How Much Longer Can the Fed Jawbone Markets?

Earlier this month, Nik Wallenda became the first man to walk over the Niagara Gorge in more than 100 years, and the first ever to walk directly over the falls. Step by step, he edged his way for 1,800 feet along a two-inch diameter steel rope suspended 200 feet above the raging waters. More than 100,000 people gathered on the American and Canadian sides of Niagara Falls to witness the feat. It was the most incredible tightrope performance I have ever seen, until the Federal Reserve announced their latest actions this week.

On Wednesday, the central bank’s Federal Open Market Committee concluded a two-day meeting and said it would extend Operation Twist through the rest of the year. The program involves selling short-term securities and using the proceeds to purchase long-term securities in order to lower borrowing costs and boost the economy. The original $400 billion Operation Twist was schedule to end this month, but the extension will raise the total amount of the program to $667 billion. Furthermore, the Fed reiterated its stance to keep the federal funds rate “exceptionally low” for at least through late 2014.

Wall Street’s initial reaction to the FOMC statement was disappointment, as many were expecting or hoping for another massive round of quantitative easing to juice the markets higher. Equities across the board declined and precious metals dipped to new intra-day lows. Gold fell to as low as $1,590 per ounce, while silver hit $27.63 per ounce. Although the Fed did not launch another QE program, it may have laid the groundwork for one in the future.

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The FOMC statement gave hints that the central bank is not completely unaware of the current economic conditions, it said that “growth in employment has slowed in recent months, and the unemployment rate remains elevated.” The statement also explained, “Inflation has declined, mainly reflecting lower prices of crude oil and gasoline, and longer-term inflation expectations have remained stable.” In contrast, the April FOMC statement noted that “labor market conditions have improved in recent months” and that “inflation has picked up somewhat.” The tone in the statements have changed quite dramatically in just one month, but economic conditions have not deteriorated enough to warrant another official QE program. Investors should keep in mind that more erosion in employment and inflation produces a more favorable environment for the central bank to take action. In the meantime, the Fed while enjoy the “Talk is Cheap” strategy.

Not only does Ben Bernanke walk a thin tightrope above Wall Street and Congress, he does so while jawboning the entire audience across the gorge. In a press conference after the FOMC statement, the Chairman said, “Yes, additional asset purchases are among the things we would consider if we need to take additional measures to strengthen the economy.” However, he keeps the audience in suspense by adding that there are costs associated with easing programs and they should not be taken lightly. He ultimately concludes that “We’re prepared to do more. We have to get additional information on the state of the economy, what’s happening in Europe.”

The Fed also downgraded its outlook on U.S. growth, setting the stage for more stimulus in the future. The central bank lowered its estimate for the 2012 gross domestic product growth to 1.9 to 2.4 percent, down from 2.4 to 2.9 percent in April. Estimates for 2013 came in at 2.2 to 2.8 percent, compared to 2.7 to 3.1 percent in the previous forecast. Domestic growth significantly below these levels and a continuing weakening employment picture will raise calls and the likelihood for more QE. Buying the central bank even more time, the Fed could still receive temporary relief from the European Central Bank, which still has room to cut interest rates, or from Congress, which still needs to reach a deal on a “financial cliff” at the end of this year.

Like many tightrope walkers, investors should keep a safety harness in their portfolio. Considering the negative real interest rate environment and the temptation for central banks to “extend and pretend” by various measures, precious metals are that safety harness. Gold and silver prices have underperformed recently, but investors should never underestimate the long-term trend. Precious metals have shown to be volatile many times as Bernanke jawbones the market. On Leap Day this year, gold and silver dropped $77.10 and $2.56, respectively, as Bernanke delivered the Fed’s semiannual Monetary Policy Report to Congress. In the first week of June, gold and silver fell another $46 and 96 cents when the Fed Chairman testified to the Joint Economic Committee in Washington. The question is, what will the Fed do when it reaches the end of its rope?

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Disclosure: Long EXK, AG, HL, PHYS