8 Reasons To Buy Gold And Other Inflation Protection Now

Includes: GLD, TLT, USO, XLE
by: Efficient Alpha

The Federal Open Market Committee [FOMC] starts its last meeting of the year on Tuesday with market participants watching for how the Fed will transition from Operation Twist. The program, formally the Maturity Extension Program, began in September 2011 and involved the selling of $45 billion in short-term paper to fund the purchase of long-term bonds. The idea was to "twist" the yield curve to reduce rates on longer-term assets and lower borrowing costs.

While the committee is expected to transition to another program of monetary easing and to continue purchasing roughly the same amount of long-term bonds, the announcement could lead to an increase in expectations for pricing pressures because of the mechanics of the new program. This could lead to strong gains in gold and other inflation-protected investments, which should also find longer-term support in the changing voting structure of the group next year.

Let's Twist again…

It seems the monetary authorities are not without a sense of nostalgia. Last year's Operation Twist came on the 50th anniversary of the original twist program, named after the dance craze of the time. As described, the idea was to fund a reduction in long-term rates by selling near-term securities. Since the Fed was selling as much as it was buying, the program did not have a significant effect on inflation or inflation-protected assets like gold.

While the program has helped to bring down long-term rates, its effectiveness is rather short-lived and rates could increase when the program ends this month if the Fed were to stop buying bonds. Market observers are expecting the FOMC to continue to purchase longer-term securities but to discontinue the funding offset.

Discontinuing the offset mechanism of selling short-dated securities would basically change the program to another round of quantitative easing, just three months after the announcement of QE3. While the program is widely expected, I think the actual announcement could boost inflation-protected assets like gold as the market reassesses its expectation for pricing pressures.

In a fight between a hawk and a dove, who wins?

CRT Capital is out with its yearly Hawk-O-Meter and the lineup for the FOMC in 2013. This year's bias to a more dovish Fed gave us an additional $267 billion in Operation Twist and a third round of quantitative easing, this time an open-ended commitment to buy $40 billion in agency mortgage-backed securities per month until substantial improvement in the labor market.

The ranking, shown below, is developed by incorporating recent public speeches and voting records to gauge each member's relative leaning toward easing or tightening monetary policy. Last year's Fed voting roster is available for comparison in an earlier article last December.

FOMC Voting Members 2013

The hawks, those generally preferring a more conservative policy, lost considerable bench strength with Lacker, Lockhart and Pianalto all coming off voting status. St. Louis Fed President Bullard and Kansas City President George become voting members next year, but I would question their true hawkish credentials.

Compared to the lineup on the hawk's side, the doves appear to be the odds on favorite for the year. Chicago President Charles Evans, generally the most accommodative of the entire group, becomes a voting member along with Boston President Rosengren. The only loss on the dovish side is Williams's loss of voting power.

As accommodative as the Fed was this year, next year looks to be even more dovish with eight of the twelve voting members generally favoring more accommodative policy. Investors should be careful to discount the benign pace of inflationary pressure over the last few years. While the pace of price increases has not increased, assets trade on the expectation of inflation and may turn well ahead of actual inflation statistics.

Shares of the SPDR Gold Trust (NYSEARCA:GLD) are down 3.2% since the Fed announced its third round of quantitative easing on September 13th but have still gained 6.3% this year. The bull market in gold may have slowed over the past month, but the shares have outpaced equities easily with an annualized gain of 13.9% over the last decade compared to an increase of just 1.8% in the S&P 500. With monetary stimulus in major markets across the globe, gold could very quickly regain its luster.

Expectations for higher prices would drive down the value of the dollar and boost prices in other dollar-denominated commodities as well. Shares of the United States Oil Fund (NYSEARCA:USO) have fallen 20.9% this year on weak petroleum prices but could rebound into next year. A safer play may be in the Energy Select SPDR (NYSEARCA:XLE) which holds securities in 45 energy companies. The shares are flat for the year but pay a 1.7% dividend yield and trade for 12.0 times trailing earnings, relatively cheaply compared to a multiple of 15.0 across the S&P 500.

The short side of the trade may be in treasuries with the iShares Barclays 20+ Bond Fund (NYSEARCA:TLT) holding near record highs. The fund peaked at $132 in July when it looked like Europe would fall apart and slowing growth in China could not support the global economy. Any increase in inflation, or a pickup in global growth, would cause rates to increase and bond prices to fall. I have a bear spread on the January 2014 options, partially funding the purchase of $125-strike puts with the sale of $120-strike options. While many expect rates to end next year pretty close to where they are now, yields could increase dramatically for shorter periods and give me the opportunity to close out the position with a profit.

For readers disappointed in not finding eight bulleted reasons for adding inflation protection to their portfolio, I would argue that the eight dovish Fed voting members should be all the reason needed. While pricing pressures have yet to present a cause for concern, changes in asset pricing and rates trade on the expectation for inflation and can turn well ahead of actual data. A more accommodative Fed runs a greater risk of erring on the side of too much liquidity and may not be able to react quickly enough.

Disclosure: I am long XLE. I have a short bear spread on TLT. 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.

Short bear spread on TLT