Gold News

Reaping the QE-2 Whirlwind

But it's not just the US Fed spurring commodity prices and sparking Middle East revolution...

"SIGNIFICANT CHANGES in the growth rate of money supply, even small ones," said the late Nobel-winning economist Milton Friedman – "impact the financial markets first," writes Gary Dorsch, editor of Global Money Trends.

"Then, they impact changes in the real economy, usually in six to nine months, but in a range of three to 18-months. Usually in about two years in the US, they correlate with changes in the rate of inflation or deflation. The leads are long and variable, though the more inflation a society has experienced, history shows, the shorter the time lead will be between a change in money supply growth and the subsequent change in inflation."

Today, it was exactly two years ago that the Federal Reserve began its hallucinogenic "Quantitative Easing" (QE) scheme, which began with cash injections of $1.45 billion into mortgage backed securities, (MBS's), and an extra $300 billion in Treasury bonds, over a 12-month period.

The Fed's QE-1 scheme was designed to stop the horrific slide in the stock market, which had just been bludgeoned by the worst bear market since the 1930s. The S&P-500 Index closed below the 700 level for the first time since October 1996, losing more than half its value over the previous 17-months, and General Motors was seeking bankruptcy protection.

The situation was very bleak, and called for radical measures by the US government and the Fed to stem the slide towards a Great Depression. The US Treasury pumped tens of billions into both Citigroup and Bank of America to stave off a major bank failure. Wells Fargo and JP-Morgan Chase cut their quarterly dividends to 5-cents, and Bank of America and Citigroup slashed their dividends to a penny, to preserve precious cash. Senator John Kerry said it might cost the US government more than $2 trillion to fully recapitalize the nation's crippled banking system, but that the government shouldn't take full control of any banks, because federal officials aren't the best managers for those institutions.

The Fed began its QE-1 liquidity injections directly into the coffers of the powerful Wall Street Oligarchs, and over the next 12-months, the Fed's high powered money fueled the most explosive stock market rally in more than seven decades.

In the first 10 trading days of QE-1 alone, the S&P 500 stock index surged 21.6% higher, its best two-week rally ever. On March 24, 2009, the Dow Jones Industrials soared 6.8% to the 7,776 level. Investors in US stocks regained $700 billion in paper wealth that day. One year later, the S&P-500 extended its QE-1 rally to a 75% gain, nearly double the historical average for the first year of a bull market.

The QE-1 rally was the most hated and non-believed rally in history. It finally began to run out of steam, soon after the Fed's QE-1 injections had dried-up. It wasn't until May 6, 2010, whenthe bears got a token of vindication, when the Dow Jones Industrials plunged 998-points, on an intraday basis, the biggest one-day point decline in the Dow's 114-year history, only to recover half of those losses within 20-minutes. The trigger for the "Flash Crash" was a spike in Greece's bond yields, and soaring credit default swap rates, amid heightened worries that Athens might default on more than $300 billion of debt.

The upward spike in Greek CDS rates hit Wall Street like a lightning bolt. At 2:42pm, the Dow Industrials was languishing 300 points lower for the day. Then the yield on Greece's 2-year note suddenly soared to as high as 17.95%. The Dow Industrials began to fall rapidly, dropping more than 600 points in 5 minutes to as low as 9,922, for an almost 1000-point loss on the day.

The sell-off wiped out $1 trillion in market value at its lowest point. However, twenty minutes later, by 3:07pm, the Dow had regained most of the 600-point drop.

The May 6th "Flash Crash" last year did prove the trigger for a 17% correction in the S&P 500 index, and briefly knocked the Dow Industrials below the psychological 10,000 level. The setback whipped-up latent fears of a "double-dip" recession in the United States, and a freeze in European bank lending, due to the debt woes of Greece, Ireland, and Portugal.

The old investment adage "sell in May, and go away" was starting to make the rounds. But on August 27th, Fed chief Ben "Bubbles" Bernanke rode to the rescue of Wall Street, telegraphing his decision to start a second round of QE, to keep the stock market's rally alive.

Much of the spillover from the Fed's new $600 billion QE-2 scheme started seeping into the commodity markets, however, pushing global food prices to all-time highs, and the price of unleaded gasoline in New York increased $1.25 per gallon over the ensuing six months. The Continuous Commodity Index (CCI) of broad commodity prices soared to all-time highs, led by explosive rallies in cotton, cattle, copper, corn, sugar, silver and Gold Bullion. In Shanghai, the price of steel, iron ore, and rubber jumped into the stratosphere. Most recently, North Sea Brent crude oil, the benchmark used for pricing two-thirds of the world's oil, jumped sharply higher towards $120 per barrel, and dramatically increased energy and transportation costs around the world. Unleaded gasoline prices jumped by 60 cents a gallon in the last two weeks alone.

Milton Friedman's theory about the linkage between the growth of the money supply and the outbreak of asset and commodity inflation was proven correct. Two-years after the Fed launched QE, the "Commodity Super Cycle" is in full stride, lifting inflation rates sharply higher around the world. But in China and Japan, government apparatchiks are fudging the inflation figures, by reducing the weighting of food and energy, and in the US, the Fed is completely ignoring commodity inflation, so it can continue to monetize the government's debt.

The Bank of Japan (BoJ) and the Fed are printing a combined $97 billion per month, and injecting the excess cash into the global banking network, offered at 0.25% or less, and causing more harm than good. As with any Ponzi scheme, there is a day of reckoning. For the BoJ and the Fed, the nightmare scenario of a Global "Oil Shock" has arrived, as West Texas Sweet crude oil crosses the $100 per barrel threshold. As the shock ripples through the rest of the economy, transportation industries from trucks to trains try to pass costs on to shippers, who then try to load the extra weight on consumers' final bills. Sharply higher raw material costs will either shrink profit margins of manufacturers, or are pass along to the final consumer, leading to less disposable income for spending.

"A long period of high oil prices would sink the world's economies and plunge the fragile global economy back into recession,"said Nobuo Tanaka, chief of the International Energy Agency, a policy adviser to Western countries. "If $100 continues through 2011, this will create the same level of crisis as in 2008," Mr. Tanaka added. Ironically, the part of the world where investors normally expect to see rising stock markets, due to the windfall from sharply higher oil prices – the Arab oil kingdoms, just the opposite is happening. Since the start of the year, Saudi Arabia's Tadawul share index has fallen 18%, even though the kingdom's main revenue earner – crude oil – has risen sharply higher in price.

The soaring costs of food is raising havoc across North Africa, where half the population earns about $2 per day or less, and more than half of the household budget is spent of the daily staples of life. The World Bank's Food Price Watch reported that record high prices for food, is increasing the number of person in extreme poverty (under $1.25 a day), which is associated with higher malnutrition, as poorer people eat less and are forced to buy food that is both less expensive and less nutritious. Deutsche Bank's agricultural commodity index, including corn, cattle, soybeans, wheat, coffee, cocoa, cotton, and sugar, is 40% higher than a year ago.

Popular uprisings where malnutrition and hunger are real threats, have already toppled long standing dictators in Egypt and Tunisia, and now extreme poverty, made worse by the side-effects of the Fed's QE-2, threatens to topple Libya's strongman, Muammar Khadaffi, and the corrupt rulers of Algeria and Yemen. What matters most to traders in the global financial markets, is the supply of crude from the oil fields around Benghazi, Libya, and the fate of the oilfields in neighboring Algeria. The supply of 1.6 million barrels of day of Libyan light crude oil is half-way shut, and could dwindle to a trickle in the weeks ahead.

There is a fear of a ripple effect spreading into the Persian Gulf oil kingdoms, with calls for a day of rage in Saudi Arabia. There was panic selling in the Arabian stock markets this week. Prince Talal Bin Abdul Aziz Al Saud, a member of Saudi Arabia's royal family, said on Feb 17th, that the kingdom may see protests unless King Abdullah introduces plans to spend about $39 billion on programs aimed at boosting subsidies for housing, education, and social welfare, and raising wages for government workers. Saudi investors were unconvinced, with bank stocks hardest hit. Al Rajhi Bank, the Gulf Arab region's largest listed lender, plunged 8% the next day. High net worth investors were heavy sellers, causing local brokers to send out margin calls, exacerbating declines and prompting redemptions at local asset management funds, while a lack of bid-side volumes also weighed.

In the six weeks since tanks rolled into the center of Cairo to quell protesters that toppled former Egyptian kingpin Hosni Mubarak, gold's market value has risen by nearly 10% to hit a record $1440 an ounce. Silver Bullion has rebounded from a correction low of $26.50 per ounce and spiked upward to $34.96 per ounce, before falling prey to profit-taking. According to the BBC, a Facebook site calling for a "day of rage" in Saudi Arabia on March 11th and then March 20th saw its number of subscribers increase from 400 to 12,000 in recent days, raising concerns that king Abdullah's royal clan will become embroiled. That could lead to an even sharper spike in oil prices and potentially throw the global recovery off kilter.

Already there have been protests in the city of Qatif and other towns in Saudi Arabia's oil-rich Eastern Province demanding, among other things, the release of political prisoners and a raft of social reforms. Up to 90% of the oil wealth of Saudi Arabia is concentrated almost entirely in the Shia-dominated Eastern Province – that sector of Arabia where popular disaffection is as profound and political alienation as explosive as it is in Bahrain.There are deep frustrations in Saudi society over high levels of poverty, unemployment, poor housing and perceived widespread corruption among the royal family. Unemployment is as high as 50% among Saudi youth, whether Shia or Sunni, and there is a serious shortfall in housing and education facilities. Citizens want more transparent governance, an end to the corruption, and better distribution of wealth and welfare.

On March 1st, Fed chief "Bubbles" Bernanke boldly told Congress that rising oil prices will cause only a brief and modest rise in US-consumer inflation. "We will continue to monitor these developments closely, and are prepared to respond as necessary to best support the ongoing recovery in a context of price stability," he said. "At the same time, the liquidity created by the Fed's purchases of up to $600 billion of Treasury notes is working as planned," Bernanke declared. In other words, the Fed's main goal is jigging-up the stock market, and inflating asset bubbles on Wall Street.

Since August 27th, when Bernanke first telegraphed QE-2 at the Jackson Hole Summit, the US equity markets have increased in value by 26%, or by $3.3 trillion, which is roughly 5.5 times as much as the Fed's QE-2 scheme. Treasury bond yields are also higher since the Fed started QE-2, but that's not inconsistent with the Fed's scheme, since it widens the profit margins on bank lending.

However, Sen. Patrick Toomey, R-Penn., said he worries about the effects of those higher prices, combined with the Fed's Treasury bond-purchase program, are "planting the seeds of serious inflation down the road," and a wave of speculative buying on Wall Street that could lead to new bubbles in the prices of stocks and bonds."Once price stability has been lost, it is difficult and very costly to regain," warned Sen. Richard Shelby of Alabama.

The new Republican majority in the House of Representatives launched a more potent attack on Bernanke's deceitful comments about low inflation. Representative Steve Pearce said "there are more people who believe aliens landed in Roswell, New Mexico, than believe inflation is currently 1.6%." Long-time Fed basher Rep. Ron Paul (R., Texas), who wrote a book titled "End the Fed", told Bernanke that "the real cause of price inflation, which is a deadly threat to us right now, is the Federal Reserve system and our monetary policy," he said. But within the Fed, Bernanke's easy money views reign supreme.

"Barring a sustained period of economic growth so strong that the economy's substantial excess slack is quickly exhausted or a noteworthy rise in inflation expectations, the outlook implies that short-term interest rates are likely to remain unusually low for an extended period," said New York Fed chief, and Goldman Sachs partener, William Dudley. He described a fairly benign inflation environment. "Core inflation is now stabilizing, and the slack in our economy is still very large, and this will continue to be a factor that acts to dampen price pressures. Inflation expectations are well-anchored today and we intend to keep it that way."

In regards to soaring crude oil and commodity prices, Dudley said the situation bears watching. "Prices there are rising rapidly and some of this pressure could feed into core inflation. Even so, it would be unwise for the Fed to overreact to recent commodity price pressures, because some of the recent gains are likely to be temporary, and commodities represent a relatively small part of overall US-inflation measures," he said. Commodity traders were heartened by these words, since the Fed isn't about to take away the punch bowl anytime soon, and the inflationary pressures would become more deeply embedded.

With regards to faster growing emerging nations, where inflation is flaring, Bernanke says their central banks are equipped to deal with it, and shouldn't blame the Fed for the upward spiral in prices. Instead, foreign central banks can raise their interest rates to squash price pressures or allowthe exchange rates of their currencies to appreciate against the US-Dollar, to counter imported inflation. QE-2 is a kind of Chinese water torture, designed to force Beijing to permit the Chinese Yuan to climb faster against the US Dollar. China reaped a $270 billion trade surplus with the US last year, helped by an undervalued Yuan.

As the BoJ and the Fed export inflation to other countries around the world, by printing vast quantities of Japanese Yen and US Dollars, and lending the ultra-cheap money at 0.25%, other central banks are being forced to hike their interest rates, to combat the inflationary impact of QE. In Brazil, the central bank hiked its overnight Selic rate for the second time in past three months, to combat escalating consumer inflation. The Bank of Brazil voted unanimously to lift the Selic rate a half-percent to 11.75%, trying to balance the fight against inflation with concern about attracting hot capital flows to Brazil's currency – the Real. Brazil's inflation is accelerating at a 6.1% clip, above the year-end target of 4.5%.

Brazilian rate hikes present a dilemma for policymakers in Sao Paulo, since higher interest rates also exert upward pressure on the Real's exchange rate versus the Chinese Yuan and US Dollar, thus undermining the competitiveness of Brazilian exporters in world markets. Last year, Brazil's trade surplus shrank by nearly a fifth to $20.3 billion, the lowest in eight years, as surging imports reached record levels. But with prices of many of Brazil's commodities soaring, such as for iron ore and soybeans, future trade figures could surprise to the upside. Meanwhile, a stronger real could shield Brazil from import price inflation.

Brazil's government calculates exports should grow another 10% this year to $220 billion, if the real keeps its current value and commodity prices stay perched at record levels. Brazil's six-month T-bill rate jumped to 12.15% this morning, roughly double the consumer inflation rate, making the real one of the most attractive currencies to own in the world right now. The central bank intervenes daily in the foreign currency market, injecting freshly printed currency into the marketplace, in exchange for US Dollars, but it might be inclined to allow for a slow and gradual appreciation of the real, utilizing it as a tool to fend off inflation.

The central banks in the emerging nations, such as Brazil, China, Chile, India, Israel, Korea, and Russia, have already joined the Bank of Australia and Canada in lifting their interest rates to combat inflation. However, the central banks of Europe, Japan, and the United States have not. Instead, the Big Four central banks – the ECB, the Fed, the Bank of Japan and the Bank of England – are still pursuing super easy money policies, and in turn, are fueling the "Commodity Super Cycle" to record heights, including sending crude oil into triple digit territory.

It's been nearly two years since the ECB lowered its repo rate to 1%, and since then, the Continuous Commodity Index, a basket of 17 exchange traded commodities, has swung from an annualized loss of 25% to a stunning 41% annual gain, the fastest rate of inflation in history. In turn, Euro-zone factories are feeling the pinch of sharply higher raw material costs, and passed along a 6% increase for manufactured goods to their customers.

Labor unions are now demanding 7% pay raises, which will further erode profit margins. This so-called secondary inflation effect has gotten the attention of the ECB, only after it's been lingering far behind the "Inflation curve," for more than a year. Much like the Fed, the ECB has clandestinely sought to artificially pump-up the value of the Euro-zone stock markets, by lending unlimited amounts of Euros to the banking oligarchs, at 1% lending rates, which in turn, is used for speculating in commodities, equities, and precious metals.

For the gold market in Europe, it's been a rocky ride this year, amid early warning signs, that the ECB is finally ready to awake from its long slumber, and divorce itself from the super-easy BoJ and Fed, by signaling its first rate hike since July 2008 – the last time its dealt a blow against over zealous commodity traders.

On March 3rd, ECB chief Jean "Tricky" Trichet said the central bank would probably increase its repo lending rate in April to fight accelerating inflation pressures. An "increase of interest rates in the next meeting is possible," he told reporters in Frankfurt. "Strong vigilance is warranted," adding that any rate hike would not necessarily be the start of a "series" of increases.

The ECB is "prepared to act in a firm and timely manner," Trichet warned, which in turn, jolted Germany's 2-year schatz yield 20-basis points higher to 1.72%, and up sharply from 81-basis points at the beginning of the year. However, if the ECB is serious about fighting inflation, which is deeply entrenched in the global economy, it would have to lift its repo rate to above the Euro-zone's 2.4% consumer inflation rate, by the end of the year. The upward spike in German schatz yields, lifted the Euro towards $1.400 vs the US Dollar, and also knocked gold lower in Frankfurt and New York. More importantly, is whether the ECB can engineer a shakeout in the crude oil market. One baby step rate won't do the trick!

Get the safest gold at the lowest prices using the award-winning, $1 billion world No.1 online, BullionVault...

GARY DORSCH is editor of the Global Money Trends newsletter. He worked as chief financial futures analyst for three clearing firms on the trading floor of the Chicago Mercantile Exchange before moving to the US and foreign equities trading desk of Charles Schwab and Co.

There he traded across 45 different exchanges, including Australia, Canada, Japan, Hong Kong, the Eurozone, London, Toronto, South Africa, Mexico and New Zealand. With extensive experience of forex, US high grade and corporate junk bonds, foreign government bonds, gold stocks, ADRs, a wide range of US equities and options as well as Canadian oil trusts, he wrote from 2000 to Sept. '05 a weekly newsletter, Foreign Currency Trends, for Charles Schwab's Global Investment department.

See the full archive of Gary Dorsch.


Please Note: All articles published here are to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please review our Terms & Conditions for accessing Gold News.

Follow Us

Facebook Youtube Twitter LinkedIn



Market Fundamentals