The Wind Beneath Bernanke's Wings (And Gold's Worst Enemy)

Includes: DUST, GLD
by: Macro Investor

When you think about it, $85B is not a lot of money.

The US GDP is about $15 Trillion. The Fed has decided to pump $85B each month until unemployment is at or below 6.5%. According to estimates, this target will be reached by the end of 2015. By then, the US money supply will increase by about $2 Trillion. Such a drop in unemployment under normal conditions should lead to a 3-4-5% growth in GDP each year, but let's be conservative and stay at a 2-3% growth. This means the US GDP will grow by about $750 Billion for $2 Trillion increase in money supply.

Sounds like a good deal to me.

However, it does not sound like that good a deal to many others. The main concern is inflation. That amount of monetary injection is unprecedented. So what if inflation creeps up as a result? (Incidentally, the GDP can grow just as well from inflation, which, of course, is not good growth.) The textbook solution is for the Fed to start selling Treasuries once inflation is back, reduce the money supply, and hence, curb inflation. During this $2 Trillion monetary injection, the Fed would have purchased about $1 Trillion in long term treasuries. It will need to sell at least half of it (the rest of the sales will go to short term treasuries).

What if there are no buyers? What if, in the doomsday scenario, the long bond market completely seizes up until rates go up to extreme levels? What if USA becomes Greece? Or, even worse, Zimbabwe?

With so any people worried, I think it is time to allay those fears a bit. In general, there is no chance of no bidders for Treasuries. These are just too important to the world economy. In fact, with financial regulations, the need for Treasuries has even gone up. For risk management purposes, many financial institutions need to hold Treasuries as part of their portfolios. In fact, the Feds buying up Treasuries has been a real problem for many.

Enter Dodd-Frank.

Dodd-Frank aims to curb the appetites of risk takers and speculators. When speculators place their punts, Dodd-Frank requires them to post collateral -- good-quality collateral. Reports Businessweek:

To improve the safety of the financial system, the Dodd-Frank reform law requires that most derivative deals be executed on a clearinghouse that will require traders to post collateral and will provide a central place for regulators to keep an eye on risk in the market.

Bank of New York Mellon (NYSE:BK) estimates that investors will need as much as $4 trillion in good collateral to comply with the new regulations.

$4 Trillion is a big number. A merely $500 Billion in Treasuries will surely find a home. So at this point, people should stop worrying. But that is not how things go, as other kinds of worries start surfacing. What if the Chinese - the largest holders of US Treasuries - start selling?

Now, this is also quite irrational. There is no reason for the Chinese to dump Treasuries and weaken their own foreign currency reserves. Also, this will strengthen the Yuan, which the export-oriented Chinese are not exactly keen to do. But "what ifs" are like that. They need no real reason. All they need is a cause to worry.

Fortunately, Chairman Bernanke has a guardian fairy, the Japanese. Reports Bloomberg:

Shinzo Abe is set to become the best friend of investors in Treasuries as Japan's prime minister buys U.S. government bonds to weaken the yen and boost his nation's slowing economy.

Abe's Liberal Democratic Party pledged to consider a fund to buy foreign securities that may amount to 50 trillion yen ($558 billion) according to Nomura Securities Co. and Kazumasa Iwata, a former Bank of Japan deputy governor. JPMorgan Securities Japan Co. says the total may be double that.

So there we have it - a $1 Trillion rainy day fund to bail out US Treasuries if and when the USA has to start selling them to drain the economy of excess liquidity. The Japanese would be in no mood for the dollar to weaken, because the market is not playing nice with the Fed. They will step in and buy the Treasuries themselves. This means interest rates will in no way skyrocket in the USA.

Still, this leaves a problem. The goal of the Fed is to drain money from the US economy. If the Japanese buy the Treasuries, that does not really serve the goal. But let's consider the ramifications of an "Abe put" under the Treasuries, if you will. This means that the Treasuries market will remain robust, and the Treasury bull may very will continue. This will for sure entice US buyers to buy Treasuries as well. After all, the main reason for them to not buy Treasuries would be a lack of confidence in the ability of the USA to service its debt. At low interest rates, that is no longer an issue.

Hence, the rumor about the Fed not being able to control the US economy is highly exaggerated. Investors at this point should rest easy, and be happy in the realization that inflation is not about to spike. This, however, is bad news for gold (NYSEARCA:GLD). (Seems like there is always a bad news for gold these days.)

Gold is the classic inflation hedge. If there is little inflation, then there is little reason for people to buy gold as a hedge. So, at best we will see a sideways market for gold for a long time. In the mean time, the extraction costs for the miners will keep going up, and their margins will continued to get squeezed.

This is not a good time for the miners.

The obvious choice to benefit from this margin squeeze for the miners would be to hold the Direxion Daily Gold Miners Bear 3x Shares ETF (NYSEARCA:DUST). This ETF is up some 47% in 2013. I believe there is another 10-15% left in this ETF this year. Of course, nothing is a guarantee, but the bull case for the gold just does not exist.

Disclaimer: This is not meant as investment advice. I do not have a crystal ball. I only have opinions, free at that. Before investing in any of the above-mentioned securities, investors should do their own research, consult their financial advisors, and make their own choices.

Disclosure: I am long DUST. 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.

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