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Fed’s Plan to Cap Yields Signals Higher Gold and Silver Prices - David Brady (30/01/2020)

Fed’s Plan to Cap Yields Signals Higher Gold and Silver Prices - David Brady (30/01/2020)
By David Brady, CFA 28 days ago 12058 Views No comments

January 30, 2020

Let me start by saying that we’re close to major lows in Gold and especially Silver, in my opinion. In fact, we may have already seen the lows in both. I still see the risk of a drop down to ~1510 in Gold and ~17.10 in Silver, but from my perspective the risk reward is skewed to the upside. This is a buy-the dip market. One of the primary reasons for my bullishness is something I have been highlighting recently, the asymmetric risk to the downside in real yields driven by the Fed’s need to cap short-term interest rates and bond yields while promoting a policy of higher inflation rates. This in turn means an asymmetric risk to the upside in Gold and Silver prices.

The Federal Reserve cannot allow interest rates and bond yields to rise materially or they risk a potential meltdown in the stock market and higher interest cost payments on existing and ballooning new amounts of treasury debt, raising questions about the U.S. government’s ability to pay and its solvency.

The 10-Year U.S. Treasury Yield peaked in November 2018 at 3.24%, its highest level since May 2011, seven years earlier. This rise in yields coincided with the biggest decline in the S&P 500 since the crash of 2008. Equities bottomed out in the following month of December. It wasn’t long before the Fed did a complete 180 on its policy of QT: interest rate hikes and balance sheet reduction on auto-pilot, to rate cuts followed by discussions on supposedly new policy tools, including “Yield Curve Control”. This simply means capping interest rates and bond yields by printing money out of thin air and buying U.S. treasury securities.

The Fed began seriously considering the idea of Yield Curve Control at the FOMC meeting last October:

“In considering policy tools that the Federal Reserve had not used in the recent past, participants discussed the benefits and costs of using balance sheet tools to cap rates on short- or long-maturity Treasury securities through open market operations as necessary.”

https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20191030.pdf

Fed Governor Brainard followed that up in November:

Fed’s Brainard argues for capping interest rate levels during the next downturn

“As part of a continuing look the central bank is taking at what potential responses it can come up with when very short-term rates go to zero, Brainard suggested using Treasury purchases to limit how high short- and medium-term government bond yields can rise.”

https://www.cnbc.com/2019/11/26/feds-brainard-argues-for-capping-interest-rates-in-next-downturn.html

Bernanke joined in on the topic of Yield Curve Control in January, saying that the Fed should also consider adopting the same tools employed by other central banks, including purchases of private securities, negative interest rates, funding for lending programs, and “ yield curve control ”.

https://www.zerohedge.com/markets/bernanke-hints-negative-rates-purchases-private-securities-fight-next-recession

Not content to sit on the sidelines, former Treasury Secretary Lawrence Summers and Adam Posen, a former policy maker at the Bank of England, countered Bernanke out of a concern that existing Fed tools might not be as effective as they were in the last crisis. They too called for yield curve control, citing Japan as a success story. With the Fed guaranteeing low rates, Congress could boost government spending. “It enables fiscal policy, it doesn’t judge it,” Posen said. It was used during World War II precisely because the government needed to boost fiscal spending. This sounds more and more like Modern Monetary Theory, or MMT, where the Fed directly finances government spending.

https://www.marketwatch.com/story/experts-doubt-fed-has-all-the-tools-it-needs-to-fight-recession-2020-01-05

Then this week, we got the following…

Suffice to say that this is coming. I would argue that this policy is already in effect since October. The Fed is already capping short-term rates via their massive liquidity injections into the repo market. The resultant effect on the stock market is obvious. The percentage increases in the Fed’s balance sheet are almost lockstep with those in the S&P 500.

So what does this all mean for Gold and Silver? The correlation between real yields and Gold has been anywhere between -0.70 to -0.98 in the past year. They are near-perfectly negatively-correlated and have been consistently so for years, save for some short-term breakdowns, such as that in 2018. This means that if real yields fall, then Gold rises, and by derivation, Silver.

Simply put, real yields = nominal bond yields – inflation.

Inflation typically refers to the CPI. For example, if the 10-Year Yield is 2% and the CPI is 1.9%, then the real interest rate or yield is 0.1%. If the bond yield rises or inflation falls, the real yield rises, and vice versa for a decline in the bond yield or a rise in the CPI.

Now to finally get to the crucial point here. If the Fed is intent on capping nominal bond yields and trying to get inflation to 2% or above, what happens to real yields? They fall. Given that Gold and Silver are near-perfectly negatively-correlated to real yields, what happens to them when real yields fall? They rise.

Repeating what I said earlier:

The Federal Reserve cannot allow interest rates and bond yields to rise materially or they risk a potential meltdown in the stock market and higher interest cost payments on existing and ballooning new amounts of treasury debt, raising questions about the U.S. government’s ability to pay and its solvency.

Short-term rates are already capped via the Fed’s intervention in the repo market. The Fed will likely decide to cap the 10-year at 2% to 2.50%, imho. It also wants to increase inflation to above 2%. It may be more successful in doing so than it wants to be, thanks to all of the money-printing they are and will be doing. It is difficult to put the inflation genie back in the bottle once it gets out. They can’t raise interest rates if it does; debt interest cost would soar. They can’t stop buying treasuries, either, for the same reason, because yields would rise. With this in mind, capped yields and the potential for higher inflation, real yields can only fall. Assuming the correlation continues to hold, this in turn means (short-term corrections aside) that Gold and Silver can only go up. Think about that.

One caveat, and it’s bound to be temporary in nature, but it could be painful nonetheless, is a spike in real yields associated with a crash in stocks. This is what occurred in 2008. Assuming the Fed and other central banks will revert to monetary insanity on steroids, such a crash won’t last long. Absent that, I am only looking up in Gold and Silver.

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David Brady has managed money for over 25 years for major international banks and corporate multinationals both in Europe and the US, with experience in Bonds, Equities, Foreign Exchange, and Commodities


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