Gold & the Fed. Too loose, too tight, or just right?
Jeff Bailey
In some recent commentary, you have written that some economists and stock market analysts feel the Federal Open Market Committee is doing a good job with interest rate policy as long as gold stays between $300 and $400 per ounce. Where does this come from, and how might it tie in with some of the bullish vertical counts you've been coming up with for gold futures, which you said were "hinting at $418."
The first that I heard of this type of rule was a couple of weeks ago when Steve Forbes was a guest on CNBC's "Squawk Box" when he mentioned that all an investor had to do was monitor gold prices and as long as gold was trading between $300/oz. and $400/oz. then gold was telling the investor that the Fed was doing a good job with interest rate policy. I'm not sure if Steve Forbes picked this up on his own, or if it has some type of historical significance.
For those of you who know me, or have followed some of my writings over the past couple of years, you probably know that I always suggest back testing anything.
Me being the curious one, and not accustomed to taking things for granted, just because somebody said something, I found Mr. Frobes' comments quite interesting.
The most interesting part of his brief comments were very basic. His assumptions were that gold is a hedge against inflation. With that in mid, if gold were to trade above $400 per ounce, then that would be a signal from the MARKET that the Fed was too easy or accommodative to the markets and had its Fed policy on interest rates to low. If gold were to trade below $300 per ounce, that that would be a signal from the MARKET that the Fed was to tight with its interest rate policy, trying to limit inflationary pressures, which could harm an economies growth.
This is too simplistic was my (Jeff Bailey) thinking. Nothing is that simple. Here, I'll disprove Mr. Forbes' comments right now!
Gold Prices - Monthly Intevals (1990-current)
All I did was place horizontal lines at $300 and $400 to define Mr. Forbes' range. I added a midpoint line at $350 to provide a level of equilibrium.
Hmmmmm, I thought. All be darned if in the last 10-year years, gold has really tended to trade within a $300 to $400 price range. And to think I didn't vote for Mr. Forbes when he last ran for President!
There have been some criticism toward Fed Chairman Alan Greenspan the past year or so. Some critics of Mr. Greenspan say he, and perhaps the FOMC were responsible for sending the U.S. economy into the recent recession, which recent economic data suggests the economy is finally recovering from.
I went back as far as the Federal Reserve's web site had posting for www.federalreserve.gov/fomc/default.htm#2003 dating back to 1996, and tried to match gold prices against what the Fed was doing with its interest rate policy. Was the Fed simply looking at gold prices to then influence its policy, or was the Fed looking at a lot of different economic data, trying to weigh the balance between economic growth and inflation?
I think it fascinating what the Fed was seeing, or thought it was seeing on both the economic and inflation front at various meetings since 1996. I tried to show some various inflection points in what gold was doing, which supposedly is a good indicator of inflation.
I started making these observations from the January 30-31, 1996 FOMC minutes. www.federalreserve.gov/fomc/minutes/19960130.htm Ugh! That was some tough reading, but if any of us think the Fed's job is easy, you should read what they were doing with currency swaps and actually setting rules and limits on how many Austrian schillings or Netherlands guilders the Fed could buy/sell in order to maintain a fed funds rate of 5.5%.
As you and I read some of the brief notes and any Fed action taken, we might try and apply the $300-$400 rule that Mr. Forbes mentioned, and test the Fed. At the same time, we could perhaps imagine that the S&P 500 Index (SPX.X) is a reflection of the economy during these periods. The thought here is that while gold prices might me a good indicator of how good/poor the Fed is doing at its job, what impact the Fed's decisions are having on the stock market, which is supposed to be a reflection of the economy.
I'm going to do this (look at the SPX) in a minute, but lets study the February 2000 comments, where I make note it was at that point, when the Fed got rather aggressive with their tightening of interest rates and raised the fed funds rate by 100 basis points (1%) in the span of 4 months, that some Fed watchers say Mr. Greenspan and the FOMC maid some mistakes.
When looking at the above chart of gold, if we were following the "too tight below $300 level" was it wise for the Fed to be tightening rates? The one thing I remember most about that time was wage inflation being a concern as labor markets were tight. Young students just coming out of college with an electrical engineering degree were getting $60k-$75k offers, with little or no professional job experience! A friend of mine had been with his current employer for 5-years, and new hires out of college with the same degree as he had were making $15K per year more than him. Fellow co-workers of his were leaving to work for competitors in order to get comparable new hire salaries. As it turn out, my friend may have outsmarted some of his old co- workers as he is still employed with high seniority.
But I digress.
Then do you see what the Fed started doing roughly 8-months later? Cut, cut, cut, cut. Suddenly the economy was showing sharp declines in multiple economic categories and the Fed was aggressively easing.
One might think that by February 2002, when gold moved back above $300 that the Fed was back on track and doing a good job.
Do you see how gold moved above $300 in February 2002, then advanced to $325? Then see that little pullback and kiss at that $300 level? I didn't have enough room on the chart, but that test at $300 came in August of 2002 and has been working its way higher, almost in increments of $25 ever since.
Also not marked on the gold chart is when gold first jumped from that $300 level kiss to $350. That took place in December 2002, and looks as if the gold market responded to another 1/4-point cut from November.
In recent comments, Fed Chairman Alan Greenspan has said the Fed is willing to keep its fed funds rate at low levels for however long it takes to see a steadily improving economic recovery take hold. If we believe the Fed is doing a good job as long as gold stays between $300 and $400, can the Fed leave its fed funds rate at the current 1% rate? While gold has been moving up, it still looks like there's some time until gold were to move above $400.
I'm trying to find prior Fed action to 1996, but it is notable that despite gold trading $400 in January/February 1996 and the Fed actually easing on its fed funds rate, gold didn't make the inflationary response move higher. Did it?
As promised, lets take a look at the S&P 500 Index (SPX.X) on a monthly interval chart. I can only show SPX data back to 1993, but it will match the same horizontal scale with the gold chart. I've set the moving averages to 6 months (about 120 trading days) and 12 months (240 trading days).
S&P 500 Index Chart - Daily Intervals
I couldn't match all the various dates with the Fed's action and comments from their meetings, but over the past 10-years, it has been rather true that as long as gold stays between $300 and $400, the Fed may indeed be doing its job to the MARKET's satisfaction when trying to provide steady economic growth with modest inflation.
Everyone, even Alan Greenspan and the FOMC can make mistakes or misjudge economic signs. In May 1998 the Fed mentioned it saw signs of inflation and might have to tighten/raise interest rates. That didn't sit well with the MARKETS and maybe, just maybe, if the Fed hadn't uttered those words with gold hovering at the $300 level, the SPX might not have fallen. Here's a link to those comments www.federalreserve.gov/fomc/minutes/19980519.htm and these may be worth noting and the economy and the SPX look to be improving.
The difference we may be seeing today is that right now, gold is trading happily at 375 and it would appear the Fed is doing a good job.
I would continue to monitor gold prices, and the technicals currently in play look to have gold holding the potential for $400 (current trend, point and figure bullish count, very low fed funds rate).
Should gold near the $400, we might expect the Fed to make a tightening move. If the Fed doesn't as it sees no sign of inflation, and gold continues higher as if the MARKET is trying to tell the Fed "you'd better tighten as inflation is coming and may turn into hyper inflation if you don't act soon," and the Fed still doesn't act, then we might expect the SPX to act as it did when gold was below $300, the Fed was not doing its best job, and was tightening when the gold MARKET was trading below $300.
I will admit that the last 10-years may not be enough historical information to draw some of the conclusions stated in this article. Some may think we should go back to the 1930's and study these models, or even the 1970's during the Carter Administration when inflation was running high.
But we should also remember just how far technology has brought forward the speed and faster flow of information compared to the 1930's and even the 1970's during times of deflation and inflation.
You can see how quickly the Fed may have realized its "mistakes" from the spring of 2000, when it aggressively began cutting rates.
Eventually the Fed will raise its target on fed funds rates. What would your reaction be? Better yet, what will the MARKET's reaction be?
In May of 1998, the Fed did nothing but say it saw signs of inflation and hinted at a rate increase. Where was gold? It was trading at the low end of the $300-$400 range at $300. While the Fed saw inflation, gold certainly didn't seem to be seeing it. The SPX was obviously heating up and corrected on the Feds comments and sent fed funds lower in anticipation the Fed would follow through on its observation that inflation may need to be tamed with a rate cut.
For gold, press reports mention that there are still very large short positions unwinding in the commodity and this unwinding of bearishness can have price moving outside of ranges.
One way I think a trader/investor can differentiate an overly bullish move or bearish move in gold is with the Treasury bond market. The bond market is much larger than the gold market and just as the gold market may be efficient at predicting inflation, so is the bond market.
I can't remember the exact dates, but it was in 2000 when gold was falling lower from $300 and Treasury YIELDS started turning lower, while the Fed was raising rates, that we thought, "something's up" or down as the case would be.
Should gold move above $400.00, we'll be keeping a very close eye on the Treasury market. If gold moves above the $400 level, a normal move in gold (without excessive short covering) we should expect Treasury YIELDS to follow, as their higher YIELD should also be predicting inflation and future Fed tightening.
Conversely, lets say Treasury YIELDS stay where they are at, and 3-months from now, gold is trading $412. It would be my opinion at that time that we're probably seeing gold "artificially" boosted by short-covering or more extreme levels of speculation.
We could also keep an eye on other commodity products, where their prices should rise under more inflationary times.
Jeff Bailey
www.OptionInvestor.com
jeff@OptionInvestor.com
27 October 2003
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