Gold & Silver: Protection Against the Fed’s Punch Bowl

The third quarter proved to be a very strong period for precious metals. The price of gold increased about 11 percent, while the price of silver surged 25 percent. In fact, it was the best quarterly performance for the two safe-havens since 2010, and silver outperformed all major asset classes. After remaining quiet for most of the summer, both precious metals broke to the upside on unlimited bond purchasing programs being announced by the European Central Bank and the Federal Reserve. With central bankers pouring more liquidity into the market, gold and silver started the fourth quarter with momentum.

Gold and silver both rallied on the opening day of the fourth quarter, as Federal Reserve  officials provided commentary regarding the central bank’s loose monetary policies. Chicago Federal Reserve President Charles Evans spoke with CNBC and claimed the Fed should keep the punch bowl of easy money flowing until the unemployment rate declines below 7 percent and growth improves. He explains, “We’re looking for substantial improvement in labor market conditions. For me, that seems like we ought to be seeing 200,000 increase in payroll employment per month, maybe a little higher than that for about six months. We ought to see growth that is above trend.”

Evans believes it could take almost a year before the economy makes these types of improvements in the labor market. Thus, he favors extending the Fed’s unlimited quantitative easing program to $85 billion per month by early 2013. Currently, QE3 purchases $40 billion a month, with Operation Twist purchasing another $45 billion worth of securities. However, Operation Twist is scheduled to conclude at the end of this year. Due to the Fed running low on short-term bonds to sell, another extension of Operation Twist would mean the program would loose its sterilization component and send the central bank’s balance sheet soaring well past its current $2.8 trillion level. Despite this though, Evans says that he does not “see any inflationary pressures.”

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Speaking at the Economic Club of Indiana, Federal Reserve Chairman Ben Bernanke also discussed central bank practices and defended recent policy decisions. He continues to believe the Federal Reserve has the tools necessary to tighten monetary conditions at the appropriate time to prevent inflationary pressures. Bernanke explains, “I’m confident that we have the necessary tools to withdraw policy accommodation when needed, and that we can do so in a way that allows us to shrink our balance sheet in a deliberate and orderly way.” He later adds, “Determining precisely the right time to ‘take away the punch bowl’ is always a challenge for central bankers, but that is true whether they are using traditional or nontraditional policy tools.”

While removing the punch bowl before the market suffers a sugar crash sounds good in theory, how fast will the Federal Reserve be able to unwind a $5 trillion balance sheet in two years? The punch bowl of the housing bubble binge was not removed in time, and now Bernanke is on record telling Congress in 2005 that surging home prices “largely reflect strong economic fundamentals.” Will this time be different?

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Knowing that history often rhymes and past fiat currency experiments have ended badly, investors continue to find safety in hard assets such as gold and silver. On Monday, the price of gold jumped to as high as $1,794.40, marking a new high for the year. Although precious metals turned in an impressive third quarter performance, October is typically a weak month, which may offer investors a great buying opportunity for dollar devaluation protection. Given the Federal Reserve’s view on the economy and willingness to provide a sugar rush to financial markets, the bull market in gold and silver appears to have years left to run.

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Disclosure: Long EXK, AG, HL, PHYS