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Stock Losses Raise Pressure on Fed

by Peter A. Grant

June 10, AM
(from USAGOLD.com) --

The stock market has rolled over, recording its sixth weekly decline since the DJIA peaked in early-May at 12,876. On Friday the market closed below 12,000 for the first time since March, losing about 7% of its value over the past 6-weeks. In recent weeks the Dow has fallen below the important 20, 50 and 100-day moving average complex. The 20-day MA has crosses below the 50-day MA. From a technical perspective, the stock market looks terrible. This comes at an inconvenient time, with the Fed's QE2 operation winding down over the next 3-weeks. Or perhaps the slump in stocks is because QE2 is poised to expire.

The recent raft of bad economic data on jobs, housing, manufacturing and consumer confidence are all weighing on investor sentiment. The weak economic recovery is sputtering; but is it just a temporary soft-patch, or is something more ominous and protracted brewing? The Fed made it clear this week that they believe the slowdown is transitory and that growth will be revived in the second half of the year. They seem prepared to stick to their guns, and allow QE2 to expire at the end of the month. Now the market seems inclined to test the Fed's resolve.

As we've discussed in the past, many in the US -- no matter how misplaced the notion might be -- view the stock market as the critical measure of the health of the economy. In pointing to the performance of the Russell 2000 as an indication that Fed policy is working, chairman Bernanke has actively encouraged that mindset. With the Russell down more than 10% since forming a key reversal on 02-May, my guess is that Bernanke doesn't reference RUT again anytime soon. Nonetheless, the stock market is curious to know at what point the Fed might consider additional accommodations. Certainly they can ill-afford more than a 20% retracement in the Dow as that would result in a bear market, which would further sap investor and consumer confidence. My guess is that in order to protect that 20% retracement level, Fedspeak starts eluding to heightened potential for QE3 around DJIA 11,000.

I'm quoted in a MarketWatch article today referencing the recent tighter correlation between stocks and gold as QE3 expectations have waxed and waned. Quantitative easing has a tendency to bolster most asset classes because the artificial demand provided to the Treasury market suppresses yields. This has a negative effect on the dollar and low yields effectively discourage investors and savers from being in yield baring instruments such as bonds, bills, CDs and money market accounts. The quest for a yield that at least keep up with inflation makes stocks, commodities and of course gold more attractive. The weaker dollar and investor demand for commodities further increases the inflation rate, creating a vicious circle.

The more normal negative correlation between stocks and gold is likely to reestablish itself if equities continue their retreat and investors start looking for a safe-harbor to weather that storm. At the point where the Fed once again starts to worry about higher unemployment and deflation, they'll cry "uncle" and likely announce further QE because with interest rates already at essentially 0%, they really don't have any other tools at their disposal. Stocks and gold will become positively correlated again and both will take off to the upside.

Here's the wildcard though: Bernanke has already acknowledged that the size of the Fed's balance sheet can become problematic. There is a point, where the negative effects -- most notably the devaluing impact on the dollar -- will outweigh any positive impact derived from artificially low yields. That's the point of reckoning that everyone should be worried about, because once QE doesn't offer any additional benefit the game is up and the dollar will have to be devalued.

Peter Grant is USAGOLD's resident economist and a well-known analyst globally in the forex and precious metals markets.

Opinions expressed in commentary on the USAGOLD.com website do not constitute an offer to buy or sell, or the solicitation of an offer to buy or sell any precious metals product, nor should they be viewed in any way as investment advice or advice to buy, sell or hold. Centennial Precious Metals, Inc. recommends the purchase of physical precious metals for asset preservation purposes, not speculation. Utilization of these opinions for speculative purposes is neither suggested nor advised. Commentary is strictly for educational purposes, and as such USAGOLD - Centennial Precious Metals does not warrant or guarantee the accuracy, timeliness or completeness of the information found here.

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Stock Losses Raise Pressure on Fed