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Fed QE3-Tapering Impact on Stocks and Gold

Stock-Markets / Quantitative Easing Sep 13, 2013 - 04:03 PM GMT

By: Zeal_LLC

Stock-Markets

The Federal Reserve’s upcoming decision on whether to slow its third quantitative-easing campaign’s debt monetizations has to be this year’s most-highly-anticipated market event.  Traders have been trying to game the odds of QE3 tapering literally all year long, driving some sharp market moves.  So the Federal Open Market Committee’s decision due out next Wednesday is likely to be a major market-moving event.

The focus on this imminent FOMC meeting is so hyper-intense that its impact should be considerable no matter what the Fed decides.  The QE3 taper (or lack thereof), its size, and what the FOMC implies for future tapering will almost certainly spark sharp price reactions in the bond markets, currency markets, stock markets, and precious metals.  All have moved violently this year on mere QE3-taper anticipation.


There are strong arguments on both sides of the Fed starting slowing down QE3 next week or waiting until later.  With Fed Chairman Ben Bernanke due to retire on January 31st, most believe he really wants to start unwinding his unprecedented quantitative-easing programs on his own watch.  He is worried about his legacy, how history will view the largest debt monetizations ever that were his brainchild.

Bernanke has spent months painstakingly telegraphing to traders that he’d like to start slowing QE3 at this September FOMC meeting.  If the Fed doesn’t taper after setting expectations so high, it is going to take a big credibility hit with the markets.  Not tapering will likely also be interpreted by traders as the Fed viewing the US economy as deteriorating, which could spark a big stock-market selloff from lofty heights.

Tapering QE3 is probably less risky at the FOMC’s September 18th meeting than its next October 30th one because the former is one of the four per year (out of eight) that are followed by a Bernanke press conference.  So if the market reaction is adverse to the taper, Bernanke will have a chance to explain the FOMC’s thought process soon after the decision.  Thus most traders believe tapering begins next week.

But this decision is far more complicated than Bernanke’s comfort and the Fed’s credibility.  Between the FOMC’s May 1st meeting and last week, mere QE3-tapering fears have catapulted the benchmark 10-year US Treasury yield from 1.66% to 2.98%!  This epic 4/5ths rally in yields is the result of a massive bond rout.  Bond investors are fleeing Treasuries, worried that the dominating buyer (Fed) is pulling back.

Higher bond yields wreak havoc on the economy, driving up all borrowing costs.  This is particularly important in the mortgage markets, since the housing recovery is absolutely essential to US jobs growth.  Since the mere threat of the Fed slowing its QE3 Treasury buying sparked a colossal bond selloff, can it risk the actual event driving yields even higher?  Unemployment will surge again if house buying slows.

Higher interest rates are a huge threat to the US government too.  Under Obama the national debt has exploded higher, yet the Fed’s record-low interest rates still led to very low debt-servicing costs.  If yields on Treasuries merely return to their 40-year average before Obama, the total federal interest costs alone on today’s debt would skyrocket by 5x!  This would consume most discretionary spending, sinking the government.

Higher yields also risk triggering a bear market in stocks.  One of the Fed’s goals through manipulating yields down as low as possible was to force investors into risky assets like stocks.  As rates rise, bonds become far more attractive again for new buyers.  So higher yields could ignite an exodus out of the stock markets by investors worried about the risks posed by the very tired and overextended cyclical stock bull.

The FOMC has foolishly painted itself into a very dangerous corner.  It is probably damned no matter when it starts tapering QE3, with serious market disruptions likely.  While bonds are ground zero, and currencies will closely follow, my primary interest as a speculator is in the American stock markets and precious metals.  Whatever the Fed chooses to do next week is likely to have major impacts on them.

To better understand their potential, we have to consider how the FOMC and all its QE3-tapering talk have affected them so far this year.  This chart looks at the flagship S&P 500 stock index (SPX) and gold.  All 2013 FOMC-meeting decisions are highlighted in black, with their subsequent minutes noted in yellow.  Most of the biggest and fastest moves in stocks and gold this year are highly correlated to the FOMC.

Before QE3’s birth last September, the US stock markets’ tired cyclical bull had been topping.  Despite multiple attempts, there hadn’t been a single new high for over 5 months.  But first on a European Central Bank decision to monetize bonds a week earlier, and then on the Fed’s QE3 announcement, the SPX finally broke out to new bull highs.  It was the Fed’s first-ever open-ended quantitative-easing campaign.

The timing of this decision was highly suspect politically.  It was less than 8 weeks before the critical 2012 US elections.  And throughout US presidential-election history, the results have had a very high correlation with the stock-market action in the Septembers and Octobers leading into them.  When the SPX is up over that final 2-month span, the incumbent party has won 94% of the time.  If down, it has lost 83% of the time.

So Bernanke goosing the stock markets right ahead of a major election, greatly raising the odds they would be higher (and they were), almost certainly gave it to Obama.  Remember that Republican lawmakers had been aggressively attacking the Fed for its QE2 debt monetizations, so the Fed faced serious political risks if the Republicans regained power.  QE3 was shrouded in controversy from its birth.

At its mid-December meeting, the FOMC decided to expand QE3 to include monthly Treasury buying on top of the original mortgage-backed-security buying.  The minutes for that meeting were released several weeks afterwards as usual, in early January.  Incredibly at the very meeting where the FOMC launched its QE3 expansion, there was already much internal dissent.  Thus 2013’s QE3-tapering debate began.

Literally since January 3rd, when the Fed would start slowing QE3’s rate of purchases has probably been the dominant driver of global financial-market sentiment.  Ever since every FOMC meeting, all their minutes subsequently released, and even each speech by individual Fed officials have been carefully scrutinized for QE3-tapering implications.  Whenever QE3 tapering seemed more likely, big selloffs arose.

This is especially true in bonds, but our focus here is on the stock markets and gold.  While other factors were at play, primarily the levitating SPX sucking capital out of the American GLD gold ETF, gold suffered its first sharp selloff in February soon after the late-January FOMC meeting.  The subsequent minutes in late February saw the SPX sell off sharply.  Then gold’s next selloff started cascading at the mid-March meeting.

Both the SPX and especially gold then plummeted when its minutes were released in mid-April.  Some of the FOMC members thought QE3 tapering would start by mid-year and finish by year-end.  Unfortunately for gold, these very minutes drove the metal right down to its critical $1550 support line.  That soon failed, unleashing an ultra-rare futures forced liquidation that crushed the gold price in an unprecedented way.

Gold’s subsequent bounce from this panic-like plummet was cut short by the FOMC’s next meeting in early May.  And the minutes of that meeting released in late May started the biggest pullback in the SPX’s levitation so far.  Then both the SPX and gold plunged dramatically at the FOMC’s next meeting in mid-June, which happened to be followed by the press conference where Bernanke laid out his QE3-tapering plan.

Then again the SPX topped soon after the FOMC’s latest late-July meeting.  As you can see above, the great majority of this year’s biggest and fastest moves in the SPX and gold were highly correlated with either FOMC meetings or their subsequent minutes.  Charts of bond yields and the US Dollar Index show similar strong reactions to the odds of QE3 tapering rising and falling.  It has dominated global markets this year!

Seeing how the stock markets and gold reacted to the mere idea of QE3 tapering, how will they react next week (or later) at the actual event?  There is a universal assumption among traders today that QE3 tapering is fully priced in for stocks, so the price impact will be minimal.  Everyone also assumes that gold is going to get obliterated by QE3 tapering, which is understandable given its horrendous Fed reactions this year.

This popular consensus may certainly be right, after the Fed starts slowing QE3 the SPX will keep on climbing higher forever and gold will plunge to zero.  But ever the contrarian, I always want to take the opposite side when nearly everyone is convinced of certain outcomes.  What if the levitating stock markets have not priced in a QE3 taper, but gold far more than has after being pummeled so mercilessly?

Despite QE3-tapering fears driving periodic pullbacks, there is no arguing that QE3 has been exceedingly good for the SPX.  Between the day before it launched and this week, this flagship stock index has soared 17.6% in exactly one year.  This extended its already-old-and-big cyclical bull born in March 2009 to an astounding 152.7% gain.  It also pushed its span since a correction to 22 months.

These metrics far exceed healthy averages.  The average cyclical stock bull in a secular bear doubles in 35 months, our current specimen is up 152.7% in 53 months!  Healthy bull markets see full-blown corrections (selloffs in the high-teen percentages) once a year or so, now we are up to nearly two without one.  There’s a strong case to be made that QE3 was the primary driver of 2013’s extraordinary SPX levitation.

If QE3 was so great for stocks, how can its slowing and eventual stopping also be great for stocks?  How can the QE3 taper be already priced into the SPX when this index has kept powering higher all year long even despite periodic QE3-tapering fears?  With the mere threat of QE3 tapering spawning sharp pullbacks, won’t the actual event also trigger a big selloff?  This QE3 tapering is hyper-risky for stock markets.

Gold on the other hand has already been annihilated on futures traders’ intense obsession with QE3 tapering.  In the year since QE3 launched, it has been pummeled down 21.2%.  The second quarter in particular was monstrously brutal, gold’s worst in something like a century.  The gold selling triggered by and exacerbated by Fed QE3-tapering fears was wildly unprecedented on virtually every possible front.

Gold’s incredible selloff during QE3 is a mind-boggling anomaly.  Quantitative easing is a happy-sounding euphemism for debt monetization, the highest-octane form of monetary inflation there is.  When the Fed buys bonds, it simply creates the money to do so out of thin air.  And in the case of Treasuries, the federal government spends this new money almost instantly which directly injects it into the real economy.

QE3 is a massive open-ended inflationary event unparalleled in history.  And gold thrives in inflationary times, it is the ultimate inflation hedge.  During the lifespans of QE1 and QE2, gold powered higher by 50.8% and 24.7% respectively.  So to see it down 21.2% so far during QE3 utterly defies belief.  It makes no sense at all, absurdly illogical.  And like all market anomalies, this one is super-overdue to reverse.

Gold plummeted 26.4% in the first half of 2013, with QE3-tapering fears playing a major role.  They helped shape the psychological backdrop that led to the mass exodus from GLD.  With such a wildly unprecedented gold selloff, isn’t it highly likely that QE3 tapering is long since priced in?  Will this critical investment class keep plunging forever simply on fears about how fast the Fed will wind down QE3?

Gold-futures traders, who are excessively fixated on the QE3 taper, are totally looking at the wrong side of it.  What they should be paying attention to is the Fed’s mammoth balance sheet!  Every dollar of bonds the Fed purchases is a direct injection of monetary inflation.  And as long as QE3 exists at all, this metric is going to keep growing.  This next chart takes a look at the incredible inflation quantitative easing has baked in.

This chart is stacked, showing the Fed’s holdings of Treasuries (red) and mortgage-backed securities (yellow) within its total balance sheet (orange).  Across it are noted key dates of FOMC meetings where major policy changes were made including quantitative easing.  This gigantic and growing balance sheet is what gold-futures traders should be focusing on, not a trivial change to the rate of QE3’s growth.

Before uber-inflationist Ben Bernanke launched the original QE1 and forced interest rates to zero in late 2008, the Fed’s balance sheet was around $890b.  It has ballooned monstrously since thanks to the bond-buying campaigns of QE1, QE2, and QE3.  All three of these were launched initially and then soon expanded.  Between these debt-monetization sprees, the Fed’s bond holdings slowly shrunk through maturing.

Before QE3 was launched last September, the Fed’s balance sheet was sitting at $2798b.  Last week nearly a year later (the Fed’s data lags by a week), it had soared to $3607b!  This is a colossal 28.9% increase in the Fed’s total bond holdings in merely a year, incredible amounts of inflation unleashed from an already very-high base.  Does it make any sense at all for gold to fall by over a fifth during such an event?

It wasn’t like gold was overbought in September 2012 when QE3 was born, which could explain poor subsequent performance.  This metal had peaked 13 months earlier and was stuck in a high consolidation ever since by the time QE3 launched.  Over that span it was already down 8.5%.  So there was no reason at all for gold to get hammered during an epic inflationary explosion of QE3’s magnitude.

Back at his press conference right after the FOMC’s mid-June meeting, Bernanke rocked the markets by laying out a very specific best-case QE3-tapering plan.  It proposed starting the taper later this year (which was interpreted as the September FOMC meeting) and ending it entirely by mid-2014.  He took great pains to emphasize this was data-dependent, that QE3’s pace could still increase if economic conditions worsen.

But let’s assume QE3 plays out like Bernanke hopes.  This month will still have $85b of purchases that will be added on to the balance sheet.  Assuming an even taper, the average monthly monetizations between now and the end of June will be half that or $42.5b.  Multiply those 9 months by $42.5b and you get another $383b of bond buying on top of September’s $85b.  That means QE3 has $468b of buying left!

So far as of the end of August, QE3 is at $440b in mortgage-backed-securities buying and $360b of Treasuries buying.  The total is already $800b, which is much larger than QE2’s $600b of new buying.  But add the additional $468b of buying on top of that in a best-case taper scenario, and QE3 is still destined to grow over half-again as large as it is today.  It will propel the Fed’s balance sheet over $4050b!

Thus even in Bernanke’s best-case QE3-tapering scenario, there is vast monetary inflation left to come.  With QE3 all but guaranteed to ultimately exceed $1250b, and go much higher if there are any economic hitches, is it reasonable to expect gold to keep falling forever?  No way.  Beyond futures traders’ paranoid gut reaction, QE3 tapering shouldn’t be bearish for gold.  This metal should soon soar on the rest of QE3!

I suspect the probability nears certainty that gold will be considerably higher when QE3 ends than it was when it begun.  It’s hard to believe, but the day before QE3 was born this metal was near $1733.  For all of human history, inflation has been very bullish for gold.  2013’s selloff, the psychological groundwork of which was laid by QE3-tapering fears, was a wildly unprecedented anomaly.  And all anomalies reverse.

The contrarian view on next week everyone thinks is crazy is that QE3 tapering will be bad for stocks and good for gold after the initial reactions.  It’s hard to fight the crowd and think differently, but that is the only way to consistently buy low and sell high.  At Zeal our contrarian approach has driven big gains.  As of the end of June, all 655 of our stock trades recommended to our newsletter subscribers since 2001 have averaged annualized realized gains of +28.6%!

We have long published acclaimed weekly and monthly newsletters to help speculators and investors cultivate an essential contrarian worldview.  In them I draw on our decades of hard-won experience, knowledge, wisdom, and ongoing research to explain what is going on in the markets, why, and how to trade them with specific stocks as opportunities arise.  Join us today, we’re buying dirt-cheap elite gold stocks due to soar as gold recovers!

The bottom line is the Fed’s coming QE3 tapering is likely to have a major market impact.  The hyper-overextended stock-market levitation is unlikely to survive the Fed reducing its debt monetizations and resulting interest-rate manipulations.  Less Fed bond demand means higher yields, giving investors forced into stocks by the Fed a chance to earn yield income again.  Their stock selling should snowball.

And despite gold’s merciless hammering this year on QE3-tapering fears, that anomaly doesn’t change the fact that QE3 is massive and growing.  Just like during QE1 and QE2, sooner or later gold will react to the enormous inflationary growth in the Fed’s balance sheet.  Even if Bernanke’s best-case ideal timeline for tapering QE3 is followed, there is still colossal bond buying coming between now and next summer.

Adam Hamilton, CPA

So how can you profit from this information? We publish an acclaimed monthly newsletter, Zeal Intelligence , that details exactly what we are doing in terms of actual stock and options trading based on all the lessons we have learned in our market research. Please consider joining us each month for tactical trading details and more in our premium Zeal Intelligence service at … www.zealllc.com/subscribe.htm

Questions for Adam? I would be more than happy to address them through my private consulting business. Please visit www.zealllc.com/adam.htm for more information.

Thoughts, comments, or flames? Fire away at zelotes@zealllc.com . Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!

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