Fed To Help Gold Soar Off 6-Month Low

Includes: GLD, GLL
by: Adam Rabie

Gold investors often fail to watch the Federal Reserve with enough attention to detail and can miss buying opportunities like the present one, as a result. The case for gold is as strong as ever and I'll outline why with details you're unlikely to see anywhere else.

Why Gold Has Suffered So Far

Gold prices have suffered this year as the Federal Reserve's balance sheet flat-lined over the last 12 months:

This is one of gold's worst performance stretches in recent memory, yet is easily explained by the lack of movement in the Fed's balance sheet, as seen in the graph above.

Gold Prices Correlate with the Fed's Printing

The correlation between the price of gold and the amount of assets purchased by the Federal Reserve is much higher than many realize:

A proactive Fed is an obvious driver of the price of gold and in particular, quantitative easing measures seem to have some of the largest effects, albeit with a lag.

Over the last year, despite no net balance sheet growth, the Fed engaged in a heavy qualitative easing, aka "Operation Twist," a measure to increase the average maturity of the Fed's holdings, by swapping relatively safe short-term assets, with riskier, longer-maturing assets. These measures, along with negative real interest rates, have helped sustain gold prices but do not seem capable of lifting the precious metal to new highs on their own.

No More Room to Twist, Infinite Room to Grow

While the Fed has indicated they will continue their maturity expansion, the fact is they have run out of room, having sold almost all of their short-term assets:

The Fed has completely run out of short-term Treasury holdings:

The Fed's agency holdings have almost run out as well:

QE Is Back in Action

Given the de facto end of the Fed's qualitative easing, the one measure they can engage with their balance sheet - that can never dry - is more quantitative easing. And this is exactly what is happening. The Fed's balance sheet so far this year has risen at an annualized pace of 21%, its first real inclines in more than a year. As interestingly, gold prices have not seemed to catch on to the trend.

Gold prices today hit a six-month low, pushing its price declines over about the same period to approximately -8%. Interestingly, this decline nearly perfectly mimics the growth in the Fed's balance sheet over the same period:

Broken Correlations or Golden Discounts?

While these facts seem to indicate that gold does not follow the Fed's expansionary efforts, it is important to realize that gold price trends historically tend to react to the Fed's action with a lag. If this is the case, gold prices may prove to be heavily discounted at present, and even more so, the more they diverge from the Fed's identifiable efforts.

A forward look at the Fed as well may help solidify which direction the yellow metal will head, and despite some internal dissent in the Fed, the overwhelming direction of monetary policy seems to indicate stimulus will remain or increase.

Federal Reserve Leadership Is United

It is important to focus on who matters at the Fed at least as much as the information that is coming from representatives of the central bank. While the media and markets have been flooded with quasi hawkish comments from St Louis Fed President James Bullard, his voting action and conviction do not seem to align with his vocal sentiment, as he heeds to the direction of his voting board's leaders.

The main directors of the Federal Reserve include its Chairman, Ben Bernanke, the vice-chair, Janet Yellen and the President of the New York Fed, Bill Dudley. These three Fed leaders have not voiced any qualms over present stimulus measures and rather the sentiment is quite the opposite, with Janet Yellen just yesterday reminding the public that stimulus measures may even remain once unemployment guidelines are hit.

The macro environment they are facing also seems to corroborate their stance, with the 10-year yield close to 2% an implicit target of the Fed, and America's outstanding debt continually growing to record levels. A desire to lift off the downward pressure on borrowing costs does not even seem considerable.

Gold Prices May Be Set to Rise

If this analysis of the Fed is correct, the rising ratio of the Fed's balance sheet priced in gold while the gold price declines, indicates a potentially lucrative buying opportunity for gold investors.

The Fed is currently set to purchase about $85 billion in net assets a month, which implies a more than 30% annual growth in the Fed's balance sheet, and could spell 2013 glitters for gold investors who just suffered a rough year.

Position Yourself to Gain from Gold

A closing fact of interest is that the low volatility over the last 12 months in both the Fed's balance and the price of gold could have a strong reversal given the Fed's balance sheet growth trajectory. This makes options with a low implied volatility a potentially worthy mechanism for exposing oneself to the seemingly strong possible upside in gold prices.

To position yourself in the options market, consider purchasing puts on ETFs that short gold. This allows you to protect against ETF management and slippage risk while still gaining upside exposure to metals. Put options on funds like GLL or similar short and short leveraged ETFs which are offering grand bargains on the underlying price and volatility, if like me you expect both to rise in the near future.

Disclosure: I am short GLL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long precious metals.