PinnacleGold

The Fed, by growing their balance sheet, creates the equity for banks and the economy in general to leverage off of. When the economy levers up prices start to rise and this requires banks, households and businesses to obtain even more funding to achieve the same level of expenditures of the past. If the Fed is not providing the necessary base of funding to keep the bubble afloat, which is the case when they stagnate their balance sheet and prices rise, then market performance will eventually suffer.

The economy simply does not have the financial means to support the newly risen prices without another money injection from the Fed. Notice in the chart below how prices have risen precipitously since QE2 to the recent highs we see today. The Consumer Price Index (CPI) rose 3.8% in the last 12 months and producer prices for capital equipment soared up as well but have just started to dip since they always lead the way into a bust:

The effect of an insufficiency of funding leads to deleveraging and a run into liquid currency, in effect US dollars, and this is the rise we are seeing today. Once QE3 arrives, however, this trend will quickly reverse.

As shown in the PPI and CPI chart above, inflation has been trending well above the Fed?s target of 2% annual increases. The Fed assures us however that they can withdraw bank reserves and decrease leverage should things get out of control in a vain effort to convince markets they can control inflation. This is a blatant lie spread by the Fed and I?ll now go over some of the reasons for why.

To start, the main tool the Fed has indicated they will use to lower market leverage is to raise the interest rate they pay on reserve balances banks hold with the Fed. By raising the interest rate the Fed pays, they will encourage banks to hold their balances idly at the Fed, thereby containing inflation. No banks will lend for less than the rate the Fed will pay on reserves, so interest rates across the economy will rise and act as an economic tightening force ? so the Fed plans. But the use of this tool is not so simple. If the Fed is paying out interest and wishes to remain solvent and profitable they must be earning at least as much in interest on their investments as they are shelling out. This places an interesting restraint on the Fed, because for them to increase interest rates they must increase the cost of their funding and they cannot increase the cost of their funding greater than the level they are earning at.

Moreover, the interest the Fed earns is on their asset portfolio which has an average maturity of 16 years. Following ?Operation Twist?, the plan the Fed has in place to make long term rates fall closer to short term rates, the maturity average can grow even further as this is the goal of the program. On top of this, the Fed?s assets likely average interest earnings of less than 4% given that the Fed has made bond purchases constantly at historical price highs. All of this means the Fed is unable to raise interest rates higher than 4% for the next 16 years at least to avoid systemically creating losses for themselves. The Fed is heavily restrained in what they can do with interest rates and even raising them a little eats into their tiny capital base.

As can be seen below, the Fed?s capital base as a percent of their total assets has collapsed to its lowest level in recent history and the Fed?s balanced sheet is about as highly leveraged as ever at 55-1 (this higher than MF Global and Lehman Brothers before both of their bankruptcies):

Effective Federal Reserve Leverage: Total Fed Assets Divided by Total Fed Capital

Given the historically large size of the Fed?s balance sheet, and their high leverage, small movements in their assets, if properly marked to market, can destroy the Fed?s capital base entirely. This is not unrealistic and is even more possible now that the Fed?s balance sheet is more weighted to long maturing assets, meaning there is a higher duration risk and increased volatility to their asset values. With ~$50 billion in capital support only, if the Fed raises interest rates by 0.25% this will cost them over $40 billion on $1.618 trillion in reserves, nearly their whole capital base. This means interest rates are actually capped at no more than 0.5% higher than the effective Fed Funds Rate now and the Fed is impotent to do any more. If the Fed runs out of money, they can technically operate under insolvency but the political consequences of this are untested. In addition the notion that the Treasury may support the Fed via supplementary financing as they?d done in the past has little basis as the Treasury is unlikely in any financial or political position to provide the Fed with the means they need to stay afloat.

The fact the Fed is incapable of dealing with inflation will mean gold has no limit on how high it can go. Already bond yields are trading at negative real interest rates making commodities very attractive as a means of preserving wealth against inflation. Since inflation will remain positive and the Fed will keep yields low, as explained above, this dynamic can be expected to remain in tact for a long time.

Gold will suffer for temporary bouts, as it has today, since deleveraging forces an initial move into currency. The demands for currency are inherently temporary in nature though and will wane once obligations are met. In the meantime, the increased demand for currency will put even more pressure on the Fed to supply such currency via another quantitative easing program. In this sense, the high US dollar, as seen today, is actually a leading indicator to a low US dollar in the future and higher price for gold.