FEATURE: Gold and the Fed's rocky relationship

Ben Bernanke 2013

The $60 an ounce spike in the gold price after yesterday's announcement by the Federal Reserve of zero cuts to its stimulus program is just the latest example of the yellow metal's sometimes rocky relationship with the US  central bank.

The bank’s quantitative easing program has pumped more than $3.6 trillion of easy money into financial markets and should the program of asset purchases and other stimulus measures stay in place till the end of the year – something that's increasingly likely – the Fed's balance sheet will top $4 trillion.

The gold price has benefited massively from the Fed's ultra-loose monetary policy that's kept interest rates near zero and until recently negative in real terms.

QE weakens the dollar and increases the risk of inflation.  The gold price and the dollar usually move in opposite directions and the metal's status as a hedge against inflation and a storer of wealth has only been bolstered by the Fed's actions.

Click for full-size chart

Click for full-size chart

After an initial spike to above $900 thanks to safe haven buying following the Lehman Brothers collapse of 15 September, the gold price had fallen back to $707 by mid-November.

Gold needed a catalyst to move higher.

Announced in late November, QE officially kicked off mid-December 2008.

QE1 and August 2010's second round set off waves of buying, that turned gold into a one-way for the next three years culminating in September 2011's $1,921 all-time high.

Predictably, traders got cold feet and futures contracts plunged shortly after hitting the record, including a $105 or 5.6% drop in value in a single session.

It was the same pattern that was followed in 1980: Gold hit a record of $850 on January 21, to this day a record high when adjusted for inflation. Just two days later gold was back to under $700 starting a bear market that lasted more than two decades.

By the end of September 2011 the gold price was in danger of crashing through $1,600 – down almost $300 in less than a month – but once again the Fed stepped in.

The Fed's rather portentous September 'Operation Twist' bond buying program which aims to twist the yield curve  saw gold (briefly) trade back above $1,800 by November.

Gold bugs were getting hooked on US dollar printing presses leading to huge swings in the gold price. 2011 was the most volatile since 1980 with the gap between the year’s highs and lows coming in at close to $600 an ounce or a 32% range.

In 2012 the relationship was souring.

Bernanke pronouncements could still move the gold market – but now hints on monetary policy was sending gold down; not up.

In February gold dropped $75 within a single hour after comments from the US Federal Reserve that seemed to indicate a third round of QE3 was off the table.

The same thing happened at the start of April and again June 7 when Fed minutes disappointed and Bernanke delivered "anti-climactic" testimony to the US Congress.

Even good news like the extension of Twist on June 20 did little for the gold price and the $1,800 level appeared to have become impenetrable.

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By the time the much-anticipated third round of QE – ambitious in scale and open-ended to boot – was announced mid-September, gold was looking tired.

The metal would top out below $1,800 early October 2012 despite the Fed's asset buying program which would top $3 trillion by the end of the year.

By December 12, the relationship had broken down to such an extent that an announcement of a $45 billion increase in asset purchases to an eye-watering $85 billion a month, could not budge the gold price.

During the first half of 2013 – which appears destined to end gold's unbroken 13-year bull-run – the Fed dynamic was being replaced by other drivers including the conflict in Syria, mine supply, Indian and Chinese consumption.

April's $200 drop over a Friday and Monday was not preceded by any Fed rumours or facts.

In stead the dramatic collapse seemed to have come out of nowhere, something akin to collective loss of confidence. (Or perhaps market manipulation?)

Gold's gap down at the end of June to near three year lows below $1,200 came after hints by Bernanke that a tapering of asset purchases could come as early as September.

While QE was no longer pushing the gold price higher, it was still providing a solid price floor.

Yesterday when fears that the floor would give way were confirmed to be unfounded, gold duly reacted.

But even after a nice $60 bump we're still a long way away from $1,900.

Image courtesy of University of Michigan Ford School.