Best of the Week
Most Popular
1.UK House Prices BrExit Crash NOT Likely Despite London Property Market Weakness - Nadeem_Walayat
2.BrExit Morning - New Dawn for Britain, Independence Day! - Nadeem_Walayat
3.LEAVE Wins EU Referendum - Sterling and FTSE Hit Hard, Pollsters, Bookies and Markets All WRONG! - Nadeem_Walayat
4.BrExit Implications for UK Stock Market, Sterling GBP, House Prices and UK Politics... - Nadeem_Walayat
5.Trading BrExit - Stocks, Bonds, Sterling, Opinion Polls, Bookmaker Odds and My Forecast - Nadeem_Walayat
6.FTSE and Sterling Brexit Trading, Deconstruction of the EU Referendum Result - Nadeem_Walayat
7.UK Interest Rate Cut to 0.25% Imminent and More QE Money Printing - Nadeem_Walayat
8.Trading BrExit - British Pound Plunges, FTSE Stock Futures Slump on LEAVE Shock Referendum Win - Nadeem_Walayat
9.The Stock Market is Reading it Wrong! - Chris_Vermeulen
10.Breakouts Galore in Gold and Silver - Jordan_Roy_Byrne
Free Silver
Last 7 days
Asset Bubbles Tend to Crash with a Vengeance - 29th July 16
Retirees Are Risking Their Life Savings on Junk Bonds - 29th July 16
The Next Recession is Coming - Expect Around 0% Returns for the Next 7 Years - 29th July 16
SPX is Shaking and Rolling - 29th July 16
Stock Market Insiders Are Secretly Selling, Cycle Top Next Month - 28th July 16
FOMC Interest Rates and Their Impact on the US Economy - 28th July 16
The State Of The Economy - 28th July 16
Elliott Wave Crash Course - 3 Ways the Elliott Wave Principle Enhances Your Trading - 28th July 16
Japan's "Helicopter Money" Play: Road to Hyperinflation or Cure Debt Deflation? - 27th July 16
Monetary Zika - The Insidious Nature of Credit Expansion - 27th July 16
Gold and Pork Bellies - 27th July 16
Silver Is Insurance Against The Worst Part Of This Depression - 27th July 16
Don’t Buy The SPX Hope Stock Market Rally! - 27th July 16
Bitcoin $650 Still in Play - 26th July 16
Deutche Bank Stock Price Crash - The EU Has Problems Far Beyond the Brexit - 26th July 16
The Forex Markets Are Getting Exciting! - 26th July 16
Underpriced Silver Is the “Rip Van Winkle” Metal - 25th July 16
Declines in Multiple Market Indexes - 25th July 16
Retailers Are Doomed as Most Americans Are Too Poor to Shop - 25th July 16
Here’s One Currency That Could Go to Zero - 25th July 16
Stock Market Top is Expanding - 25th July 16
Silver Manipulation – Because They Needed the Eggs - 25th July 16
Silver Market COT Stuns: What's Going On Here? - 24th July 16
Gold Demand Remains Stable During Sector Weakness - 24th July 16
Sernova, Diabetes and Haemophilia - 24th July 16
Russia: Tensions, Turmoil, and Western Hubris - 24th July 16
Soybean Commodity Price to Soar Again - 23rd July 16
SPX Stock Market Uptrend Continues - 23rd July 16
Gold And Silver – Debt Addiction Will Carry Precious Metals Higher, Guaranteed - 23rd July 16
Pokemon Go - How to Play, First Use, Balls, Stops, Catching Pokemon's... Great Excercise! - 23rd July 16
7 Signs That the Gold Market Remains Resilient - 23rd July 16
Basic Income in The Time of Crisis - 23rd July 16
Silver Bull Faces Correction - 22nd July 16
The Serious Warning No One’s Talking About - 22nd July 16
Stock Market Insight from Greed, Volatility, and Put/Call Ratio - 22nd July 16
What Will Happen To the Stock Market When Interest Rates Rise? - 22nd July 16
How to Escape the World’s Biggest Ponzi Scheme - 22nd July 16
Addicted to Debt - We Can’t Borrow from the Future Anymore - 21st July 16
Not Everything Is Bullish for Gold - 21st July 16
Don’t Get Sucked Back Into the Stock Market - The Big Picture Hasn’t Changed - 21st July 16
Silver – Caught Inside - 21st July 16
Forex: "The Markets Are Getting Exciting!" - 20th July 16
China Economic Troubles - Is Kyle Bass Finally Getting His Revenge? - 20th July 16
Why Lithium Will See Another Price Spike This Fall - 20th July 16

Free Instant Analysis

Free Instant Technical Analysis


Market Oracle FREE Newsletter

The Power of the Wave Principle

The Fed’s Normalization and Gold

Commodities / Gold and Silver 2016 Jan 29, 2016 - 08:36 PM GMT

By: Arkadiusz_Sieron

Commodities

The Fed hike is not the end of the world. The U.S. economy experienced many tightening cycles. Actually, many analysts are citing past rate hike environments as a guide to the future. However, three things make this tightening cycle (if there are more hikes at all) unique. First, the U.S. central bank increased interest rates when the economy is actually decelerating and the manufacturing sector is in a recession. This makes new hikes less probable, while increasing the odds for the U.S. recession in the new year. Both effects are fundamentally positive for the gold market.


 

Second, the Fed has never hiked before from almost zero. Thus, to normalize its monetary stance and provide itself with the necessary ammunition to fight the next downturn, the Fed should hike to at least 3.5 percent (usually, the U.S. central banks cut the federal funds rate by 350 basis points in each easing cycle). Given the slow and gradual tightening cycle, the Fed will be generally unprepared for another recession. The U.S. central bank will then be forced to implement another round of quantitative easing, or perhaps even to implement helicopter money and negative interest rates.

 

Third, the Fed has never raised its interest rates with the interbank lending market practically dormant, massive excess reserves at commercial banks (worth around $2.4 trillion) and enormously expanded balance sheets. The U.S. central bank’s balance sheet is now around $4.5 trillion, as opposed to the $800-900 billion range before the crisis (see the chart below).

 

Chart 1: The Fed’s balance sheet (blue line, right scale, in trillions of $) and the bank’s excessive reserves (green line, left scale, in trillions of $) from 2005 to 2015

 

In normal times, the U.S. central bank controlled the federal funds rate by changing the supply of reserves via open market operations. When the Fed wanted to raise rates, it would sell securities, which led to a reduction of reserves in the banking system. As the reserves become scarcer, the interest rate increased. However, because of the Fed’s quantitative easing programs, the banks are now awash with reserves, so they do not need to borrow funds from each other as they used to before the financial crisis. It means that to raise interest rates by open market operations, the Fed would need to unwind all of its earlier purchases (around $3.6 trillion since 2008).

 

Therefore, the U.S. central bank will be using two other tools during the normalization process: interest on excess reserves (IOER) and reverse repurchase operations (RRP). The IOER is interest paid on funds held at the Fed in excess of what is required, and it would be the primary tool for raising the federal funds rate. According to the U.S. central bank, the IOER puts a “floor” on the main Fed rate, as no bank would want to lend money to other banks at lower rates than it may safely park cash at the Fed.

 

However, there is a notable problem with the IOER. It does not create a perfect floor since it is only available to depositary institutions (among other problems), which do not have accounts with the Fed, so they would lend money for less. This is when the reverse repurchase operations enter the scene. In the RRP, the Fed sells securities to the non-banks (such as money market funds) and agrees to buy it back the next day at a specified price. In essence, the U.S. central bank takes an overnight collateral loan, which also puts a floor under the federal funds rate, as no investor would lend money to commercial banks at a rate lower than what the Fed is willing to pay in the RRP. As one can see, the main difference between these two interest rates is different eligible entities. Since the investors who can participate in the RRP are the same ones who might undercut the IOER, the changes in both rates should push up the federal funds rate. Indeed, the Fed’s strategy has worked so far.

 

Along with the federal funds rate, the U.S. central bank raised the IOER to 0.5 percent, while the overnight RPP rate rose to 0.25 percent (it also increased the discount rate to 1.00 percent. That is, the rate charged to depository institutions on loans they receive from the Fed’s lending facility, which creates the “ceiling” on the federal funds rate, since no banks should want to borrow money from other banks at a higher rate than from the U.S. central bank. Consequently, the effective federal funds rate was traded on average at 0.375 percent after the Fed’s hike (a level three times higher than 0.125 percent in 2015 before the hike!). The chart below shows the Fed’s interest rates before and after the December hike. As one can see, the effective rate is actually formed between the ON RRP rate and IOER, which were set during December meeting at, respectively, the lower and upper bounds of the federal funds target.

 

Chart 2: The Fed’s interest rates (discount rate – red line; green line – IOER; blue line – effective federal funds rate; purple line – ON RPP rate) before and after December hike (between December 1, 2015 and January 6, 2015)

 

Therefore, it seems that the Fed, by using new tools, retained control over its main interest rates. However, there may be some unintended consequences of using them. First, paying banks for holding reserves at the Fed provides banks with easy money and discourages them from participating in the interbank market and from more intense restructuring (not to mention the ethical and political issues related to the fact that the U.S. central bank pays tens of billions of dollars to the banks not to use the trillions it paid them before). Second, the use of RPP would expand the Fed’s intermediation in short-term funding markets, which could crowd out private financing (the U.S. central bank is already the largest lender in the tri-party repo market), magnifying flight-to-quality flows and their repercussions during crises – as the investors will likely to seek the safety of the Fed (the ultimate ‘risk-free’ counterparty) instead of lending to private institutions – and promote ‘shadow banking’ (by transacting with non-banks) that are largely beyond the Fed’s regulatory scrutiny.

 

The bottom line is that the Fed raised the federal funds rate in December. After the end of quantitative easing, the hike was the next step toward the normalization of monetary policy. There is still a long way to return to normal monetary policy, as the Fed should raise interest rates significantly above zero and unwind its balance sheet. Therefore, the Fed stance will remain accommodative for a long time, as the U.S. central bank will not start selling its assets until the normalization of the federal funds rate is well under way. This is very good news for the gold market, since the quick normalization of the Fed’s balance sheet would boost the real interest rates, which are negatively correlated with the price of bullion. Another piece of positive news for the gold bulls is also that the tightening cycle would be slow and gradual, and based on the use of relatively new tools, such as IOER and RRP. As the Fed is entering unchartered waters, the use of these interest rates could alter financial markets in unpredictable ways and further impair the functioning of free markets and risk loss of the Fed’s credibility in case of losing the control over the federal funds rate in case of some negative shocks.

Thank you for reading the above free issue of the Gold News Monitor. If you'd like to receive these issues on a daily basis, please subscribe. In addition to these short daily fundamental reports, we focus on the global economy and the fundamental side of the gold market in our monthly gold Market Overview reports. We also provide Gold & Silver Trading Alerts for traders interested more in the short-term prospects. If you're not ready to subscribe yet, or are unsure which product suits you, we encourage you to sign up for our mailing list and receive other free alerts from us. It's free and you can unsubscribe anytime.

Thank you.

Arkadiusz Sieron
Sunshine Profits‘ Market Overview Editor

Disclaimer

All essays, research and information found above represent analyses and opinions of Przemyslaw Radomski, CFA and Sunshine Profits' associates only. As such, it may prove wrong and be a subject to change without notice. Opinions and analyses were based on data available to authors of respective essays at the time of writing. Although the information provided above is based on careful research and sources that are believed to be accurate, Przemyslaw Radomski, CFA and his associates do not guarantee the accuracy or thoroughness of the data or information reported. The opinions published above are neither an offer nor a recommendation to purchase or sell any securities. Mr. Radomski is not a Registered Securities Advisor. By reading Przemyslaw Radomski's, CFA reports you fully agree that he will not be held responsible or liable for any decisions you make regarding any information provided in these reports. Investing, trading and speculation in any financial markets may involve high risk of loss. Przemyslaw Radomski, CFA, Sunshine Profits' employees and affiliates as well as members of their families may have a short or long position in any securities, including those mentioned in any of the reports or essays, and may make additional purchases and/or sales of those securities without notice.

Arkadiusz Sieron Archive

© 2005-2016 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

Catching a Falling Financial Knife