The Fed took the markets by surprise this week when it announced plans to begin quantitative easing by buying treasury bonds and mortgage securities. With central bank interest rates at zero to 0.25%, the Fed is running out of options to get both the commercial and private lending market moving again. The sums involved are mind boggling – the New York Times reports the fed intends to purchase an additional $750 billion worth of government-guaranteed mortgage-backed securities on top of the $500 billion they are already in the process of buying. Since last September, the Fed’s lending programs have roughly doubled the size of its balance sheet, to about $1.8 trillion, from $900 billion. The actions announced this week are likely to expand that to well over $3 trillion over the next year.
The rights or the wrongs of this approach to the economic crisis are not a topic we will explore here. In our opinion, the recession is being exacerbated by a highly desirable move by individuals and companies to reduce their levels of debt, and by the banks unwillingness to lend to each other when the level of toxic debts are still hidden. Neither of these issues will be addressed by the Fed printing money and so there is disagreement about how effective these latest actions will be in returning the economy to health. Our concern is more over the possibility that it will fuel inflation next year and the impact that will have on the metals markets.
A large part of the surge in metals prices during 2007-8 was due to fears over inflation. Gold, copper and oil in particular were all supported by rising inflation during this period and the growth of Commodity Electronic Traded Funds, ETF’s, was in part, a hedge play against perceptions of a weakening dollar and rising inflation. China played it’s part but so did perceptions of rising inflation especially toward the end of the cycle. What happened this past week when the Fed announced it’s bold new move to buy bonds and mortgage securities? Gold jumped from $890 to $936/oz in one day, something the relentless barrage of producer and broker urgings over the last month have failed to do. The dollar promptly fell the most in one day since 1985 against a basket of currencies after the announcement according to Fortis Bank. An increase in gold prices along with the dollar drop represent signs the markets also view quantitative easing as an inflation risk.
Some metals are moving closer to demand-supply balance and so will be more sensitive to an increase in speculative investment should the risks of inflation appear to increase. It will not take much to get speculators back on the band wagon we saw in 2007-8. It is not a rise in inflation that will trigger buying, it is merely the belief taking hold that inflation could return which could move the markets. A weakening dollar also results in rising dollar denominated metals prices. This works two ways. As the dollar weakens, a copper price of $3500/ton is progressively less attractive for a seller in euros or yen as they receive less in their local currency for every ton sold so they demand a higher dollar price to compensate. The other driver is knowing this, the speculators often start to bid up the price of metals on futures markets when they see the dollar weaken – the effect becomes self-fulfilling.
The Fed’s latest move raises risks in a number of areas. Let’s hope they have thought these through and have controls in place to counter the possible downside. What’s your take?