Common Misperceptions about the Fed and Gold

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...Gold’s entrance into a new steep phase of the bull market will be caused not by further decline in the dollar exchange rate but by a widespread distrust in all fiat currencies, especially the euro (since it is currently viewed as the main alternative to the USD). It is important to note that a major buy signal for gold will come when the Gold/Euro ratio breaks out from its three month base. In light of this, the coming ECB meeting on Thursday July 3rd will be very informative for investors in precious metals.

A common view of the Federal Reserve is that it is some sort of a nearly omnipotent being standing on guard of healthy economic expansion maintaining a delicate balance between growth and inflation in the way of regulating money supply and the cost of borrowing. This view may be correct, but only theoretically so.

In reality, the Federal Reserve is a private, not a public, institution representing the interests of the US banks through its 12 regional branches. Therefore, the nature of the Fed is that it is a banking system insider; the Fed first and foremost defends the banking system and only secondarily represents broad economic interests as mandated by the US Congress. These two objectives are not necessarily always in harmony with each other. For example, the most profitable cycle for the banks started during the 2001 recession as a result of the Fed’s super loose monetary policy eventually leading to today’s disaster in the housing market.

Today, we are in the midst of a worldwide financial system crisis. That is why, even more so than before, the greatest priority for the Fed is an immediate rescue of the banking sector. The most pressing need for the Fed now is to buy more time, (much more than just several months) which is desperately needed by the banks in order to continue their delevereging process...

We think that the Fed will try to maintain dollar stability in the next few months and attempt to prevent it from falling to new lows. Short term stabilization of the exchange rate through a concerted effort by central banks can surely be accomplished, but only for the short term. Therefore, we cannot rule out intervention especially if the US dollar continues to slide. Again, such an intervention can help the US dollar but only temporarily.

How does this relate to the current situation in gold? We do not share a widespread perception that the main driver of the gold bull market is the decline in the US dollar. Although gold and the US dollar have strong inverse correlation, this has been the case in the past and is not necessarily a good proxy for the future. This correlation in fact, tells us that the real bull market has not even begun in gold; to date, it has mostly been a bear market in the US dollar. Gold is still way below its inflation adjusted peak set in 1980 and is also one of the weakest performers among hard assets. All this leads us to believe that the most powerful run in gold is still ahead.

Gold’s entrance into a new steep phase of the bull market will be caused not by further decline in the dollar exchange rate but by a widespread distrust in all fiat currencies, especially the euro (since it is currently viewed as the main alternative to the USD). It is important to note that a major buy signal for gold will come when the Gold/Euro ratio breaks out from its three month base. In light of this, the coming ECB meeting on Thursday July 3rd will be very informative for investors in precious metals.

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