As everyone knows by now, QE3 has officially come to an end. What does this mean for markets and metals? The short answer: deflation ahead. The longer answer: almost all asset prices are about to come down (sharply) except the U.S. Dollar.
The rationale behind the end of QE has been documented by the FOMC yesterday as follows:
The Committee judges that there has been a substantial improvement in the outlook for the labor market since the inception of its current asset purchase program. Moreover, the Committee continues to see sufficient underlying strength in the broader economy to support ongoing progress toward maximum employment in a context of price stability. Accordingly, the Committee decided to conclude its asset purchase program this month. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.
The last two rounds of QE ended badly, with most markets taking a significant dive and the volatility index spiking up. Since the start of QE3, stocks have gone up dramatically and volatility has fallen to multi-year lows. The next chart, courtesy of Zerohedge, shows the correlation between monetary expansion and U.S. stock prices.
The most likely reaction of the stock market is that it will continue its euphoric ascent for some days or weeks (“you see, the economy is really doing better and it can survive without monetary stimulus”), after which volatility will start increasing and prices will come down systemetically. We believe that our call of early this year, when we predicted that 2014 Will Be The Year Of The Super Crash, will unfortunately come true. A crash is not an event but a process. Although we do not expect a full crash between now and December 31st of this year; we rather believe that the start of a very severe correction of at least 25% is imminent.
Now what does this mean for precious metals?
One thing is for sure: the collapse of the gold miners over the last days does not bode well. Usually, miners lead the metals in both directions. We were still positive about the metals till two weeks ago, when metals were heading lower but miners kept up very well. Unfortunately for gold bulls, the miners are now in the lead, which suggests that metals will follow their decline.
The GDX index has come down 15% since October 16th. Gold declined 3.4% and silver 5.6% over the same period of time.
Is another crash in precious metals prices imminent? We sense that the strengthening U.S. Dollar, which looks strong from a chart point of view, will put enormous pressure on gold and silver, at least in the short run. This could likely result in a phase of capitulation. If there is one “good” thing about capitulation, it is that all sellers will get exhausted on (much) lower prices, leaving the marketplace with no sellers. Capitulation are rare events but, when they tend to progress very fast. In a matter of two weeks, prices could come down with 30% followed by a spike up.
That scenario seems quite realistic, as we are already advanced in that process. It would fit with the idea that stocks would rise a bit higher and then start coming down, resulting in money starting to flow towards the deeply oversold precious metals sector. If the Swiss gold referendum on November 30th would result in a “yes” vote, then we would have the first country after more than 4 decades returning to a gold standard. What’s more, significantly lower gold prices will probably cause another rush to physical gold in the East, putting a floor on gold prices.
Our personal belief is that this scenario has a probability of 50%. Another likely scenario is that precious metals are moving to a lower trading range, for instance between $1000 and $1200 gold where they will stay for an extended period of time, after which they will move to a higher or lower trading range.
We believe that the U.S. Fed is underestimating the deflation that has been creeping into the system. Sooner rather than later, they will have to launch another “money printing” program to push back deflation. Chances are high that it will feed inflation expectations which is beneficial for precious metals. The only question, in our view, is “when” not “if.”
One final note on gold and silver. Mind that the metals in other major currencies (e.g. Euro) have not declined to the same extent as the metals in U.S. Dollars, because of the Dollar strength.