Gold's Retreat And The Fed's Balance Sheet

• The FOMC Meeting is expected to see them begin reversing QE.
• Gold has pulled back sharply.
• Will this change make things worse for gold bulls?

With the FOMC meeting later this week, it is likely we'll see the beginning of the Fed shrinking its balance sheet. With a decrease of open hostilities developing between the U.S. and North Korea, gold (SPDR Gold Shares (NYSE:GLD)) has backed off previous highs with the S&P 500 (SPDR S&P 500 (NYSE:SPY)) and the Dow Jones Industrials (SPDR Dow Jones Industrial Average (NYSE:DIA)) are at new highs.

Gold rallied against a falling dollar (PowerShares DB US Dollar Bullish (NYSE:UUP)) and the political uncertainty emanating from Washington. President Trump is making deals with Democrats and the foreign policy establishment , infuriating the GOP leadership and forcing it to adopt his domestic agenda, most of which is back on the table.

So, the question is how will gold react to the FOMC’s decision? In other words, will this action by the Fed be deflationary or inflationary?

And the reason why the second question is so important is because gold is continuing to react to market pressures in predictable ways. And the case for any new bull market in gold of the kind we saw from 2001-11 requires gold to act counter to conventional wisdom.

In that gold bull market, the dollar was in a bear market. The European Union pursued strong monetary policy and the breakdown of the financial system in 2008 is what took gold from a low near $700 during the crisis to a peak over $1900 by 2011.

During the bull market competitive, round-robin QE from the major central banks added trillions in liquidity which supported the gold price.

And it was these competitive devaluations that kept confidence in the system low and it culminated in Standard & Poor’s downgrade of U.S. sovereign debt. But then the central banks coordinated their efforts, the Swiss National Bank pegged the franc (Guggenheim CurrencyShares Swiss Franc (NYSE:FXF)) to the euro (ProShares UltraShort Euro (NYSE:EUO)) and confidence was restored to the financial system.

Gold has been riding out that rising confidence in the central banks for six years now.

And any argument against a new bull market is predicated on the belief that the central banks have a handle on global liquidity issues and can stave off any potential collapse before it gets out of hand.

I don’t believe that to be the case. Janet Yellen, apparently, thinks otherwise.

If I’m wrong people, stop reading my articles. If she’s wrong the global monetary system fails, again.

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So, the main question is, will reversing some of the QE, by selling U.S. Treasures (iShares 20+ Year Treasury Bond (NASDAQ:TLT)) the Fed bought from 2009 through 2014 and has reinvested since then, be inflationary or deflationary?

That answer is complicated. Sterilized QE of the type former FOMC chair Ben Bernanke engaged in was deflationary.

The money printed by the buying of Treasuries never circulated. It’s sitting as excess reserves on account with the Fed. At last count, the amount was over $2.36 trillion (see section 5, “Other Deposits held by Depository Institutions”).

The banks are currently getting 1% on that money. That number will go up as the Fed hikes rates, which it will.

By reversing QE, the Fed is hoping for inflation by putting more dollars back into the financial system and raising rates, which also implies a weaker dollar.

However, by signaling that the economy is strong enough to weather higher inflation the market also will demand higher rates than the Fed is preparing for. And higher rates in the current environment means reversing the capital outflows we’ve seen this year thanks to a weaker dollar, since none of the other central banks are following suit yet.

The trend down in the dollar isn’t over yet but with the Fed reversing QE the signal for a higher dollar is here. Capital is still flowing out of the U.S. while the political and fiscal landscape looks suspect.

But in the long-run this is what will set up the next bull market. Yield differentials between the U.S. and Europe/Japan will drive capital into the U.S. taking the dollar higher, draining emerging markets and taxing the political situation in the U.S. further.

Gold will respond positively once faith is lost in one of the major central banks and my bet on whose up first is the ECB. But, for now, gold is reacting at the margin violently to any positive change in the dollar.

Gold is down $50 off its recent high because the dollar is strengthening on decreased domestic political risk – potential tax reform, a debt ceiling deal, Obamacare repeal, etc. The dollar is beginning to rally.

I told my subscribers at Stocks, Shocks & Rocks that gold would fall for these reasons in a note early last week.

A break below $1,298 in gold would be a signal of a much deeper correction as that area should be strong support. I’ve been warning this move up in gold (and the euro) has been a bull trap. And it looks very possible I’m going to be right about this.