Eyes Down, Spin the Wheel

Placed your bets yet for today's US Fed meeting...?

 

ALL EYES on the US Federal Reserve – again – today, writes Greg Canavan in The Daily Reckoning Australia.

 

The US central bank concludes a two-day meeting Wednesday to decide on whether to 'taper' or not.

 

Yes, we sound like a broken record, but how pathetically sad have capital markets become? Place your bets folks, the Federal Reserve is about to spin the wheel...

 

The market is placing its bets on no taper. Overnight, the S&P500 rallied 0.6% and the Dow Jones jumped 129 points, or 0.8%. Even if the Fed does pare back its asset purchases by a few billion per month, the message from the statement is likely to be:

Our guess is that the US Fed will slowly phase out QE during 2014, and replace it with something else. The whole point of looser monetary policy is to create enough inflation to lighten the crushing debt load that is currently weighing on the global economy.

 

But QE doesn't lead to inflation...or at least not goods and services inflation. The digital money created via the QE process goes into the banking system. The 'fed funds' (the 'money' created) sit as a liability on the Fed's balance sheet and as an asset on the banks' balance sheets. The banks make use of this asset to speculate in financial markets.

 

It leads to asset price inflation. So QE causes asset price inflation but not goods and services inflation. In other words, QE created money does not find its way into the economy.

 

The Fed understands this. That's why we think 2014 will be the year of more 'innovative' monetary policy. As Ben Bernanke hands the reigns over to Janet Yellen, she'll make her mark with some new-fangled policy experiment.

 

That's the argument we made in the December issue of Sound Money. Sound Investments. We think the change from QE to something else will see gold and commodities bottom in 2014 and start another big move higher as the market starts to discount a pick-up in inflationary pressures. At some point in the first part of the year we think global capital will start moving back into these deeply oversold markets.

 

And we think such a move is still possible, despite the prospect of a big slowdown in China next year (yesterday's HSBC manufacturing data release wasn't encouraging for the China bulls). If the performance of the gold market is any guide, the major commodity markets seem to be driven more by trading sentiment than underlying physical demand these days.

 

Through the proliferation of derivatives, traders can speculate on price moves much more effectively and efficiently than buying or selling a physical good. And once momentum builds in either direction, the price moves take on a life of their own, no matter what the underlying physical market looks like.

 

Despite China continuing to grow robustly (albeit a little more slowly) over the past few years, most commodity markets have been in decline. Only iron ore has bucked the trend. That's largely because China has the world's largest and most uneconomical steel production industry. But it also could have something to do with the fact that the iron ore market trades separately from other industrial commodities.

 

Until recently iron ore contracts were negotiated annually between the major suppliers and the end users. In the past few years BHP led the development of a spot market. As such, the iron ore derivatives market is still in its infancy. If you're a hedge fund and you want to short iron ore, what do you do? Well you can't really short the price, so you'd probably have to short sell the producers. In gold, oil or any other widely traded metal like copper, you can do both.

 

The point we're making is that physical demand seems like only one part of the equation these days. With vast amounts of speculative global capital moving around the place, and a massive amount of derivative products available to accommodate that capital, anticipating where it will move next is a valid speculative strategy.