QE, Inflation and Bullion Prices

Question: What do 1987, 1998, and 2008 have in common? Answer: they were all years when the Fed flooded the monetary with liquidity to prevent the financial system seizing up. This was after, respectively, the program-trading triggered stock market crash, the LTCM debacle, and the credit crunch and Lehman Brothers collapse.

Are there consequences from this largesse? You betcha. Despite promises that the liquidity will eventually be drained from the system, it invariably finds its way into either consumer price inflation or soaring asset prices. In the 1998 example, it ushered in the internet bubble. After that burst, the outlet was in real estate prices and the sub-prime mortgage boom – a direct link to the next crisis.

The Fed’s largesse this time round has been staggering. By the end of 2011, unless steps are taken to reverse the recent monetary creation, the likelihood is that the US central bank’s balance sheet will have tripled in size from pre-crisis levels. The Fed has apparently tested measures to drain liquidity from the system, but will it do so when it comes to it?

Former Fed chairman’s Alan Greenspan’s record on this score was not good. And despite the Fed’s supposed independence from the political process, the current chairman may have to contend with Congressional objections if anything of this nature is proposed. The recent extension of the Bush era tax cuts demonstrates, if proof were needed, that the US Congress has little appetite for fiscal, and by extension monetary, discipline.

The money injected into the system will find an outlet somewhere, and so far it appears to have been the bond markets, the assets the Fed is using to administer the monetary ‘fix’, and gold and other precious metals, as the more savvy among investors reckon that the only logical result of all this is more inflation. The Fed will probably tighten policy eventually, but not before the damage is done and the inflation genie is out of the bottle.

Gold’s ascent has been spectacular, inducing vertigo in some bullion buyers – me included. I sold out of most of my holdings of physical bullion at around $1200 back in March, although thankfully I have had some exposure to the metals market in other ways since then.

Yet, for all that the rise from a low of $240 an ounce a decade ago looks spectacular, gold’s inflation-busting characteristics are beyond doubt. According to research from the World Gold Council, in years when US inflation has exceeded 5%, gold has posted real returns that averaged around 15%. This compares with only minor positive real returns in years of moderate and low inflation.

Over most time periods between 1974 and 2009 gold has offered the best real return with an appreciably lower level of volatility than either commodities or real estate, and also beaten TIPS.

Personally speaking, however, I have until now been less confident that the boom in other precious metals would be sustained. Industrial demand tends to muddy the water a bit. But I am starting to change my mind. Silver, for example, is in demand as an affordable alternative to gold for retail investors. Industrial demand is also increasing because of recovering Western economies and buoyant demand from emerging markets. Put the two together, and its price could continue rising for some time.

Trading physical silver is out of the question for UK investors: it is subject to VAT. So ETFs, futures and CFDs, depending on your appetite for leverage, are the only realistic way to gain exposure.

Finally, today’s government bond yields will seem, in hindsight to have been absurdly low if inflation ticks up consistently. When the turn comes is anyone’s guess, but there will be trading opportunities a-plenty on the short side when it does.

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