This past week was good for holders of gold, with the world's most well-known preciousmetal jumping 2% on concern that the global economy is in trouble.
A drop in equities accompanied the jump in gold, with, for example, the S&P 500 down about 3% for the week.
Current discussions seem to focus on two main factors behind the weakness - a potential recession in Europe and slower growth in China.
There is another, perhaps more reasonable explanation for the rise in gold and the drop in global equities. The U.S. Federal Reserve indicated that it plans to finish "tapering" in probably November/December. (Tapering refers to the central bank's policy of buying bonds to lower longer-term interest rates.)
An end to the Fed's bond buying would mean an end to the expansion of the central bank's balance sheet.
The figure below shows what the S&P 500, gold, and the U.S. central bank's balance sheet has done before and following the past two ends to quantitative easing (known as QE).
In June 2010 when QE1 ended, the S&P 500 shed about 15% from peak to trough. Over the same period (April to mid-August), gold jumped 14%.
In November 2010, chairman Bernanke announced QE2, a $600 billion bond-buying program.
After less than a year, the Fed eliminated QE2 in July 2011.
Unsurprisingly given the QE1 response, QE2 saw equities lose about 15% in value, while gold increased in value by about 20% (peak to trough for equities and trough to peak for gold).
The disapproval of ending QE2 brought about QE3. Announced on September 13, 2012, the Federal Reserve indicated initially that it would buy $40 billion worth of bonds per month. The $40 billion limit quickly expanded to $85 billion.
Less than a year after the start of QE3, Bernanke announced tapering, with the Fed initially decreasing the bond purchases amount from $85 billion to $65 billion.
With the history of QE1 and QE2 as the background, it is completely unsurprising how the market is responding to the idea of the end to QE3.
Interestingly, if history is any guide, gold has another 10% to 15% to gain in the near future, while equities have another 10% in downside risk.
The experience of the prior two ends of quantitative easing poses a question:
Will the Fed bring QE back, in the form of QE4, before the Fed raises rates in perhaps June 2015?
If history is any guide, the answer is probably yes.
What does another expansion in the Fed's balance sheet mean for gold?
On a long-term outlook, it certainly increases the upside potential, as it increases the risk of inflation pressure. Interestingly, it probably will have a positive effect in the short-term as well, in that it signals lack of confidence in the global economy, a component behind the demand for gold.
