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While the Fed Parties, Gold & Oil Have Left the Building

June 18th, 2013 · J.W. Jones · 14 Comments

Risk assets and financial markets around the world have been supported by central bank action for several years. Performing financial alchemy on a scale larger than has been seen in the history of mankind, central banks have hijacked global financial markets. Mountains of liquidity, artificially low interest rates, and the creation of future asset bubbles has been their calling card for the past few years.

Unfortunately, time is starting to run out and these great Keynesian minds are on the verge of encountering a series of problems. While central banks can create fiat currency out of thin air, they cannot create real wealth. In fact, central banks cannot print jobs, earnings growth, or an increase in wages.

Furthermore, in a paper put out by the New York Federal Reserve in 2012 and covered by (“Fed Confused Reality Doesn’t Conform to Its Economic Models, Shocked Its Models Predict Explosive Inflation”) the Fed openly admits that forward outcomes cannot be predicted with accuracy by their economic models. Furthermore, one of the models known as the Smets and Wouters Model has predicted significant inflation if interest rates were held near zero for more than 8 quarters.

For inquiring minds, I would forward readers to the article for a more in depth explanation. Ultimately the Federal Reserve is performing a gigantic experiment in real time while admitting their economic models do not accurately portray outcomes in the future. Nowhere can this be seen more than in recent price action in U.S. Treasury prices.

Since mid-November of 2012, the 30 Year Treasury Bond has seen prices go down by roughly 9% in value. When Treasury prices are falling, interest rates are rising as there is an inverse relationship between bond prices and yields. When longer term Treasury bonds are demonstrating rising interest rates it is a signal that the bond market is expecting higher inflation levels out into the future. The weekly chart of the 30 Year Treasury Bond is shown below.


As can clearly be seen above, prices have been coming down for several months and we have initiated a price pattern with lower highs and lower lows. This is not a bullish pattern by any means and should the 30 Year Treasury bond take out key support around the 135 price level the Federal Reserve will be in an awkward position.

The Fed’s problem lies in the fact that the Federal Reserve is printing nearly $85 billion dollars of fiat currency to purchase U.S. Treasury and agency bonds and rates have still risen. It would only make sense that at some point, the Federal Reserve will have to ratchet up their program to defend Treasury prices.

If the printing presses fire up fast and furiously to help put a floor under Treasury bonds (cap rates), what is going to happen to commodity prices such as oil? As shown below, the oil futures daily chart illustrates a coiled price pattern that ultimately will lead to a strong move in price.


A move in oil prices above the $96 – $98 / barrel level will likely lead to a powerful move higher in oil prices toward the $100 – $112 / barrel range. Obviously a big move is coming and we could see a move lower just as easily. I have no idea where price is going, but what I do know is that oil prices are staged up for a fast, large move in price.

Interestingly enough, gold futures are also in a basing pattern after selling off sharply earlier this year. Similar to oil futures, gold futures prices are coiling up as well and could go either direction as shown below:


As can be seen above, gold futures are trading in a consolidation pattern which could lead to a strong breakout in either direction. While the upside seems more likely, it goes without saying that lower prices are always a possibility. However, the point I would make to readers is that a large move in the near future seems likely in both gold and oil futures.

Gold is simply a hedge for inflation and acts as a senior currency, however if inflation increases gold will protect owners from a reduction in purchasing power. From an economic standpoint, oil and energy prices are far more important than gold prices. If the Federal Reserve’s Smets and Wouters Model is accurate in its expectation of strong inflation pressure in the future, I would anticipate seeing a strong move higher in both oil and gold prices.

However, the real point is that the Federal Reserve will likely find itself in a precarious position in the future. On one hand, they have to print money to backstop Treasury bonds through additional quantitative easing machinations.  On the other hand, the additional liquidity may start pouring into commodities if inflationary pressures begin to mount.

Ultimately the Federal Reserve may attempt to hold down interest rates to help the economy but if their activities cause energy prices to spike the U.S. economy will begin to move toward recession quickly. In addition to that scenario, it should leave many readers unsettled that it would appear Treasury rates are rising while the Federal Reserve continues to print vast sums of fiat currency to buy more government debt.

Ultimately, the Federal Reserve does not have a great answer about the future since they publicly admit many of their models do a poor job of predicting future economic conditions based on actions that they are taking. At the end of the day, this is just one gigantic Keynesian experiment worldwide and the outcome will follow historical trends.

It does not take an economic genius to understand that the vast amounts of fiat currency created by the unprecedented recent actions of the Federal Reserve will have to find a home somewhere. This process will likely manifest as dramatically higher prices for a host of necessities in the future. In fact, the recent parabolic rise in stock market prices can be viewed not as higher prices for equities, but simply lower valued U.S. dollars.

Perhaps instead of concocting models with large names which simply do not work, why doesn’t the Federal Reserve open a few history books. Regardless of what central bankers believe or what their models produce, history’s version of the outcome is simply unpleasant. Ultimately the Federal Reserve should focus on the old adage that those who ignore history are doomed to repeat it.

This material should not be considered investment advice. J.W. Jones is not a registered investment advisor. Under no circumstances should any content from this article or the website be used or interpreted as a recommendation to buy or sell any type of security or commodity contract. This material is not a solicitation for a trading approach to financial markets. Any investment decisions must in all cases be made by the reader or by his or her registered investment advisor. This information is for educational purposes only.

14 responses so far ↓

  • 1 Lachlan // Jun 19, 2013 at 11:41 am

    Just looking at chart shapes….looks like a slightly higher chance that oil will rise on that chart. Gold ain’t out of the woods so much and may test a little lower imo….despite the fact you’d think it would be 2500 by now based on the queues in Asia. The world is rigged. Apparently the Matrix movie was just softening us up 😉

  • 2 Greg Atkinson // Jun 19, 2013 at 12:08 pm

    Not sure a few people lined up at a gold store in Shanghai will support the gold price much. Most of the extra demand that has pushed up the prices over the last few years is from ETF’s and if investors keep selling out of those then the price will drop.

    If I had to pick between the two though I would go for oil, but picking a price..well that is a little harder.

  • 3 Richard // Jun 19, 2013 at 7:12 pm

    I just want to know where the sharemarket will go from here. Is this correction phase over or another large sell-off coming?

    We may find out tonight after Ben Bernanke speaks to the media.

  • 4 Greg Atkinson // Jun 19, 2013 at 8:17 pm

    Yes Richard I think you might be right. If Ben says the dollars will stop being printed there could be major sell-off in the U.S tonight. Maybe that is why he will not say much at all?

  • 5 Lachlan // Jun 20, 2013 at 6:58 am

    Big surprise, not. DX oversold short term and Ben turns it around with some taper talk.

  • 6 Lachlan // Jun 20, 2013 at 7:10 am

    Greg there were even to my surprise about ten thousand people in one Chinese queue the other day.
    In some photos there they actually seem to be buying gold jewellery. Interesting. However I do agree with the premise that there are too few average Joe’s buying to send gold prices way up. The CB’s might be different but it’s hard to tell the truth of it all. Maybe this gold story will change when the supply from
    the west gets tighter.

  • 7 Greg Atkinson // Jun 20, 2013 at 7:59 am

    Not sure about the Zero Hedge piece Lachlan. It didn’t look like ten thousand people to me and seeing such crowds of people in large Asian cities is not really a novelty..especially if there is a decent sales campaign.

    Maybe Zero Hedge is a bit of s site for gold bulls?

  • 8 Lachlan // Jun 20, 2013 at 10:46 am

    Yes Greg, ZH is a gold bull site. The exuberance there is down though compared to the old days when people were hoping for a breakout of 1000.
    I think people have realised that the markets are not making any sense. This is a good reason imo, no matter what peoples tastes are to keep a long term perspective, accumulate low /on dips, avoid trading and maintain some diversification. Personally I prefer physical assets also. People should also keep in mind that the bail-in idea has not disappeared and could rear up anywhere again.

  • 9 Stillgotshoeson // Jun 20, 2013 at 11:01 am

    The Aussie had quite a large fall against the USD last night so even though Gold dropped a little in USD it has gained in AUD

  • 10 Greg Atkinson // Jun 20, 2013 at 11:02 am

    Yes Lachlan the markets are hard to read. Ben says he may wind back the dollars and stocks fall which is sort of weird in a way because it should mean the economy is improving. But all that stimulus money swishing around is distorting things. It seems we have yet to escape the grip of the GFC!

  • 11 Stillgotshoeson // Jun 20, 2013 at 11:11 am

    “Greg Atkinson // Jun 20, 2013 at 11:02 am
    It seems we have yet to escape the grip of the GFC!”

    Come August/September the message will be that the US economy is not quite ready to stand on its own and QE will continue for the foreseeable future.

    The DOW and S+P500 will respond with glee and happiness shall return, and gold will resume its upside and head towards $1500USD+

  • 12 Greg Atkinson // Jun 20, 2013 at 7:34 pm

    Well gold is now down near $1200 USD and ounce and trading down -6% at the moment. That will spook plenty of gold investors. The question is now..where is the bottom?

  • 13 Lachlan // Jun 21, 2013 at 7:17 am

    Gold in USD 1285 and 1398 in AUDs at present. I believe the gold action is, as I’ve said a few times a precursor to another GFC (08/09) style event. I do not expect it to be as monumental as the first sell off five years ago. But gold probably leads the way.

    Once gold had technically topped I predicted 1300’s for the bottom depending on currency. I’ll stick with that because it’s based on a 30% GFC style correction. However Greg I will concede that a longer intermediate bear market is a chance, albeit the outside one imo and I am talking about prices down to your 1000 ish level….. because the past 6 months has shown…..
    assuming the reports and information we have are true….
    there can be record physical demand from CB’s with Asian joes joining the fray and yet the price can fall, mostly unabated for months on end. For now I think the market is so oversold that it is likely to turn up sooner than later. Even the RSI is turning up against the price where shares are concerned.
    Regarding the ongoing crisis I believe it will remain intact until at least 2020.

  • 14 Lachlan // Jun 21, 2013 at 7:27 am

    Yes Shoes the USD gold price is weak over the AUD price.
    I remain an AUD bull and see the future of AUD gold prices tied to a very high USD gold price while the AUDollar remains strong but otherwise has a natural upside barrier which is more limited than gold. I’d rather that scenario over the US. Not looking forward to trading in my goldies for a ten dollar meat pie.

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