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Fed to Taper QE, Gold Prices to Rise?

How gold prices got here, plus a roadmap for QE tapering ahead...
THE VALUE of gold has fluctuated wildly over the past few years, writes Gary Dorsch, editor of Global Money Trends.
After rallying for 12 straight years, the yellow metal has tumbled as much as 38% from its all-time high of $1923 per ounce reached in August 2011. Gold prices officially fell into the quagmire of a bear market on April 12th, and even central bankers were caught off guard.
Central banks were net buyers of 535 tonnes of gold last year – the most they've ever accumulated in any single year. Today, the central banks are among the biggest losers as gold prices fall, holding 31,700 tonnes as a group, or roughly 19% of all the gold ever mined.
No one has more to lose from gold's slump than miners in South Africa, where the break-even costs are the highest in the world. Anything below $1400 per ounce is a red flag for South African gold miners. Costs are steeper than competitors abroad because of the extra labor that's needed to dig deeper into its aging mines.
Globally, gold-mining companies are moving to include capital expenditure in their per-ounce cost figures. Sibanye, South Africa's second-largest gold miner by output, has total costs including production and capex of $1334 per ounce. Costs at Harmony, the country's third-largest producer, are $1487 per ounce. AngloGold, the country's largest gold miner, was the only South African bullion producer whose costs in the nation of $1204 an ounce were below the current spot gold price.
Even the world's biggest gold miner – Barrick Gold (ABX.TO) – is at risk of defaulting on its longer-term debt obligations if the price of the yellow metal falls significantly lower.
Shares in Barrick have lost about $40 billion in market value since April 2011. After gold prices fell below $1400 per ounce in April '13, the yield to maturity on Barrick's 6.35% note due in Oct 2036, soared to as high as 7.85%. The cost to insure $10 million of ABX's debt in the credit default swap market jumped to as high as $344,000 on July 5th.
Moody's and S&P rate Barrick's debt at Baa2 and BBB respectively, but its long-term debt trades in-line with junk bonds.
The problem plaguing Barrick is that three acquisitions in the last five years for a total cost of $8.4 billion increased its debt load to $16 billion today, the most among gold miners worldwide. In April, ABX said it expects "all-in sustaining costs" including output and capex costs to be between $950 and $1050 per ounce. But after ABX burned through $1.2 billion of cash in the 12-months through March, it could be forced to slash its $800 million annual dividend in order to preserve cash on hand, if gold falls much further.
Asked about the price of gold, which is down about 23% this year, the chief of the Federal Reserve, Ben Bernanke also admitted on July 17th that he doesn't understand the yellow metal.
"No one really understands gold prices," Bernanke told the Senate Banking Committee, adding he doesn't get it either. Calling it "an unusual asset," the Fed chief said that investors hold gold for "disaster insurance" and as an inflation hedge. He expressed surprise about the latter, noting "movements in gold don't predict inflation very well."
Bernanke took some solace in the recent sharp decline in gold prices, though, suggesting they could reflect diminishing concerns over really bad outcomes.
Gold has a multi-faceted personality, but nowadays, its behavior is mostly influenced by the direction of 10-year US Treasury notes. Spooked by the increasing likelihood that the Bernanke Fed will begin to "taper" down its $85 billion per month of liquidity injections into the money markets, the price of gold has nosedived, alongside what appears to be the early stages of a bursting of the US T-Note bubble. 
Lower T-note prices – and higher interest rates – are sending a clear signal to the marketplace that the Fed is seriously entertaining the idea of winding down in radical "quantitative easing" QE, money printing scheme.
The top central bankers and finance chiefs from the Group-of-20 nations, huddled in Moscow on July 19th, heard behind closed doors that the Fed intends to down-size its purchases of bonds, probably starting in September.
"Unconventional monetary policies that were decided by the Federal Reserve, the Bank of England, the European Central Bank, and the Bank of Japan have consequences on capital flows. The unwinding of these policies needs to be phased outcarefully," said IMF managing director Christine Lagarde.
"The current turbulence in global financial markets could continue and deepen," the IMF chief warned at July's G20 meeting in Moscow.
"Growth could be lower than projected due to a protracted period of stagnation in the Euro area, and risks of a longer slowdown in Emerging markets have increased. The eventual exit from low rates and unconventional monetary policy in advanced economies could pose challenges for emerging economies, especially if it proceeds too fast or is not well communicated."
However, it wasBank of Japan chief Haruhiko Kuroda who let the cat out of the bag, with the most explicit signal yet of the Fed's next move on QE. "An eventual tapering of monetary stimulus by the Federal Reserve would be natural and appropriate," he said on July 19th.
The partial unwinding of the Fed's radical QE scheme has been telegraphed to the marketplace during the past two months through a series of leaks and hints to the media.
The most influential and powerful voice comes from the Bank for International Settlements. On June 23rd, the BIS said that G7 central banks should not allow fears of disrupting markets to delay the timely withdrawal of cheap money. The BIS anticipated that signaling anexit might cause market disruptions but warned that the risks fromdelaying was likely to rise over time.
"Central banks will need to strike the right balance between the risks of exiting prematurely and the risksassociated with delaying exit further. The longer the current accommodative conditions persist,the bigger the exit challenges become."
Former Fed chief Alan Greenspan used to be famous for keeping his listeners in the dark about the central bank's future plans. "I guess I should warn you. If I turn out to be particularly clear, you've probably misunderstood what I've said," he used to say. So it was shocking to hear Mr Greenspan tell the viewers of CNBC on June 7th, in crystal clear terms, that the Fed must begin to taper its QE scheme, even if the US economy is not ready for it.
"The sooner we come to grips with this excessive level of assets on the balance sheet of the Federal Reserve – that everybody agrees is excessive – the better," he said in a Squawk Box interview.
"There is a general presumption that we can wait indefinitely and make judgments on when we're going to move. I'm not sure the market will allow us to do that. But if the Fed moves too quickly in reining in its accommodative policies, it could shock the market, which is already dealing with a very large element of uncertainty. I'm not sure the markets will allow an easy exit. Gradual is adequate, but we've got to get moving."
As for the Fed's Zero Interest Rate Policy (ZIRP), Greenspan said it's buoying stock prices, but the markets need to be prepared for a faster-than-expected rise in long-term interest rates.
"Bond prices have got to fall. Long-term rates have got to rise. The problem, which is going to confront us, is we haven't a clue as to how rapidly that's going to happen. And we must be prepared for a much more rapid rise than is now contemplated in the general economic outlook.
"We're still well below the interest rate level we normally ought to be at this stage. The consequence of that is that when the bond market begins to move we may not be able to control it as well as we'd like to. And that has a lot of ramifications with respect to all sorts of markets."
Greenspan's comments knocked the gold market $30 per ounce lower on June 7th to $1383 per ounce, but bigger carnage began two weeks later, on June 20th, when Fed chief Bernanke hinted at a timetable for unwinding QE3.
The upward surge in US Treasury yields isn't the only factor that's undermining gold prices.
Long-term interest rates in Britain, Canada, and Hong Kong have increased by +1% or more in lockstep. Corporate and sovereign bond yields in the emerging nations of Brazil, Russia, India, and South Africa have surged between 125 basis points and 250 bps higher in recent weeks.
This synchronized increase in bond yields across the globe has caused many investors to lose faith in gold as a store of value. As investors dumped ETFs that are backed by gold bullion, fund managers were forced to sell 13.6 million ounces since April 1st. That represents about $58 billion in market value.
Some investors switched tactics, by plowing the proceeds into stock market indexes, with the best performers in Britain, Germany, Japan, and the US.
Now, according to the Wall Street Journal's Jon Hilsenrath on May 10th, "Fed officials say they plan to reduce the amount of bonds they buy in careful and potentially halting steps, varying their purchases as their confidence about the job market and inflation evolves."
"I don't want to go from wild turkey to cold turkey," Dallas Fed chief Richard Fisher told the WSJ. Withdrawing the QE3 stimulus would be combined with promises by the Fed to keep the fed funds rate locked at near zero percent into 2015. "Jawboning" techniques would also be utilized to influence trader psychology at key price levels on the T-bond charts.
Still, US T-note yields have already built in expectations of a $20 billion cutback in the Fed's QE3 scheme at the upcoming Sept 18th meeting. Until then, 10-year Treasury bond yields could gyrate within a tight range between 2.45% and 2.75%.
Likewise, British Gilt and Canadian government bond yields are expected to continue to track the US T-note yield, although their rates are priced about 25 bps less. If the recent past is any guide to the near term future, gold prices would still be hounded by fear of yet another jolt in T-note yields into a higher plane of equilibrium, up to between 3% and 3.50%. In order to knock the gold price towards $1250 per ounce, it might require a second round of tapering of QE3 to $45 billion per month.
Given the shrinkage in the US budget deficit, expected at $660 billion this fiscal year, the Fed has the leeway to reduce the size of its monthly purchases of T-bonds. If correct, the Global Money Trends newsletter suspects that Fed chief Bernanke would move to taper down the QE injections to $65 billion per month in September, and to $45bn at the next meeting in December. At the behest of the BIS, the Fed might downsize QE3 to $45 billion, even if it becomes increasingly apparent that the US economy is sliding into a mild recession.
Still, the next Fed chief would be appointed in January 2014 by liberal Democrats, who are QE lovers. Therefore, the next Fed chief might placate his/her political masters by stonewalling any attempt to taper QE3 to less than $45 billion in 2014, especially if it becomes increasingly apparent that the US-economy is sliding into a full blown recession.
As for gold prices, the key question is; did the recent slide to $1200 per ounce fully price-in the scenario of a complete tapering of QE3 to zero by mid-2014?
If yes, then such bearish ideas were overblown. In that case, gold has found its bear market bottom at $1200 per ounce, where it could start to build a sustainable base of support and begin a recovery rally in fits and starts, in the months ahead.

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.


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