"Strange days" meets "Nothing Rhymed"

James Bond and Auric Goldfinger were never close friends, even when playing a game of golf. And in economic reality, it rarely occurs that both assets - gold and bonds - go hand in hand. The main reason is that gold serves as a kind of inflation hedge which normally implies an environment of rising yields (and losses on bonds). Since 2009 however, gold has almost constantly moved up and in the same time span, this also occurred in an environment of declining yields : deflation ahoi, a warm welcome to gold, what is going on here ? It's an interesting observation which merits attention, certainly in view of monetary policy over the past couple of years, its close ties with budgetary policy since 2008 and what to expect from next Friday's BB speech at Jackson Hole. Again great expectations in the markets and the main question once again seems to be : can BB save the world and will he deliver.

The markets' main pre-occupation right now is that in view of poor macro numbers - poor on business cycle outlook and disappointing on inflation (higher than expected) - the FED will nevertheless wire new stimulus measures down the road. This could take all forms : punitive rates for banks (negative yield) on holding excess reserves at the FED, FED making bank loans with strings attached (cfr latest BoJ initiative), operation twist and finally, a new round of straightforward QE. What are the odds ?

1) On a new round of QE, it's questionable whether BB can push this through without creating a revolution within the FOMC. On the other hand, those already against probably rightfully point out that we already live in a world of permanent QE : when the FED announced QE2 last November, it simultaneously committed itself to re-invest all maturing bonds (toxic asset included) into new US Treasury notes. So keeping the balance sheet constant at 1,8 trillion USD of assets (+/- 14% of GDP) is in fact QE ad infinitum. And in view of the effects printing has generated on the real economy, it seems the Law of diminishing returns is at work here. Which raises doubts over the effectiveness of yet another round of QE.

2) FED policy towards banks. A punitive rate on excess reserves is an option (no miracle either) as are bank loans with strings attached. Some inspiration may be coming from out of Japan where the Boj recently set up a facility of 3 trillion JPY in term loans at interesting funding conditions, provided banks could prove that they would lend the money to sectors supporting the economy. Two questions : at which rate will this occur and could it be an incentive for banks to make unnecessary risky loans (again) ?

3) Operation twist : no extra QE but changing the term structure of the FED's holdings on its balance sheet, this in an attempt to drive down long term yields. During QE1 and 2, the FED has focused on the intermediate part of the curve, snapping up all US notes in a maturity range of 3 to 7 years. They could swap these lines into 10-30ies, twisting the yield curve (for longer term municipal bonds, a change the federal reserve act is required) . A possibility but personally I believe that this is the most tricky initiative, a kind of "Texas poker-no limit- hold them" game and at the same time "going all in". It's tricky because it ties the hands of the central bank even more in terms of future exits. Remember that by announcing a zero-rate policy at least until summer 2013, the FED already made a bold statement on timing. By buying up longer term maturities and in case changing circumstances require bold action (reversing policy and speeding up off-loading of assets on the balance sheet), the FED has the choice of doing nothing and coming too late (as usual) or exit and incur considerable losses on its balance sheet in case of rates spiking. And during the process, it aggravates the situation by selling onto the market. Briefly, an operation of this size in terms of future exits is a gamble and envisions a long period of deflationary forces.

4) Varia - "creative" solutions

• Issuing money that depreciates in value over time (in case they have not been already doing this over the past decades with the greenback). Not a lot of examples of this kind of short term notes exist. The idea is also of an anarchist nature (19th century economist Silvio Gessel) but surprisingly, it exists very close to home since 2003, ie in Bavaria : the money is called "Chiemgauer" and is designed to lose 2% after every quarter.
• Directly support Wall Street by purchasing equity derivatives. Might seem strange but it's not a new idea. Back in 1989, former FED Governor Geller already mentioned in a WSJ article that the FED could always buy stock index futures in times of distress, adding that "Wall Street is certainly not too big to handle for the FED".

So there are options on the table with various drawbacks. How is the market positioning itself right now ? Depending on the source, it seems that the invisible hand would ideally desire a stimulus of approximately 500 bio USD equivalent coming from the visible hand. To put it differently : if less or nothing at all, equities could take a dive while even bond yields could rise because of front-running the FED in vain. It also of course depends on the accompanying message. We have already mentioned that the gold rally and rally on bonds is something of a "conundrum" since 2009. You could frame it under "safe haven buying" and "flight to quality" or risk aversion and asset allocation switches.

Nevertheless, Jim Morrison meets Gilbert 'O Sullivan : strange days have found us while nothing new, nothing old, nothing ventured, nothing gained, nothing still-born or lost... That's why it's strange that under current circumstances - with debt escalating and ZIRP monetary policy - risk premia on bonds are virtually non-existant. Also QE is a paradox in various ways : it is designed to generate inflation expectations while thinking it can achieve this during a considerable period of low long term rates. And its effect on the economy is to prop up asset price and commodity price inflation, the latter not really helping the consumer either.

So will gold and bonds continue to benefit tailwinds down the road ? If there is one paradox right now is that we have the following disconnect : despite yields testing their lows of 2009 and summer 2010, the market of Credit default swaps, even on "safe haven AA+ - AAA", is moving into the opposite direction. So this side of the market merely judges you can't have it both ways, at some point the day of reckoning looms if monetary and budgetary policy continue along the same line of thinking. And then even people like Paul Krugman might be surprised over the "vengeance of the bond vigilantes". Should that disconnect occur, gold might really give you a good run for your money.