As Currencies Devalue due to Central Banks Policy of Monetary Expansion, Gold Prices are Headed Higher

Last week the gold sector was filled with action as gold prices got yet another major boost on Thursday when Ben Bernanke, chairman of the U.S. Federal Reserve announced another round of quantitative easing. After, an initial sell-off on the opening of the US session on Comex, which has become practically a customary trade of the bullion banks prior to any major monetary policy statement, the price of gold exploded moving sharply upwards from an intra-day low of $1717 an ounce to $1779 an ounce in less than two hours.

The Fed said that it will begin buying $40-billion in agency mortgage-backed securities every month starting Friday. It also extended its so-called “Operation Twist” program to the end of the year, whereby it sells its short-term bonds for longer-term bonds in an effort to drive down mortgage rates. The Fed also extended it’s near-zero interest rate guidance until mid-2015. All of this will bring the Fed’s monthly asset purchases to US$85-billion a month until the end of the year.

The most important part of the announcement was that all of this is open-ended, meaning the Fed is committed to the new round of quantitative easing for as long as it takes.  But, here is the problem. What has buying Mortgage-Backed Securities got to do with creating economic growth and lowering unemployment?

A ‘Mortgage-Backed Security (MBS)’ is a type of asset-backed security that is secured by a mortgage or collection of mortgages. These securities must also be grouped in one of the top two ratings as determined by an accredited credit rating agency, and usually pay periodic payments that are similar to coupon payments. Furthermore, the mortgage must have originated from a regulated and authorized financial institution.

When you invest in a mortgage-backed security you are essentially lending money to a home buyer or business. An MBS is a way for a smaller regional bank to lend mortgages to its customers without having to worry about whether the customers have the assets to cover the loan. Instead, the bank acts as a middleman between the home buyer and the investment markets. 

This type of security is also commonly used to redirect the interest and principal payments from the pool of mortgages to shareholders. These payments can be further broken down into different classes of securities, depending on the riskiness of different mortgages as they are classified under the MBS (*1)

In the post FOMC meeting press conference, Bernanke explained that this policy is intended to push money into the economy in the hope that the money will stimulate activity.  Ultimately, the Fed hopes to stimulate growth by making consumers “feel” wealthier. Bernanke said the Fed will continue with the stimulus even after it sees unemployment falling, saying “we’re not going to rush to begin to tighten policy. We’re going to give it some time to make sure the recovery is well established.”

At his press conference, when trying to explain the Fed’s actions, Bernanke said.

“There are a number of different channels – mortgage rates, I mentioned corporate bond rates, but also prices of various assets, like for example the prices of homes. To the extent that home prices begin to rise, consumers will feel wealthier; they’ll feel more disposed to spend.

“If house prices are rising people may be more willing to buy homes because they think that they will make a better return on that purchase. So house prices is one vehicle … stock prices, many people own stocks directly or indirectly.

Bernanke also said “The issue here is whether or not improving asset prices generally will make people more willing to spend.” This is one thing he was absolutely correct about. Will the American consumer be enticed into spending more simply because their perceived wealth increases due to a perceived increase in the value of their equity portfolios and homes?

Frankly, I doubt it. I believe that this current monetary policy will do nothing to improve the rate of employment and I doubt that the average consumer will suddenly be induced to spend simply because he feels wealthier. If you don’t have a job and you are not earning any income you will be unlikely to spend more simply because the aggregate value of houses has suddenly increased slightly. In fact it may have a negative impact in that people may be forced to sell at the higher prices in order to have some liquidity. And, if the Fed hopes to prompt investors to take greater risks by maintaining long-term interest rates lower, making traditional savings vehicles unattractive any rise in equity prices will be muted due to the underlying stagnant growth.

Gold prices began to move upwards before the US Fed announced another round of QE. In fact, they reacted by moving sharply higher when the European Central Bank (ECB) pledged unlimited buying of European sovereign bond markets. At the time, it seemed that ECB head, Draghi was awaiting a ruling from Germany’s Constitutional Court. And, that decision came last Wednesday when Germany’s Constitutional Court dismissed a range of legal challenges aimed at preventing German President Joachim Gauck from signing two crucial crisis-fighting tools into law – the European Stability Mechanism (ESM) and fiscal pact.

Reading the 85-page ruling, Chief Justice Andreas Vosskuhle specified that any financial burden for Germany arising from the ESM is strictly limited to its share of the fund’s capital or 190 billion euros ($244 billion).

If the burden were to increase beyond that amount, then it could only be done with the express approval of the German parliament, and both the upper and lower houses must be kept fully informed, the court said.

The ruling clears the path for the 500-billion-euro ($620-billion) ESM that was set up to replace the EU’s current bailout fund for stricken members, the EFSF.

With Bernanke’s delusive perception of wealth and Draghi’s action to drive interest rates down, the inevitable result of these policies will be a much weaker US dollar, significantly higher inflation and the eventual collapse of US Treasuries. The value of the dollar has lost some 6% since the end of July when it was trading at 84.The dollar has already been devalued by more than 90% over the last century alone.

Today, gold is well above its 200-day moving average for the first time since March. It has stayed above its moving average for weeks. In short, this means that the gold bull market is back. And, as central bankers continue to debase their currencies, we are going to see a greater shift back into gold the one reserve asset that cannot be printed by any central bank. The trend for gold prices will be upwards while the trend for the dollar and other currencies will be down.

TECHNICAL ANALYSIS

My short-term price objective still remains $1800/oz. 
Source *1 Investopedia

By David Levenstein
www.lakeshoretrading.co.za