Fed Rate Cut/Fed Financing of Bear Stearns/Gold Prices

There has been a lot of panic regarding the recent reaction of gold prices and gold mining shares. First of all….Relax! It is hard to predict or trade daily price movements in any commodity or stock. The most important thing in investing is to “look through the muck” and identify important longer-term trends. Daily price movements are simply daily price movements and, at times, have no bearing on longer-term trends.

To summarize, the Fed has recently taken three important steps to provide solvency/liquidity to the financial markets. One, they have recently lowered the discount and fed funds rate thereby increasing the steepness of the yield curve. Financial institutions make money by borrowing short and lending long and capture the spread (i.e., steeper yield curves increase profitability, over time). Second, they have made available the collateral liquidity mechanism to security dealers (i.e., broker/dealers) that has historically been reserved for commercial banks (i.e. Member banks). Third, they have essentially brokered the take-out of Bear Stearns by a member bank (JP Morgan) and essentially guaranteed the worst-aspect of Bear Stearns debt.

The market has treated these series of events as evidence that the Federal Reserve/Treasury is willing to “step-in” and provide financial assistance to the financial markets. The reaction of the market over the past two days is that the “worst is over” and you should sell the “insurance policies” that were recently purchased by investors/traders. Gold is a type of insurance policy.

With respect to the gold market, it naturally sold off as investors/traders sold part of their positions as they view risk being reduced. I would not be surprised for gold to have a 10% correction taking it down to the low 900’s or high 800’s. This is an event that should be purchased. Gold has a very tight inverse correlation with real interest rates. More specifically, it is very much correlated with the marginal change in real interest rates but let’s not get too specific. When real interest rates are low (under 3%) or negative, gold tends to do very, very well. When real interest rates are high (over 3%), gold tends to perform poorly. So where are real interest rates? It depends on what figures you choose to accept. If you accept the ridiculous government-reported CPI as an inflation gauge, then real interest rates are running at –1% to –2%. If you were to utilise a more acceptable monetary inflation gauge (M2 or M3), then real interest rates are between –5% to –10%. In other words, gold is still in a very powerful upwards trend that will only get more attractive as inflation pressures continue to worsen.

Recall, when the Fed/Government begins to talk about deflationary pressures, that is our signal to buy and buy aggressively. It is absurd to discuss the concept of deflation in a fiat currency regime. The Fed can print or, as in this recent case, can back-stop any debt that they wish. How can that be deflationary? In a levered, fiat currency regime (i.e. The United States), deflation can only occur after a complete collapse in the financial system. This can occur with financial institutions writing down a substantial amount of debt (not likely to occur as this would wipe out bank capital by at least 2-3 times) or through loss of confidence due to hyperinflation. We bet the later will occur although we believe this occurs during the next crisis/bubble.

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