QE2 and Precious Metals

A reader writes in, in response to my blog on Friday, QE2′s fatal flaw. In this blog, I expressed concern that QE2, in addition to failing, also risked exposing the long end of the yield curve to market forces, (what a novel concept, market forces determining the level of prices), which in turn could expose the federal government to global concerns as to whether it can roll-over its debt at a reasonable rate. I do not think QE2 is a good idea, but I do like what it has done for my precious metals recommendation. Here is what this reader has to say:


“What policy alternative is there to QE2?  Our economic system is predicated on the ability of the consumer to spend their income before they earn it by way of leveraging their wealth. Since their wealth has largely evaporated, a huge chunk of potential demand in the economy has also evaporated. Most people no longer have the ability to borrow against future earnings.  This leaves us with a much smaller economy looking forward that cannot depend on the consumer. And, this problem is still growing as the value of homes continues to melt away with credit worthiness going with it.  Unless money is injected into the system to take the place of the money that has disappeared, the economy will continue to suffer.


Inflation cannot be a worry until well down the road for anything other than imports. We have a huge excess capacity (9.5% unemployment, huge vacancies in commercial and industrial property, and a great deal of money sitting in low interest accounts). Growth has to be the first goal. The Fed has plenty of ways to take away the easy money down the road (increase bank reserve requirements, increase rates…), but if we do not get to sustained and recognizable growth that eats up the excess capacity, we will not be able to move forward. The economy cannot get a foot-hold where investors have some predictability to risk capital until sustained growth is achieved. On a side note the budget deficits would also look better if we returned to more robust growth. 


Nowhere is this QE2 going to be felt harder than here in Hawaii. This will mean that Oil prices and hence vacation costs are headed upwards and that Hawaii’s recovery will be delayed for quite some time. Yet, short of a public works program that puts the unemployed back to work (not happening in this congress), the QE is the only way to move us towards growth.” (end of readers comment)


First off let me say that you are putting way too much hope in what QE2 will do for the economy. Other than the euphoria created by the 3 month surge in risk assets leading up to the announcement of QE2, I really have a hard time sorting out how this will increase economic activity. To some extent, the wealth effect will help consumer demand, but I question how much of that will fuel demand for imports. 


I consider the Fed’s move as a desperation move, since whatever else is coming from our government, is not going to carry the day, and get employment back to where it was 2 years ago. In fact, structural changes in how our economy operates needs to be conceived and implemented. Traditional Keynesian economic solutions, tax and spending policies will not carry the day any more. We have shifted too much of our industrial base overseas to think that the normal types of stimulus programs will bail us out of our economic malaise, since most of the demand created domestically results in economic activity overseas. Additionally, there will come a time when another crisis unfolds, and the ability of the Fed to print money to meet liquidity needs will could have adverse consequences, and be otherwise ineffective. It’s like the boy who cries wolf, it only works a few times, then it just becomes an inflationary phenomenon.


* Further buttressing this opinion is this letter which will appear in tomorrow’s WSJ, signed by 23 notable hedge fund managers, economists, and academics:


“The following is the text of an open letter to Federal Reserve Chairman Ben Bernanke signed by several economists, along with investors and political strategists, most of them close to Republicans: 


We believe the Federal Reserve’s large-scale asset purchase plan (so-called “quantitative easing”) should be reconsidered and discontinued.  We do not believe such a plan is necessary or advisable under current circumstances.  The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed’s objective of promoting employment.


We subscribe to your statement in the Washington Post on November 4 that “the Federal Reserve cannot solve all the economy’s problems on its own.”  In this case, we think improvements in tax, spending and regulatory policies must take precedence in a national growth program, not further monetary stimulus.


We disagree with the view that inflation needs to be pushed higher, and worry that another round of asset purchases, with interest rates still near zero over a year into the recovery, will distort financial markets and greatly complicate future Fed efforts to normalize monetary policy.


The Fed’s purchase program has also met broad opposition from other central banks and we share their concerns that quantitative easing by the Fed is neither warranted nor helpful in addressing either U.S. or global economic problems.” (end of letter)


The point in bringing all this forward in today’s blog, is to reiterate that non-keynesian solutions need to be implemented to get our economy back on its feet. Incentives to grow new businesses, or bring exported business activities back to the US, is critical to replace the 8 million lost jobs, as well as provide an environment which can absorb 2 million new workers a year, (correct me if that 2 million number is not correct).


* More on precious metals – while this is my best long term investment strategy, and pretty much, has been my only strategy for the last two years, we are at a cross-roads which should be pretty disconcerting for those who own precious metals, but do not want to watch prices fall as much as 20% in gold, and 35% in silver. I am going to key my ideas for both gold and silver based on my observations about the silver market. Silver has had a dramatic run since August, rising to last Tuesday’s 29.34 high, by 65% from its August 24th low at 17.74, when the recent rally began.


On the way back down, even if the market only corrects some of this rally, I expect to see an equally impressive sell-off, which has begun. As I have previously harped on, the first sign of an impending sell-off will be a drop in open interest in the futures contract, and such an event occurred a few days before the market’s top, as I reported last week. While I think that silver, gold and all real assets have a place in everyone’s portfolios, I also recognize that there will be stretches when these asset classes do not do so well.


In fact, this mornings protest letter against QE2, has lead to some talk that the Fed might not get to implement all of the QE2 it has planned. If the Fed does not implement all of QE2, then that would mean that some of the rally in risk assets, gold and silver included, could go in reverse.


As another sign that we have seen a recent top, here is a comment by a reader which operates a jewelry store on 47th Street, sent to me last Tuesday, when gold and silver were making a top:


“As you know I follow the markets all day long and it’s been my life for the last 32 years… I love your blog and enjoy reading it.


This is the first time in my life where I can tell you from where I sit, that people are scared. Bankers, stock brokers and financial people, who know me, are coming in to buy fair amounts of physical product ie: coins and bars, both silver and gold, and a little platinum.


With that said, I now believe it is very possible for metals to double from here in the next few years, especially if we have two things happen, one a world event and two hyper inflation. OHHHHH and by the way, forget about it if we decide to have currency backed by gold….” (end of reader’s comment)


This comment captures the current mood, but usually the mood reflects what is happening NOW, not what will happen over the near term. As when a bull or bear appears on a magazine cover, it is time to fade that trend. The reason to pass on the reader’s comments is two-fold: the buying frenzy had to reach a peak before this reader felt compelled to write. In fact, his comment came at the top of the market, so on some level, I consider these comments as a contrary indicator. But secondly, and along the lines of what will happen going forward, this reader place in the precious metals world gives us good insight into what the frenzy will be like when a global rush away from the dollar comes home to roost.


* Conclusion – while I have been advocating shorting silver to my real time distribution (ask to be included if you are interested), I remain firmly invested in a variety of less liquid forms of mostly gold and silver. While my short term bearishness applies also to gold, I expect silver to outperform gold to the downside. Despite this, I am keeping all of my core holdings in both metals.