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The Fed Needs To Slow Down; Look For Gold To Benefit - Sprott Asset Management

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(Kitco News) - The U.S. Federal Reserve is likely to scale back its planned rate hikes by yearend, providing a powerful tailwind for gold, according to a recent report from Sprott Asset Management.

“Fed policy reversal would be the final component of a potent combination of fundamentals which has been developing in gold’s favor during the past several quarters,” the report said.

The Fed initiated its monetary policy tightening in December 2015, and since then has raised the fed funds rate six times to 1.75%.

Concurrently, the world’s largest central bank has embarked on a process of reducing its $4.5 trillion post-quantitative easing balance sheet by gradually scaling back Treasury and mortgage-backed security holdings by $10 billion a month starting in fourth quarter 2017, up to a monthly peak of $50 billion per month by fourth quarter 2018.

Analysts at Sprott said that pursuing this dual mandate simultaneously poses a risk of causing severe harm to the markets.

“We are skeptical the Fed can continue the simultaneous pursuit of its policy goals without inflicting significant damage on U.S. financial markets,” the report said.

Sprott added that the “liquidity destroying implications of the Fed’s proposed quantitative tightening (QT) schedule are almost completely being ignored by consensus.”

According to the report, the two-pronged monetary tightening strategy of hiking rates while reducing the Fed’s balance sheet is overly-aggressive. Citing Chairman Bernanke, Sprott said that every $200 billion in reductions in the Fed’s balance sheet are already equivalent to a 25-basis point rate hike.

“We do not believe outstanding debt levels in the U.S. financial system can withstand this type of blunt force monetary tightening, especially in concert with the FOMC’s telegraphed schedule of fed-fund hikes,” the report said.

Evidence of an already strained global financial system comes in the widening LIBOR-OIS spread in first quarter 2018, the firm said.

The LIBOR-OIS spread measures the premium of 3-month LIBOR to the fed funds rate. While the spread usually hovers around ten basis points in “normal” market conditions, it can widen when U.S. dollar liquidity is challenged, or banks perceive heightened peer-lending risks.

The current LIBOR-OIS spread is at its highest level since the 2008 recession. “In retrospect, the spread’s initial spike above 50 basis points in August 2007 proved to be a prescient warning for mounting financial stress,” the report said.

 

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