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Gold And The Dollar: It's The Economy, Stupid

Monday March 31, 2014 08:09

(Kitco News) - It's the economy, stupid.

That, of course, was Bill Clinton's campaign slogan in his 1992 presidential race. Well, the same could be said now for gold and U.S. dollar action in the first quarter 2014.

From the December low to the March 17 high, Comex June gold futures gained over 17% to start the year. Meanwhile, in the same period, the U.S. dollar index fell just under 1%.   

First quarter U.S. economic data was a disappointment to all, with lackluster labor market growth and weak consumer spending data. Wells Fargo estimates first quarter GDP growth will total about 1.1%.

There are lots of reasons that economists point to for the very slow growth levels,  including abnormally cold and snowy weather across parts of the country, the expiration of long-term jobless claims benefits at the start of the year and an inventory overhang —following four consecutive quarters of inventory building throughout 2013.

Despite the weak and disappointing data, the U.S. Federal Reserve is forging ahead with its so-called "tapering" or the reductions in asset purchases. By most estimates, the Fed will conclude its quantitative easing program by the end of 2014 or early 2015 at the latest.

Really, the Fed has to start moving toward policy normalization. The central bank's main policy rate—the federal funds rate stands at zero to 0.25% and has sat at that historically low level since December 2008. Fed watchers point to the 4.0% as a more historically "normal" or balanced fed funds rate which mean the Fed has a long way to go to normalize monetary policy.

But, even now, the Fed's balance sheet (which represents all assets held at the central bank) is still rising. The Fed's balance sheet is currently around $4.2 trillion —and it will continue to rise until the Fed finishes the tapering process.

This current Fed policy normalization cycle is unlike any other period of tightening in Fed history. Never before has the Fed's balance sheet stood above $4 trillion. Never before has the Fed held excess bank reserves currently totaling around $2.6 trillion.

Ryan Sweet, director at Moody's Analytics, reminds us that "this tightening cycle will be unlike any that they have ever done. They are in uncharted territory."  First the Fed needs to taper its asset purchases and let quantitative easing end. Then, they need to look at the balance sheet and stop reinvesting assets.  The Fed has no playbook to follow here. Fed Chairman Janet Yellen will be making this up as she goes along.

Sweet estimates the Fed will "prevent the balance sheet from contracting for about six months [after QE ends]. When the balance sheet begins to contract, quantitative easing turns into tightening."

Then, the Fed will need to actually start raising and hiking interest rates. This is a multi-step exit strategy that will take years to unfold. The timing of an actual first rate hike remains up for debate and ranges from the second quarter 2015 to the fourth quarter 2015, and is expected to be a .25% basis point hike.

Moody's Sweet is fairly optimistic that the Fed will navigate the exit strategy ahead successfully. "There is a 70% chance the Fed gets this right," he said.

Nonetheless, there are risks. "The biggest risk to the U.S. economy is a sudden spike in interest rates. If long-term interest rates shoot up, mortgage rates will follow and that would take a big bite out of the economy," he warned.

"If there is a miss-step by the Fed, if the Fed is unwinding QE and you see interest rates spike, it could do damage," he said.

While economists are hopeful that the second half of 2014 will be better than the first —with forecasts for monthly non-farm payroll gains at 200,000 per month or higher, along with a rising GDP pace on a quarter-by-quarter basis throughout the year, we have heard rosy projections in recent years.

The U.S. economy has officially out of recession in June 2009. The U.S. economy has been slogging along for nearly five years post recession with lackluster and below trend growth.

Some point to the U.S. housing market as a key catalyst which could help finally drive economic growth to higher levels throughout 2014. Time will tell.

Meanwhile, the U.S. dollar index has been stuck in the doldrums going virtually nowhere since the start of 2014. While the gold market saw a strong January-mid March rally and then a subsequent corrective pullback.

The U.S. dollar index would need to wake from its slumber and rally through multi-month resistance in the 81.50 area in order to suggest a significant strengthening in the dollar is actually ahead.

For gold, a large nearly year-long intermediate term neutral range has formed on the weekly continuation chart. Gold could be vulnerable to additional profit-taking and long liquidation pressures in the very short-term, but major long-term support has been carved out in the $1,180 per ounce range. See Figure 1 below.

Near term, if the economy does pick up and the dollar does gain some strength, it could take a little wind out of the gold market. But, strong support lies below. For now, this is a big range trade.

Just keep an eye on the economy to see if this long-awaited pick-up in growth finally emerges.

Kira Brecht is managing editor at TraderPlanet.

By Kira Brecht, Kitco.com
Follow her on Twitter @KiraBrecht



Disclaimer: The views expressed in this article are those of the author and may not reflect those of Kitco Metals Inc. The author has made every effort to ensure accuracy of information provided; however, neither Kitco Metals Inc. nor the author can guarantee such accuracy. This article is strictly for informational purposes only. It is not a solicitation to make any exchange in precious metal products, commodities, securities or other financial instruments. Kitco Metals Inc. and the author of this article do not accept culpability for losses and/ or damages arising from the use of this publication.
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