Common Misconceptions About the Fed and Gold

Why Isn't the Fed Listening to the Markets?

A common view of the Federal Reserve is that it is some sort of a nearly omnipotent being standing on guard of healthy economic expansion maintaining a delicate balance between growth and inflation in the way of regulating money supply and the cost of borrowing. This view may be correct, but only theoretically so.

In reality, the Federal Reserve is a private, not a public, institution representing the interests of the US banks through its 12 regional branches. Therefore, the nature of the Fed is that it is a banking system insider; the Fed first and foremost defends the banking system and only secondarily represents broad economic interests as mandated by the US Congress. These two objectives are not necessarily always in harmony with each other. For example, the most profitable cycle for the banks started during the 2001 recession as a result of the Fed’s super loose monetary policy eventually leading to today’s disaster in the housing market.  

Today, we are in the midst of a worldwide financial system crisis. That is why, even more so than before, the greatest priority for the Fed is an immediate rescue of the banking sector. The most pressing need for the Fed now is to buy more time, (much more than just several months) which is desperately needed by the banks in order to continue their delevereging process. 

To date, this delevereging process has been happening way too slowly and with huge losses for the banks. In April/May, many banks recapitalized their balance sheets by writing off bad loans and issuing long term noncumulative preferred stock (at 7.75% – 8.50%) to bolster their cash positions and support their diminishing lending ability. As a result of this attempted recapitalization, the financial sector temporarily rebounded.  By the end of June, the situation reversed. Most of the preferred shares are now underwater with some equities losing up to 40% in just a couple of months.  

Since the banking situation is not getting any better, how does one raise more capital to allow for more write-downs and delevereging to occur? And how harsh will the terms of the new financing be? It is not pretty! There is much more pain to come and our financial troubles are far from being resolved. 

Many blame the Fed for not raising interest rates and letting the inflation genie out of the bottle. Others are concerned that such actions or lack thereof, are causing the Fed to lose credibility in the eyes of the public. But we believe that the Fed has simply been caught in its own trap and US equity markets are falling for reasons which are now outside of Fed’s control. If the Fed were to raise rates, it would be blamed for devastating the failing banking sector. The equity market would still have continued its downward spiral anyway.  

Major Driver Behind the Gold Bull  

The main result of the Fed’s “inaction” last week is the failure of the so-called multi-month dollar rally. Technically, the US dollar is on a verge of another downward slide with a reasonable target of 65-68 in the US Dollar Index ($USD). While nothing can be ruled out, we doubt this will happen in the next 1-2 months.  

This is because there is an unprecedented pressure being exerted on the Fed to stabilize the USD.  Having switched from blaming major oil companies and the so-called speculators, the media is now designating the Federal Reserve as one of the main culprits for high oil prices. 

We think that the Fed will try to maintain dollar stability in the next few months and attempt to prevent it from falling to new lows.  Short term stabilization of the exchange rate through a concerted effort by central banks can surely be accomplished, but only for the short term. Therefore, we cannot rule out intervention especially if the US dollar continues to slide. Again, such an intervention can help the US dollar but only temporarily.  

How does this relate to the current situation in gold? We do not share a widespread perception that the main driver of the gold bull market is the decline in the US dollar. Although gold and the US dollar have strong inverse correlation, this has been the case in the past and is not necessarily a good proxy for the future. This correlation in fact, tells us that the real bull market has not even begun in gold; to date, it has mostly been a bear market in the US dollar. Gold is still way below its inflation adjusted peak set in 1980 and is also one of the weakest performers among hard assets. All this leads us to believe that the most powerful run in gold is still ahead. 

Gold’s entrance into a new steep phase of the bull market will be caused not by further decline in the dollar exchange rate but by a widespread distrust in all fiat currencies, especially the euro (since it is currently viewed as the main alternative to the USD). It is important to note that a major buy signal for gold will come when the Gold/Euro ratio breaks out from its three month base. In light of this, the coming ECB meeting on Thursday July 3^rd will be very informative for investors in precious metals.   

Distrust in fiat currencies when translated into politically correct economic language is called a high level of inflation expectations. In such environment, long term yields (which are uncontrolled by the Fed) will explode, yield spreads will widen as the Fed is unable to keep up with rising inflation expectations and investment demand for gold will skyrocket. 

Another common misconception is that traditional supply/demand relationship observed in commodity markets governs gold market behavior. In reality, the main factor in a gold bull market is investment demand which soars when investors seek safe haven in gold against inflation and uncertainty.  

We are not aware of any universal indicator of worldwide investment demand for gold. In our opinion, the best such indicator is the change in Net Assets (in tonnes) by SPDR Gold Shares (GLD). 

Investment demand typically leads gold price. As shown on the chart, the number of tonnes owned by GLD has spiked over the past few weeks – a bullish signal for gold going forward. 

This is an excerpt from a Resource Stock Guide Newsletter dated June 29, 2008. 

Comments

[johndaniels123:]

the New Wrold Order is 'cracking'.

The system is failing because debt is money now: and these 'masters of the universe' are finding out if people trade debt for precious metals, and should the populace (the people: middle and poor classes) realize that by hoarding prec metals and going deeper into debt, they can disrupt and perhaps bring down the entire system. sure it is possible for these men to manipulate gold prices downward, and even attempt to make gold a non currency or without value: but this would fail because over the centuries the common man has regarded prec metals as the primary source of trading currency: and no amount of spin or 'reeducation will change this.

now the New World Order is more exposed than it ever has been; the banking system is on the brink of ruin because people simply stop paying their debts. the valuation of a promise to pay over true value was the (greedy) mistake in the first place.

when the system crashes, its back to the gold standard. Because thats all that will have credibility.

2008 Jun 30 10:08 AM

[BxCapricorn:]

Nice article Boris. I would have switched two paragraphs and re-written them a little to more clearly state that you believe that gold will enter a renewed bull market because of gold now being a worldwide alternative to the USD, and that although the USD's decline has helped propel gold to a solid bull run, further declines in the USD, although inevitable, will not be needed to continue gold's perceived value.

2008 Jun 30 10:33 AM

[Dickvm:]

If the Fed is a private institution as you claim then how does the president get to nominate the head and why does congress have to approve the nomination? How does a private institution get to borrow all the cash they need from the treasury?

2008 Jun 30 10:36 AM

[moonbat1775:]

Interesting article. I would just add that Central banks can only lower the price of gold so much. Once they run out of it, they can't print more!

Fractional-reserve banking is showing its dishonest roots and disastrous consequences.

2008 Jun 30 11:30 AM

[GMiki1:]

Nice piece, Boris. It's ridiculous that the price of gold reacts so much to the dollar index. Just because another sick currency weakens, that doesn't actually strengthen the dollar.

I'm so enjoying reading the Jesse Livermore book online at GoldSeekradio. Livermore was there at the Panic of 1907 when J. P. Morgan himself sent in the banks to shore up the brokers--and the whole system. This led to the meeting on Jekyl Island and the creation of the Federal Reserve, ratified by Wilson in 1913. What a mess.

2008 Jun 30 06:14 PM

[GMiki1:]

Dick, He doesn't just "claim" the fed is a private institution--it IS a private institution with shareholders--the banks. As a nation, we jump to the tune of J.P. Morgan and the banking interests.

2008 Jun 30 06:16 PM

[bruin532:]

Dick it was the deal that congress made with the devil!

2008 Jun 30 08:17 PM

[Mark McHugh:]

Real good article, Boris.

I'm telling you, you can't highlight the fact that the Fed is a private institution enough. People don't know! I watched Paulson's speech about expanding the powers of the Fed and not once did he mention that it is private (maybe he doesn't know). Central banks are bankers helping bankers, that's all.

I hope your analysis is correct, because for me, the hardest part of investing has always been waiting for things to happen.

Keep writing

2008 Jun 30 09:51 PM

[User 220057:]

Read Ron Pauls new book, A Revolution, Manifesto. He explains how the FED is corrupt!

2008 Jun 30 10:21 PM

[Robert Sczech:]

There is this old claim that the Fed is a private institution which enslaves the American people via the issue of debt money. This claim although true, misses the main point. The Fed is only a legal construct designed to obfuscate the truth. Monetary policy is set by the US government and money is issued (via the treasury bonds) by the US Treasury. The main purpose of fiat money is to simplify the collection of taxes. In order to keep taxes steady and growing, the US government needs a tool to control the economy. That tool is the Fed and its manipulation of short term interest rates.

In order to truly understand our monetary system, we need to look at it from the point of view of generating a stream of taxes to support congress and the general government. These tax collections have been rising steadily over the years, regardless of how the economy is doing. It is this rising percentage of the GDP which is collected by the governments which is the actual problem - not the fact that the Fed is officially a private institution. Although the Fed is a private institution, no Fed chairman will ever act against the will of congress or the US president.

2008 Jul 01 12:23 AM

[ussmls7:]

A bit more info about the Fed,it was a Banker that wrote the paper that was delivered to the Senate,there was a call by many for a roll call because no one knew who authored the bill,all requests were denined as many stood in protest against the lack of procedeure process that a bill of this magitude would effect upon a Nations People! From the day it became law,the Dollar has conutined to lose purchaseing power!
This reminds me of our Congress today. Back then,it was bankers takeing care of bankers,today bankers are rescued,while Congress are controled by special interest groups,created from the bills they pass into law! The rights of the American People are lost,as Congress worry about staying in power at any cost,even if it means passing more laws that are a breading ground for large scale coruption,ie.,CAP & TRADE & for OTHER PURPOSES!
What does that have to do with Gold & other PM's?Plenty,Cap & Trade is traded daily in the UK,Corps like JPMChasae,Golmans & countless others buy & sell Carbon Credits in these markets,it affects Miners,Refinerys,Power Plants,passing on the cost of buying Carbon Credits to the End User,if PM's cost more to get to market,the cost sores & the Corps or Shadow Banks make Trillions!
WWW.FOLLOWTHEMONEY.ORG gives you a up close look at the voteing & spending of each member in Congress, to bad it is not posted on the front pages of every News Paper in this Nation,it would leave many jobless in a election cycle,or they might be outed before that by ticked off voters. There seems to be a sea change accross this Nation,just look to the example of the long time incombent of OK Senate,He stood for illgales being giving instate benifits for colleage, Americans had told him no to this,but with all the warnings,he chose illegales over Americans & LOST,So let that be a Warning to all of the rest,on board the Giving illegales ,Legal Status, You will be Voted Out!
PM's are on a steady rise,even while the Shadow Banks & the Fed use all it has to keep prices down,by any means it has,naked short selling in the ETF's has been brought to light by many that read & follow how these investments have been a way that I Banks,Hedge Funds,OCDs,ie., make use of the many ways opened to them,to make it hard to for transparitity & thus a easy way to surpress prices at any time they need, in other words,they make up the rules as it fits there desired out-come at a giving time!
As many have said,a paper promise is that,& it they default,you are left with what?nothing but a worthless paper promise,like the dollar has become!What a mess the world faces,& so many have no clue,untill it hits the fan!!Then Gold & Silver will be king,as it always is when the paper promise has lost its backers!

2008 Jul 01 12:31 PM

[Mark McHugh:]

Excellent points, Robert.

2008 Jul 01 01:30 PM

[deuxsous:]

Save all the BS about the FED and the US dollar. Gold goes up in inflationary times which typically last 20-30 years. We're just ten years into it. I suspect we will have another big pullback before long which, of course, no one will buy since they only get excited when it goes up.....:))))

2008 Jul 01 02:11 PM

[Tom Szabo:]

The Fed is only private in the sense that federally chartered banks are required (not permitted, <i>required</... -- no bank would do so otherwise because the 'investment' returns very little in profits) to own a piece of it. Congress can repeal the Federal Reserve Act anytime it wishes (with two-thirds majority if required to override a Presidential veto).

Be that as it may, I think the best way to view gold is as a competing currency. Then we can easily see that gold priced in U.S. dollars IS in a bull market partly because the dollar is in a bear market. Gold priced in euros is also in a bull market, so clearly it's not just about the dollar. In fact, it looks like about 1/3rd of gold's rise is due to dollar weakness and 2/3rds due to relative weakness of all fiat currencies. I think we can expect that most of gold's future gains will be made not against the dollar in particular but fiat in general

2008 Jul 04 07:31 AM