Gold was enjoying a solid spring rally until a couple weeks ago, nearing major upside breakouts. But its nice advance has crumbled since, really weighing on sentiment. Gold fell victim to a rare major short squeeze in US Dollar Index futures. The surging USDX motivated gold-futures speculators to flee rather aggressively. But this will likely prove a short-lived anomaly, after which gold’s assault on highs will recommence.
Gold’s seasonally-atypical weakness over the past couple weeks is very important for speculators and investors to understand. It had nothing at all to do with fundamentals, but was completely driven by the hyper-leveraged gold-futures traders. These guys have long been fixated on the US dollar’s fortunes, looking to its benchmark US Dollar Index for trading cues. That can slave gold’s price to the dollar at times.
Six weeks ago, gold slumped to a major seasonal low of $1310 the day before the universally-expected 6th Fed rate hike of this cycle. The gold-futures traders fervently believe Fed rate hikes are very bearish for gold, so they usually sell leading into FOMC meetings with potential hikes. This has happened before every Fed rate hike of this cycle. The theory is higher US rates boost foreign investment demand for US dollars.
The ironic thing is modern history proves the opposite! Fed-rate-hike cycles are bearish for the US dollar and bullish for gold. The last cycle ran from June 2004 to June 2006, where the Fed hiked 17 times in a row for 425 basis points. Despite those aggressive and relentless rate hikes, the USDX still slipped 3.8% lower over that exact span while gold rocketed 49.6% higher! Clearly futures specs’ theory is sorely lacking.
The Fed’s current rate-hike cycle out of extreme zero-interest-rate-policy lows got launched in December 2015. Gold was hammered to a 6.1-year secular low leading into it, as futures specs were absolutely certain higher rates were bearish for gold and bullish for the USDX. Yet again they were proven dead wrong, wrong, wrong! As of the middle of this week, gold is up 23.0% since then while the USDX fell 5.5%.
You’d think after some market thesis fails to work over and over again for decades, traders would try something else. But not futures speculators, they are a stubborn lot. So leading into every likely Fed rate hike, they bid up the USDX and dump gold. Then immediately after those rate hikes the dollar fails to surge and gold doesn’t plunge, so they reverse those excessive trades driving the dollar down and gold up.
So like clockwork after the Fed’s latest rate hike in late March, gold started rallying as gold-futures specs bought back in. Gold enjoys a strong seasonal spring rally in April and May, which I discussed in depth last week. By mid-April, that propelled gold within spitting distance of a major bull-market breakout. Gold regained its $1365 bull-to-date high from July 2016 on an intraday basis on April 11th, but failed to push through.
Ironically futures speculators’ irrational obsession with the Fed was again to blame. That day the FOMC released the minutes from its March 21st rate-hiking meeting. Traders interpreted them as hawkish, so the USDX was bought and gold was sold. For 24 trading days in row between mid-March to mid-April, gold simply did the opposite of whatever the USDX did on every single day but one. The dollar ruled gold.
Gold managed to hover near $1350 multi-year-horizontal-resistance breakout territory for another week after those Fed minutes. But that started changing on April 19th. That day the USDX rallied 0.3%, which was actually its biggest up day in a couple weeks. USDX-futures speculators were excited because the yields on benchmark US 10-year Treasury notes crested 2.9%. Higher yields are great for the dollar, right?
For decades I’ve closely followed speculators’ collective gold-futures positions every week in the famous Commitments of Traders reports published by the CFTC. I discuss them and their implications for gold’s near-term price action in every weekly newsletter. But I haven’t had the time to dig deeply into USDX futures. The analysts who traffic in that realm said USDX short positions were the largest seen in several years.
The leverage inherent in currency speculation is extreme beyond belief. Since major currencies tend to move slowly, the margin requirements equate to maximum leverage of 50x, 100x, or even 200x! That compares to the decades-old legal limit in the stock markets of 2x. At 50x, 100x, or 200x, mere 2.0%, 1.0%, or 0.5% currency moves against traders’ positions would wipe out 100% of their capital risked. It’s crazy!
So when currency speculators are wrong, they have to exit positions fast or risk getting obliterated. The traders short USDX futures had no choice but to buy. The more long USDX futures they bought to offset and close their shorts, the faster the dollar rallied. That forced still more traders to buy to cover even if they were running more-conservative leverage. This self-reinforcing dynamic feeds on itself, fueling short squeezes.
As the USDX buying mounted, the dollar’s rally accelerated in subsequent days. Traders continued to use 10-year Treasury yields as a fundamental excuse for their purely technical trading, as within a week they crossed the psychologically-heavy 3% threshold to 3.03%. That was the highest seen since the very end of 2013! The USDX rallied 0.3%, 0.5%, and 0.7% in the initial few trading days of that buying to cover.
It had already become the biggest dollar short squeeze since soon after Trump won the election in late 2016. That heavy futures buying forced the USDX to surge 1.5% in those first 3 trading days. Although that sounds trivial, at 50x, 100x, or 200x leverage it hammers speculators to catastrophic 75%, 150%, or 300% losses! I wonder how these guys can sleep at night bearing such ridiculous and unforgiving levels of risk.
Gold-futures speculators run extreme leverage too, but much less than currency traders. This week a single gold-futures contract controlling 100 troy ounces of gold worth $130,500 only required speculators to keep $3100 cash margins in their accounts. That equates to 42.1x maximum leverage! For traders running at the edge, every 1% adverse move in gold would wipe out an insane 42% of their capital risked.
So these guys nervously watch gold on a minute-by-minute basis. And in a fascinating confirmation that gold is indeed a currency, they look to the US dollar for their trading cues. They started selling their gold-futures positions as the dollar started rallying. That drove gold 0.2%, 0.7%, and 0.9% lower in the first 3 trading days of that USDX short squeeze that ignited on April 19th, forcing gold down 1.9% overall to $1324.
Our lone chart this week looks at gold during this current Fed-rate-hike cycle superimposed on the long and short positions large and small speculators hold in gold futures. Again these are published once a week in those Commitments of Traders reports. All 6 Fed rate hikes of this cycle are also highlighted, to show how gold is bludgeoned lower leading into them which spawns strong rebound buying in their wakes.
While the weekly CoTs are current to each Tuesday, they are released late Friday afternoons. Thus the newest-available CoT when this essay was published covers the week ending April 24th. That includes those initial few trading days of that USDX-futures short squeeze. And it’s very illuminating, showing why gold was pummeled back down from major-breakout levels and its strong spring rally was short-circuited.
For pre-dollar-rally baselines, on Tuesday April 17th speculators held 284.2k long and 98.9k short gold-futures contracts. These were running 27% and 15% up into their own past-year trading ranges. Thus these traders had the capital firepower and room to still do about 3/4ths and 6/7ths of their near-term long buying and short selling. Of course buying gold-futures longs is bullish for gold, while shorting is bearish.
When gold-futures shorts are low, there’s always the risk speculators will aggressively sell on the right catalyst coming along. That forces gold’s price lower. And this unlikely dollar short squeeze erupting out of the blue proved that triggering event. On seeing the USDX surge, the gold-futures specs were quick to start jettisoning longs and ramping shorts. Thus gold fell 1.2% on the 1.4% USDX rally over that CoT week.
The magnitude of this initial gold-futures selling became evident in the next CoT report current to April 24th. During that CoT week, specs sold 7.9k gold-futures long contracts while adding another 15.6k on the short side. That made for big total CoT-week selling equivalent to 73.0 metric tons of gold. That is simply far too much for normal buying to absorb. Thus the only possible outcome was a lower gold price.
Just this week, the World Gold Council released its latest Gold Demand Trends report for Q1’18. That’s the definitive source for world gold fundamental supply-and-demand data. In Q1, global gold investment demand averaged 22.1t per week. So heavy gold-futures selling easily overwhelms that. Gold always falls when the futures specs get on a selling kick. They flood the market with too much short-term supply.
That dollar-short-squeeze reaction left specs’ collective long and short gold-futures positions running up 22% and 30% into their past-year trading ranges. So these traders still had room to do about 4/5ths of their likely near-term long buying, but expended a significant chunk of their shorting firepower. That left total spec shorts at a 12-CoT-week high of 114.5k contracts. The higher spec shorts, the more bullish gold gets.
Short positions in futures are bullish because they necessitate proportional near-term buying. In selling short, speculators essentially borrow futures from other traders to sell. The specs are legally obligated to buy back those contracts relatively soon to close out those trades and repay those effective debts. So futures shorts are guaranteed near-future buying, whether they are in the USDX, gold, or anything else.
This essay was penned and proofed Thursday, and then published Friday morning. The newest CoT data current to this Tuesday May 1st won’t come out until late Friday afternoon about 4 hours after this essay went live. So while I can’t wait to see the latest CoT, I can only speculate about it at this point. During this latest CoT week, the USDX-futures short squeeze continued which drove more spec gold-futures selling.
The dollar rally actually accelerated in this newest CoT week ending Tuesday, as shown by the sharp 1.9% rally in the USDX. Thus gold’s CoT-week selloff also grew to 2.0%. That was 2/3rds larger than the prior CoT week’s 1.2%. So odds are the gold-futures selling ballooned significantly in this latest CoT week. That implies another 35k to 40k gold-futures contracts were dumped, with the majority likely on the short side.
Assuming the prior week’s spec gold-futures-selling mix of 1/3rd long and 2/3rds short holds, total spec longs could’ve dropped another 12.9k contracts while shorts could’ve soared 25.8k. If that proves true, total spec longs and shorts could have been running near 14% and 54% up into their past-year trading ranges as of this Tuesday. That would mean the majority of the likely gold-futures shorting is already done!
While I don’t have the USDX-futures data and background to analyze in depth, odds are the USDX is in a similar opposite place. I suspect the majority of the dollar short covering has already run its course. That paves the way for this sharp dollar rally to at least peter out and probably reverse. Trade-war fears are going to flare again soon as the distraction of stocks’ Q1 earnings season passes, which is bearish for the dollar.
If you look at the chart above, the green line shows specs’ total gold-futures long contracts. Note even a CoT week ago that was trading below bull-market support. There is big room for these traders to flood into gold on the long side when the USDX inevitably stalls or reverses. They likely now have the capital firepower to do about 6/7ths of their potential near-term buying! That portends big gold upside in coming weeks.
While gold’s strong seasonal spring rally was interrupted by this surprise USDX-futures short squeeze, I doubt it was killed. Gold was driven to a new seasonal low of $1304 this week, under its previous $1310 of mid-March. Thus all the usual spring-rally buying in April and May will likely be compressed into this month alone! That means gold could enjoy a major mean-reversion bounce rally in the coming weeks.
During the 10 trading days as of the middle of this week since the dollar’s sharp rally started, gold has moved inversely proportionally to the USDX on every trading day but one. 8 of these trading days of the past couple weeks saw the dollar rally, and gold’s biggest losses of 0.9% both occurred on the dollar’s best up days of 0.7%. Gold’s down days were all about the same size as the dollar’s up days, mirror images.
But in the 2 trading days of the past couple weeks when the USDX retreated modestly, gold surged way out of proportion to the dollar’s weakness. These trivial 0.2% and 0.1% USDX slides allowed gold to rally a relatively-outsized 0.6% and 0.5%! Gold wants to rally, and will likely quickly surge back up near major-breakout levels soon after this dollar-rally pressure abates. And that’s likely going to prove very soon.
The mounting US/China trade war has been pushed out of the financial-media spotlight by Q1 corporate earnings, which have soared on the big corporate tax cut. But earnings season is winding down just as major trade-war deadlines are looming for the US to implement recent tariff announcements. The dollar looks far less attractive to foreign investors if tariff threats become reality, their capital will seek refuge elsewhere.
And though the extreme leverage inherent in gold futures enables their speculators to wield outsized influence on short-term price action, investors’ capital massively dwarfs the speculators’. So when investors’ vast funds start bidding on gold again, likely on the next major stock-market selloff driving demand for prudent portfolio diversification, gold-futures specs’ influence will be overwhelmed and drowned out.
Add in strong spring seasonals to all this, and gold has a fantastic foundation for a strong rebound rally. Speculators’ low gold-futures longs are very bullish, as they will rush to buy back in to ride any upside momentum in gold. Speculators’ mounting gold-futures shorts are increasingly bullish, as these will have to be covered and closed by buying offsetting longs. And investors’ super-low gold allocations are wildly-bullish.
So odds are gold’s atypical counter-seasonal drop in the last couple weeks driven by the surprise USDX short squeeze will soon reverse hard. It won’t take much buying to drive gold back up near those major bull breakout levels around $1365. And gold powering higher again will quickly turn sentiment around, with buying begetting more buying. The dollar depressing gold prices leaves this metal more bullish, not less so.
While investors can ride gold’s coming mean-reversion rebound in physical bullion itself or shares in the leading GLD SPDR Gold Shares gold ETF, far-better gains will be won in the stocks of its leading miners. They are already radically undervalued at today’s prevailing gold prices, and their profits tend to amplify underlying gold gains by 2x to 3x. This small contrarian sector’s upside is vast, dwarfing everything else.
With gold still so near a major bull-market breakout, it’s ironic gold stocks remain so deeply out of favor. Between our weekly and monthly newsletters, we have 30 open gold-stock and silver-stock trades added in the past year. As of this week near gold’s lows, fully 25 had average unrealized gains of 18%. One gold miner added in late November is already up 95%! The 5 other trades had average unrealized losses of just 5%.
When gold inevitably rebounds, these unrealized gains are going to explode higher. Buying low first is necessary before selling high later to multiply wealth. That means adding gold stocks when you least want to, when they’re hated. That’s what we do at Zeal. We spend all our time relentlessly studying the markets so you don’t have to, and share our acclaimed research through our popular financial newsletters.
They draw on my vast experience, knowledge, wisdom, and ongoing research to explain what’s going on in the markets, why, and how to trade them with specific stocks. As of the end of Q4, we’ve recommended 983 stock trades in real-time to our newsletter subscribers since 2001. They’ve averaged big annualized realized gains of +20.2%, well over double stock markets’ long-term average! For only $12 per issue, you can learn to think, trade, and thrive like contrarians. Subscribe today and get deployed!
The bottom line is gold’s recent weakness is the result of a rare major short squeeze in US Dollar Index futures. The resulting dollar rally spooked gold-futures speculators, who rushed to sell to avoid getting slaughtered by their extreme leverage. While that short-circuited gold’s spring rally, this anomaly won’t last. Gold-futures speculators and gold investors are far too bearish and under-allocated, with big room to buy.
The USDX short covering is likely running out of steam, which will clear the way for gold’s big seasonal spring rally to resume. All that delayed buying will likely be compressed into May, and drive gold back up near recent major-bull-breakout levels. Any dollar/gold reversals will force gold-futures specs to quickly buy to cover their ballooning shorts. The resulting rally will entice in long-side traders, then gold is off to the races.
Adam Hamilton, CPA
May 4, 2018
Copyright 2000 – 2018 Zeal LLC (www.ZealLLC.com)
This week’s landmark Federal Open Market Committee decision to launch quantitative tightening is one of the most-important and most-consequential actions in the Federal Reserve’s entire 104-year history. QT changes everything for world financial markets levitated by years of quantitative easing. The advent of the QT era has enormous implications for stock markets and gold that all investors need to understand.
This week’s FOMC decision to birth QT in early October certainly wasn’t a surprise. To the Fed’s credit, this unprecedented paradigm shift had been well-telegraphed. Back at its mid-June meeting, the FOMC warned “The Committee currently expects to begin implementing a balance sheet normalization program this year”. Its usual FOMC statement was accompanied by an addendum explaining how QT would likely unfold.
That mid-June trial balloon didn’t tank stock markets, so this week the FOMC decided to implement it with no changes. The FOMC’s new statement from Wednesday declared, “In October, the Committee will initiate the balance sheet normalization program described in the June 2017 Addendum to the Committee’s Policy Normalization Principles and Plans.” And thus the long-feared QT era is now upon us.
The Fed is well aware of how extraordinarily risky quantitative tightening is for QE-inflated stock markets, so it is starting slow. QT is necessary to unwind the vast quantities of bonds purchased since late 2008 via QE. Back in October 2008, the US stock markets experienced their first panic in 101 years. Ironically it was that earlier 1907 panic that led to the Federal Reserve’s creation in 1913 to help prevent future panics.
Technically a stock panic is a 20%+ stock-market plunge within two weeks. The flagship S&P 500 stock index plummeted 25.9% in just 10 trading days leading into early October 2008, which was certainly a panic-grade plunge! The extreme fear generated by that rare anomaly led the Fed itself to panic, fearing a new depression driven by the wealth effect. When stocks plummet, people get scared and slash their spending.
That’s a big problem for the US economy over 2/3rds driven by consumer spending, and could become self-reinforcing and snowball. The more stocks plunge, the more fearful people become for their own financial futures. They extrapolate the stock carnage continuing indefinitely and pull in their horns. The less they spend, the more corporate profits fall. So corporations lay off people exacerbating the slowdown.
The Fed slashed its benchmark federal-funds interest rate like mad, hammering it to zero in December 2008. That totally exhausted the conventional monetary policy used to boost the economy, rate cuts. So the Fed moved into dangerous new territory of debt monetization. It conjured new money out of thin air to buy bonds, injecting that new cash into the real economy. That was euphemistically called quantitative easing.
The Fed vehemently insisted it wasn’t monetizing bonds because QE would only be a temporary crisis measure. That proved one of the biggest central-bank lies ever, which is saying a lot. When the Fed buys bonds, they accumulate on its balance sheet. Over the next 6.7 years, that rocketed a staggering 427% higher from $849b before the stock panic to a $4474b peak in February 2015! That was $3625b of QE.
While the new QE bond buying formally ended in October 2014 when the Fed fully tapered QE3, that $3.6t of monetized bonds remained on the Fed’s balance sheet. As of the latest-available data from last week, the Fed’s BS was still $4417b. That means 98.4% of all the Fed’s entire colossal QE binge from late 2008 to late 2014 remains intact! That vast deluge of new money created remains out in the economy.
Don’t let the complacent stock-market reaction this week fool you, quantitative tightening is a huge deal. It’s the biggest market game-changer by far since QE’s dawn! Starting to reverse QE via QT radically alters market dynamics going forward. Like a freight train just starting to move, it doesn’t look scary to traders yet. But once that QT train gets barreling at full speed, it’s going to be a havoc-wreaking juggernaut.
QT will start small in the imminent Q4’17, with the Fed allowing $10b per month of maturing bonds to roll off its books. The reason the Fed’s QE-bloated balance sheet has remained so large is the Fed is reinvesting proceeds from maturing bonds into new bonds to keep that QE-conjured cash deployed in the real economy. QT will slowly taper that reinvestment, effectively destroying some of the QE-injected money.
These monthly bond rolloffs will start at $6b in Treasuries and $4b in mortgage-backed securities. Then the Fed will raise those monthly caps by these same amounts once a quarter for a year. Thus over the next year, QT’s pace will gradually mount to its full-steam speed of $30b and $20b of monthly rolloffs in Treasuries and MBS bonds. The FOMC just unleashed a QT juggernaut that’s going to run at $50b per month!
When this idea was initially floated back in mid-June, it was far more aggressive than anyone thought the Yellen Fed would ever risk. $50b per month yields a jaw-dropping quantitative-tightening pace of $600b per year! These complacent stock markets’ belief that such massive monetary destruction won’t affect them materially is ludicrously foolish. QT will naturally unwind and reverse the market impact of QE.
This hyper-easy Fed is only hiking interest rates and undertaking QT for one critical reason. It knows the next financial-market crisis is inevitable at some point in the future, so it wants to reload rate-cutting and bond-buying ammunition to be ready for it. The higher the Fed can raise its federal-funds rate, and the lower it can shrink its bloated balance sheet, the more easing firepower it will have available in the future.
But QT has never before been attempted and is extremely risky for these QE-levitated stock markets. So the Fed is attempting to thread the needle between preparing for the next market crisis and triggering it. Yellen and top Fed officials have been crystal-clear that they have no intention of fully unwinding all the QE since late 2008. Wall Street expectations are running for a half unwind of the $3.6t, or $1.8t of total QT.
At the full-speed $600b-per-year QT pace coming in late 2018, that would take 3 years to execute. The coming-year ramp-up will make it take longer. So these markets are likely in for fierce QT headwinds for several years or so. At this week’s post-FOMC-decision press conference, Janet Yellen took great pains to explain the FOMC has no intentions of altering this QT-pacing plan unless there is some market calamity.
Yellen was also more certain than I’ve ever heard her on any policy decisions that this terminal $50b-per-month QT won’t need to be adjusted. With QT now officially started, the FOMC is fully committed. If it decides to slow QT at some future meeting in response to a stock selloff, it risks sending a big signal of no confidence in the economy and exacerbating that very selloff! Like a freight train, QT is hard to stop.
With stock markets at all-time record highs this week, QT’s advent seems like no big deal to euphoric stock traders. They are dreadfully wrong. CNBC’s inimitable Rick Santelli had a great analogy of this. Just hearing a hurricane is coming is radically different than actually living through one. QT isn’t feared because it isn’t here and hasn’t affected markets yet. But once it arrives and does, psychology will really change.
Make no mistake, quantitative tightening is extremely bearish for these QE-inflated stock markets. Back in late July I argued this bearish case in depth. QT is every bit as bearish for stocks as QE was bullish! This first chart updated from that earlier essay shows why. This is the scariest and most-damning chart in all the stock markets. It simply superimposes that S&P 500 benchmark stock index over the Fed’s balance sheet.
Between March 2009 and this week’s Fed Day, the S&P 500 has powered an epic 270.8% higher in 8.5 years! That makes it the third-largest and second-longest stock bull in US history. Why did that happen? The underlying US economy sure hasn’t been great, plodding along at 2%ish growth ever since the stock panic. That sluggish economic growth has constrained corporate-earnings growth too, it’s been modest at best.
Stocks are exceedingly expensive too, with their highest valuations ever witnessed outside of the extreme bull-market toppings in 1929 and 2000. The elite S&P 500 component companies exited August with an average trailing-twelve-month price-to-earnings ratio of 28.1x! That’s literally in formal bubble territory at 28x, which is double the 14x century-and-a-quarter fair value. Cheap stocks didn’t drive most of this bull.
And if this bull’s gargantuan gains weren’t the product of normal bull-market fundamentals, that leaves quantitative easing. A large fraction of that $3.6t of money conjured out of thin air by the Fed to inject into the economy found its way into the US stock markets. Note above how closely this entire stock bull mirrored the growth in the Fed’s total balance sheet. The blue and orange lines above are closely intertwined.
Those vast QE money injections levitated stock markets through two simple mechanisms. The massive and wildly-unprecedented Fed bond buying forced interest rates to extreme artificial lows. That bullied traditional bond investors seeking income from yields into far-riskier dividend-paying stocks. Super-low interest rates also served as a rationalization for historically-expensive P/E ratios rampant across the stock markets.
While QE directly lifted stocks by sucking investment capital out of bonds newly saddled with record-low yields, a secondary indirect QE impact proved more important. US corporations took advantage of the Fed-manipulated extreme interest-rate lows to borrow aggressively. But instead of investing all this easy cheap capital into growing their businesses and creating jobs, they squandered most of it on stock buybacks.
QE’s super-low borrowing costs fueled a stock-buyback binge vastly greater than anything seen before in world history. Literally trillions of dollars were borrowed by elite S&P 500 US corporations to repurchase their own shares! This was naked financial manipulation, boosting stock prices through higher demand while reducing shares outstanding. That made corporate earnings look much more favorable on a per-share basis.
Incredibly QE-fueled corporate stock buybacks have proven the only net source of stock-market capital inflows in this entire bull market since March 2009! Elite Wall Street banks have published many studies on this. Without that debt-funded stock-buyback frenzy only possible through QE’s record-low borrowing rates, this massive near-record bull wouldn’t even exist. Corporations were the only buyers of their stocks.
QE’s dominating influence on stock prices is unassailable. The S&P 500 surged in its early bull years until QE1 ended in mid-2010, when it suffered its first major correction. The Fed panicked again, fearing another plunge. So it birthed and soon expanded QE2 in late 2010. Again the stock markets surged on a trajectory perfectly paralleling the Fed’s balance-sheet growth. But stocks plunged when QE2 ended in mid-2011.
The S&P 500 fell 19.4% over the next 5.2 months, a major correction that neared bear-market territory. The Fed again feared a cascading negative wealth effect, so it launched Operation Twist in late 2011 to turn stock markets around. That converted short-term Treasuries to long-term Treasuries, forcing long rates even lower. As the stock markets started topping again in late 2012, the Fed went all out with QE3.
QE3 was radically different from QE1 and QE2 in that it was totally open-ended. Unlike its predecessors, QE3 had no predetermined size or duration! So stock traders couldn’t anticipate when QE3 would end or how big it would get. Stock markets surged on QE3’s announcement and subsequent expansion a few months later. Fed officials started to deftly use QE3’s inherent ambiguity to herd stock traders’ psychology.
Whenever the stock markets started to sell off, Fed officials would rush to their soapboxes to reassure traders that QE3 could be expanded anytime if necessary. Those implicit promises of central-bank intervention quickly truncated all nascent selloffs before they could reach correction territory. Traders realized that the Fed was effectively backstopping the stock markets! So greed flourished unchecked by corrections.
This stock bull went from normal between 2009 to 2012 to literally central-bank conjured from 2013 on. The Fed’s QE3-expansion promises so enthralled traders that the S&P 500 went an astounding 3.6 years without a correction between late 2011 to mid-2015, one of the longest-such spans ever! With the Fed jawboning negating healthy sentiment-rebalancing corrections, psychology grew ever more greedy and complacent.
QE3 was finally wound down in late 2014, leading to this Fed-conjured stock bull stalling out. Without central-bank money printing behind it, the stock-market levitation between 2013 to 2015 never would have happened! Without more QE to keep inflating stocks, the S&P 500 ground sideways and started topping. Corrections resumed in mid-2015 and early 2016 without the promise of more Fed QE to avert them.
In mid-2016 the stock markets were able to break out to new highs, but only because the UK’s surprise pro-Brexit vote fueled hopes of more global central-bank easing. The subsequent extreme Trumphoria rally since the election was an incredible anomaly driven by euphoric hopes for big tax cuts soon from the newly-Republican-controlled government. But Republican infighting is making that look increasingly unlikely.
The critical takeaway of the entire QE era since late 2008 is that stock-market action closely mirrored whatever the Fed was doing. Ex-Trumphoria, all this bull’s massive stock-market gains happened when the Fed was actively injecting trillions of dollars of QE. When the Fed paused its balance-sheet growth, the stock markets either corrected hard or stalled out. These stock markets are extraordinarily QE-dependent.
The Fed’s balance sheet has never materially shrunk since QE was born out of that 2008 stock panic. Now quantitative tightening will start ramping up in just a couple weeks for the first time ever. If QE is responsible for much of this stock bull, and certainly all of the extreme levitation from 2013 to 2015 due to the open-ended QE3, can QT possibly be benign? No freaking way friends! Unwinding QE is this bull’s death knell.
QE was like monetary steroids for stocks, artificially ballooning this bull market to monstrous proportions. Letting bonds run off the Fed’s balance sheet instead of reinvesting effectively destroys that QE-spawned money. QE made this bull the grotesque beast it is, so QT is going to hammer a stake right through its heart. This unprecedented QT is even more dangerous given today’s bubble valuations and rampant euphoria.
Investors and speculators alike should be terrified of $600b per year of quantitative tightening! The way to play it is to pare down overweight stock positions and build cash to prepare for the long-overdue Fed-delayed bear market. Speculators can also buy puts in the leading SPY SPDR S&P 500 ETF. Investors can go long gold via its own flagship GLD SPDR Gold Shares ETF, which tends to move counter to stock markets.
Gold was hit fairly hard after this week’s FOMC decision announcing QT, which makes it look like QT is bearish for gold. Nothing could be farther from the truth. Gold’s post-Fed selloff had nothing at all to do with QT! At every other FOMC meeting, the Fed also releases a summary of top Fed officials’ outlooks for future federal-funds-rate levels. This so-called dot plot was widely expected to be more dovish than June’s.
Yellen herself had given speeches in the quarter since that implied this Fed-rate-hike cycle was closer to its end than beginning. She had said the neutral federal-funds rate was lower than in the past, so gold-futures speculators expected this week’s dot plot to be revised lower. It wasn’t, coming in unchanged from June’s with 3/4ths of FOMC members still expecting another rate hike at the FOMC’s mid-December meeting.
This dot-plot hawkish surprise totally unrelated to QT led to big US-dollar buying. Futures-implied rate-hike odds in December surged from 58% the day before to 73% in the wake of the FOMC’s decision. So gold-futures speculators aggressively dumped contracts, forcing gold lower. That reaction is irrational, as gold has surged dramatically on average in past Fed-rate-hike cycles! QT didn’t play into this week’s gold selloff.
This last chart superimposes gold over that same Fed balance sheet of the QE era. Gold skyrocketed during QE1 and QE2, which makes sense since debt monetizations are pure inflation. But once the open-ended QE3 started miraculously levitating stock markets in early 2013, investors abandoned gold to chase those Fed-conjured stock-market gains. That blasted gold into a massive record-setting bear market.
In a normal world, quantitative easing would always be bullish for gold as more money is injected into the economy. Gold’s monetary value largely derives from the fact its supply grows slowly, under 1% a year. That’s far slower than money supplies grow normally, let alone during QE inflation. Gold’s price rallies as relatively more money is available to compete for relatively less physical gold. QE3 broke that historical relationship.
With the Fed hellbent on ensuring the US stock markets did nothing but rally indefinitely, investors felt no need for prudently diversifying their portfolios with alternative investments. Gold is the anti-stock trade, it tends to move counter to stock markets. So why bother with gold when QE3 was magically levitating the stock markets from 2013 to 2015? That QE3-stock-levitation-driven gold bear finally bottomed in late 2015.
Today’s gold bull was born the very next day after the Fed’s first rate hike in 9.5 years in mid-December 2015. If Fed rate hikes are as bearish for gold as futures speculators assume, why has gold’s 23.7% bull as of this week exceeded the S&P 500’s 22.8% gain over that same span? Not even the Trumphoria rally has enabled stock markets to catch up with gold’s young bull! Fed rate hikes are actually bullish for gold.
The reason is hiking cycles weigh on stock markets, which gets investors interested in owning counter-moving gold to re-diversity their portfolios. That’s also why this new QT era is actually super-bullish for gold despite the coming monetary destruction. As QT gradually crushes these fake QE-inflated stock markets in coming years, gold investment demand is going to soar again. We’ll see a reversal of 2013’s action.
That year alone gold plunged a colossal 27.9% on the extreme 29.6% S&P 500 rally driven by $1107b of fresh quantitative easing from the massive new QE3 campaign! That 2013 gold catastrophe courtesy of the Fed bred the bearish psychology that’s plagued this leading alternative asset ever since. At QT’s $600b planned annual pace, it will take almost a couple years to unwind that epic $1.1t QE seen in 2013 alone.
Interestingly the Wall-Street-expected $1.8t of total QT coming would take the Fed’s balance sheet back down to $2.6t. That’s back to mid-2011 levels, below the $2.8t in late 2012 when QE3 was announced. Gold averaged $1573 per ounce in 2011, and it ought to head much higher if QT indeed spawns the next stock bear. That’s the core bullish-gold thesis of QT, that falling stock prices far outweigh monetary destruction.
Stock bears are normal and necessary to bleed off excessive valuations, but they are devastating to the unprepared. The last two ending in October 2002 and March 2009 ultimately hammered the S&P 500 49.1% and 56.8% lower over 2.6 and 1.4 years! If these lofty QE-levitated stock markets suffer another typical 50% bear during QT, huge gold investment demand will almost certainly catapult it to new record highs.
These QE-inflated stock markets are doomed under QT, there’s no doubt. The Fed giveth and the Fed taketh away. Stock bears gradually unfold over a couple years or so, slowly boiling the bullish frogs. So without a panic-type plunge, the tightening Fed is going to be hard-pressed to throttle back QT without igniting a crisis of confidence. As QT slowly strangles this monstrous stock bull, gold will really return to vogue.
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The bottom line is the coming quantitative tightening is incredibly bearish for these stock markets that have been artificially levitated by quantitative easing. QT has never before been attempted, let alone in artificial QE-inflated stock markets trading at bubble valuations and drenched in euphoria. All the stock-bullish tailwinds from years of QE will reverse into fierce headwinds under QT. It truly changes everything.
The main beneficiary of stock-market weakness is gold, as the leading alternative investment that tends to move counter to stock markets. The coming QT-driven overdue stock bear will fuel a big renaissance in gold investment to diversify stock-heavy portfolios. And the Fed can’t risk slowing or stopping QT now that it’s officially triggered. The resulting crisis of confidence would likely exacerbate a major stock-market selloff.
Adam Hamilton, CPA
September 22, 2017
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