fed do?
Unbelievably, on June 22, 2011 Ben Bernanke said: “We don’t have a precise read on why this slower pace of growth is persisting”. Bernanke further said that “some part” of the slowdown was due to temporary factors such as higher food and gasoline prices and disruptions to manufacturing because of lack of key parts from earthquake ravaged Japan.
Any takers for this argument? The Fed has now wedged itself in a no win situation. It cannot raise interest rates since it thinks that will kill the economy. It cannot reduce interest rates since it will further create commodity inflation. Between the two choices, most likely the easy monetary policy will continue. They will keep nearly 0% interest rates and will continue to buy back treasuries by reinvesting maturing bonds. A stealth QE3 will thereby continue.
What should we do?
Investors should continue doing more of the same, as I have written over the last few years: Gold, precious metals, mining shares and CDs. Besides physical metal, GLD is an ETF that may be suitable for some, if they are frequently trading. You may consider accumulating energy if oil recedes below $75 per barrel. VDE is a good play there.
Disclosure: I am long VDE.
Additional disclosure: Long Gold, Precious Metals, precious metal / mining mutual funds, 10 year CDs