Quantitative Tightening: Four Things We Learned from the Fed in July

The Federal Reserve has now signaled that it is embarking on a quantitative tightening (QT) program for the American financial system. After mounting fears over a $4.5 trillion-dollar balance sheet and what it could mean for the economic future, the central bank has finally decided to act.

The Fed set out on a groundbreaking policy to raise rates for the third time in six months in June, but what happened in July could have an even greater impact.

As a primer to the new age of QT and Fed “normalization,” here’s the four major things that we learned in July:

The Fed is a Threat to the Dollar

As of July 24, the U.S dollar index is down 8 percent on the year. In the current market, the U.S dollar has fallen to a 13-month low. Against the euro, the dollar has hit 2.5 year lows.

The expectation is that it will continue to fall further in a selloff that was bolstered after the Fed decided to maintain its current policy rate.

Even Barron’s got in on the action running the headline, “The Dollar Gets Closer to Falling off a Cliff.”

While there are many factors to such a downturn pushing toward the cliff, the Fed is by far one of the biggest. The lack of action on tax reform and a stimulus package that is virtually non-existent continues to weigh heavily on confidence to the dollar.

As more rate hike uncertainty floods investor thinking, the dollar may continue to come under threat.  It is true that political noise plays into the equation, but the sweeping impact that the Fed continues to press on the dollar outweighs any negative uproar from political pressures.

Gold is the Real Winner from July

The struggling dollar has a history of bolstering the market price of gold.  The looming quantitative tightening program could further a gold rally that seems to be underway.

Gold has hit seven week highs. The growth in gold comes after questions continue over economic data and uncertainty from the Fed on where it might be headed with rates.

Speaking to Reuters, Commerzbank analyst Eugen Weinberg noted that, “Dollar weakness is driving the gold price. It’s not just against the euro, it’s against most major currencies.”

Confirming the uncertainty from the Fed and legislators the analyst said, “U.S politics is a mess and U.S data has not been inspiring.”

For quantitative tightening policy measures, strengthening in gold will likely show economic data that encourages the Fed to act. Although QT policy will be gradual, the uptrend in gold shows that there are concerns amongst investors that believe the policy could be more disruptive than markets have prepared for.

Economist Jim Rickards first reported on The Daily Reckoning in May that he saw great potential for gold in the second half of the year.

Rickards’ remarked that he expects gold to have, “a more powerful surge toward $1,400 later this year based on Fed ease, geopolitical tensions, and a weaker dollar.”

That means July could prove to be a true turning point on the year for gold and present real opportunity for the remainder of 2017.

Even Janet Yellen has Market Anxiety

While Yellen’s speech in London had many roaring about her commentary over not having another financial crisis “in our lifetime,” there also a noteworthy signal given.

The Fed Chair, when speaking on the state of the current markets signaled that the current financial cycle might be overextended.

She went on to elaborate on the rich historical standards facing markets highlighting that, “Asset valuations are somewhat rich if you use some traditional metrics like price earnings ratios.”

What that means is that a new era of irrational exuberance could have finally caught up with a “dieting” Fed.

If markets continue to be stretched out with ‘easy’ policy outlooks, the underlying concern then shifts to what Yellen and her colleagues believe real financial stability looks like.

Historically, the Fed reacts far slower than markets. The anxiety seen in July will be worth watching in the weeks and months ahead.

Expect Quantitative Tightening ‘Relatively Soon’

After meeting in July, the Fed has given firm evidence that QT is coming, but how soon?

The Federal Open Market Committee (FOMC) statement from July 26 reported:

“The Committee expects to begin implementing its balance sheet normalization program relatively soon, provided that the economy evolves broadly as anticipated…”

For the remainder of 2017, the Fed has signaled that it plans to unleash the $4.5 trillion housed in its balance sheets. By reducing the trillions it holds at a faster pace than expected in 2016, the Fed has offered markets indication that unwinding will not be interrupted.

The QT program outlined is set to start at $10 billion a month and will gradually be increased quarterly up to $50 billion a month in reductions.

Many have speculated that poor inflation numbers could stall QT. However, the Fed has urged that regardless of inflationary data it plans to stay locked in.

The July statements relating to quantitative tightening relay that the Fed is now shifting priority away from an interest rate focus.

So What Does it All Mean?

Ultimately, it appears that the Fed is backing hawkish tones – for now. This means that Fed policymakers may be stepping away from the dual-mandate objectives that work toward inflationary goals and stability.

The move may further divide the real economy to a financial climate continues to heighten in risk. A policy that divides economic and financial cycles provides climate for crisis – built from debt, bubbles and massive financial risk taking.

QT could bring about a program of tightening into weakness.

As the U.S dollar depreciates, gold and other commodity sectors will show greater signs of life.  Savvy investors have already begun to jump into gold, oil and other hard assets. Such moves could potentially encourage the Fed to continue in this quantitative tightening path.

Will the markets finally wake up to realize before it’s too late? If July was any signal for the future, the answer seems to be unlikely.

Thanks for reading,
Craig Wilson@craig_wilson7
for the Daily Reckoning

The Daily Reckoning