Overlook tapering and tap gold? - Outside View by Chirag Mehta

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Overlook tapering and tap gold?
Apr 5, 2014

After getting battered for most of last year, gold was in a bright spot for the most part of this year. However, the bounce back seems to be losing steam. The physical buying that supported gold prices waned with the sharp run up in prices seen over the first two months of the year. The Geopolitical risk premium also subsided as there was no further escalation of the conflict between Russia and Ukraine, thus reducing the safe haven appeal for gold. Gold prices were further hit as the Fed surprised with an indication of interest rate hike sooner than many had anticipated. Gold lost about -3.2% in the last month reducing the year to date gains to 6.5% from about 15% seen at its peak in the middle of March 2014.

Gold is considered by many as the true global asset since time immemorial. Gold prices move up and down due to several global factors, the major contributor to the oscillations in gold prices being the monetary policy of major countries across the globe. Since the US is the world's largest economy, decisions taken by the US Fed in tweaking America's monetary policy will surely affect the prices of gold globally.

Thus every move the Fed makes could have a potential impact on gold prices. This article will focus on what the policy makers in the US are thinking and how this will affect the price of gold.

Global powerhouse held by duct tape?

At the last monetary policy meet, the Fed decided to continue with a $10 billion reduction in asset purchases. This means they will now be buying $55billion worth of assets in a combination of government securities and mortgage debt. Although this was on expected lines, what surprised the markets was a possibility of a rate increases in six months after they drawdown on asset purchases. With the current pace of reduction of $10 billion in asset purchases every month, this form of quantitative easing is likely to end by October 2014. Six month on would be April 2015. Markets had been expecting a rate hike by end of 2015 at the earliest.

This early possibility of a rate hike furthered the fall in gold prices as any possibility of moving away from QE and zero interest rate policy would help strengthen the dollar and weaken gold, all other things being equal (Ceteris Paribus condition, Economics 1.01!).

It's still early days yet for the new Fed chairwoman Janet Yellen, and we had seen even Bernanke struggle with getting expectations right in his early days. There seems to have been a communication gap as far as the policy intention on the timing of interest rate increase. Yellen's policy got mis-read by the markets in a way that she may well not have intended to. She fumbled in getting across the change in forward policy guidance which has so far worked well in managing markets expectations and thereby avoided adverse reactions.

The unemployment rate in the US, one of the important factors which most US policymakers focus, before deciding on interest rates, has now fallen to 6.7% which is close to the unemployment threshold of 6.5% mark set earlier to indicate markets the minimum level before any review of the prevailing easy monetary policy in practice. Markets were expecting that a new lower threshold would be guided with as the decrease in unemployment has been on account of decrease in labour participation rate which meant that more people have stopped looking for a job. Instead, the policy committee chose not to include any new threshold number to replace 6.5% unemployment. The new guidance says the policymakers will weigh "a wide range of information" on inflation, the job market, and private-sector financial conditions. The statement also said that the committee believed that it would be appropriate to maintain rates near the zero mark for "a considerable time" after its policy of quantitative easing comes to an end.

When further probed about considerable time, Yellen didn't have a number in mind but made an offhand comment that it could be something like six months. We read that she didn't mean six months as a deadline, but was more referring to it as "atleast". As she realized, she have tried to calm the markets by referring to clauses like the rate increases would dependent on "conditions at that time". But it will take some time to reset expectations which has so far been a key to keep markets under check.

If you cannot convince....

The one thing that the markets aren't focusing is that there hasn't been much evidence of an economic improvement, either in the data, which remain at best mixed, or in the Fed's own forecasts that would indicate a shift of stance towards rate increases. As far as the data goes, there is little sign of inflation which is stuck around the annual rate of 1.1%, well below the Federal Reserve's target of 2%. Even, wages are growing just at 2%. House building activity has fallen sharply in recent months. The employment to population ratio shows an improvement of just 1% from the lows seen during the recession and is still more than 4% lower than its pre recession readings. This tells us that there is much progress to be made if the economy were to be looking healthy.

Until the last Fed meet, there weren't many supporting a hawkish stance in policy setting. How could the possibility of a preponement of rate increases pass through without major improvement in the economy? The voting pattern indicate that many of the Fed officials are now less fearful about some of the more extreme risks that could potentially face the economy. That would justify a more hawkish stance in the absence of strong evidence of improvement in the economy. However, the obvious internal divisions within the Fed will become very evident if the American economy fails to accelerate as anticipated following the first quarter weather related lull. If that happens the QE proponents will want to end tapering at the first signs.

Outlook for gold

Having said that, the tapering and a hawkish perception from the Fed is likely to prevail until we see deterioration in the financial markets. The Fed chair will try to undo the communique in a subtle manner to slowly make markets believe that she isn't taking the punch bowl off the table. With further rounds of drawdown, gold is likely to be grinded lower - a continuation of the correction and consolidation. It won't be too far before the economy shows signs of further deterioration and asset markets start to feel the pinch of lower money on the table. This would likely compel the policymakers to soon enough change their stance towards a more easing bias. Until this plays out, the markets and the Fed will continue to assess and reassess the health of the economy by filtering each set of economic data in isolation and in totality. Investors will have to bear the brunt of the precarious state of the markets caused by the resulting uncertainty and the liquidity flows that distort the markets at best.

An allocation to gold in such uncertain times is important. I would like to state that the main reason to own gold is just the sheer fact that it is an extremely good portfolio diversification tool, acts as a hedge against inflation and shields your portfolio. As seen in the past currencies have been and can be devalued at will but the value of gold will always remain.

Chirag Mehta is Fund Manager, Commodities for Quantum Mutual Fund and manages the Quantum Gold Fund ETF and the Quantum Gold Savings Fund among others.


The views expressed in this Article are the personal views of the author Chirag Mehta and not views of Quantum Asset Management Company Private Limited(AMC), Quantum Trustee Company Private Limited (Trustee) and Quantum Mutual Fund (Fund). The AMC, Trustee and the Fund may or may not have the same view and DO not endorse this view.

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