What happens when the Fed stops printing money?

It was another 'buy everything except the dollar' day yesterday.

The euro was up, stocks were up, gold was up the Dow Jones hit a three-year high, while the yellow metal hit a fresh all-time high above $1,500 an ounce. Silver is rocketing, surging above $45 an ounce at one point yesterday.

Meanwhile the Vix index sometimes known as Wall Street's fear gauge fell to its lowest point since July 2007. It's a far from perfect measure, but it suggests that investors are unusually complacent right now.

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And the dollar itself is at its lowest point since August 2008, just before it rebounded as panicked investors piled back into it as Lehman Brothers collapsed.

Getting dj vu yet?

Silver is due a correction, along with the rest of the commodities market

My worries about the market right now are perhaps best summed up by looking at silver.

We've long been fans of silver here at MoneyWeek. I seem to remember that when my colleague Merryn first began tipping it near the start of the decade, it was trading below $5 an ounce. Now it's nearer $45.

And despite its recent surge, I suspect silver could still go higher in the longer run. But would I buy it right now?

My main worry about silver is that the commodities market in general feels overheated to me. The 'supercycle' story of the wealth shift from West to East is now fully embraced by the mainstream (interestingly, this perception shift started to happen just as the credit crunch was ripping the guts out of the global economy). And you've got other red flags such as oil surging at a time when we're not particularly short of the stuff, and the approaching Glencore float.

I don't think that the story is about to hit its grand finale yet. But I do think we're due a hefty correction. And because silver is partly an industrial story as well as a precious metals, anti-currency debasement story, it'll suffer along with the rest of the commodities.

I don't know exactly what will cause it. A surprise move by China to revalue its currency perhaps (this might be long-term bullish for commodity prices but it could rattle markets in the meantime). A panic over Europe. Or plain old demand destruction prices getting too high and forcing people to look for substitutes.

Or maybe it'll be the end of quantitative easing (QE) that does it. So far, the plan is still that Ben Bernanke and the Federal Reserve will end QE2 on schedule, at the end of June. What happens when and if they do it?

The end of QE isn't priced in yet

Given that investors know the end of QE is coming, you'd expect markets to be pricing it in already. However, that's not necessarily the way these things work. Chuck Prince, ex-chief executive of Citigroup, issued the defining quote of the credit crisis when in July 2007, he said: "When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance".

Right now, the music is still playing. And a lot of people still believe that Bernanke will do anything to avoid calling a halt to the money printing. So I don't think you can take any comfort from this notion that the market is 'pricing in' the end of QE it's not.

So I think there's a good chance that any confirmation of the end of QE will actually take a lot of people by surprise. And that could be quite nasty for markets. In practice, QE is just like cutting interest rates it's how you loosen monetary policy when your base rate is already at or near 0%. So when we talk about QE ending, we're talking about monetary policy tightening up.

The big question in that case is: how strong is the underlying economy? Can it hold up under tighter monetary conditions? Or are asset prices simply floating on a sea of printed money? We may soon find out.

Hang on to gold

So what would this mean for gold? Well, gold I'm more comfortable with. Here's why. If the end of QE sends the markets into a swoon, then by hook or by crook, Bernanke will find a reason to print more money.

It shouldn't be too hard. After all, a slide in markets would hit commodity prices too, reducing inflationary pressure. Under this scenario, the enemy is still deflation and recession, and central banks will do what they can to stave it off. Gold might fall, as it did in 2008, but it would probably recover faster than other assets.

But if markets manage to stay strong, even in the face of QE ending, then it will prove that the biggest threat really is inflation. If the underlying economy turns out to be tough enough to withstand both modestly tighter monetary policy, and the threat of austerity on both sides of the Atlantic, then overheating will be the biggest danger.

The problem we face then is, just how far behind the curve are the world's big central banks? Real interest rates (adjusted for inflation) in Britain are incredibly low, sitting at around minus 5%. Effectively, you're being paid to borrow money (if you can get it at a decent rate of course).

Historically, a more normal level for interest rates when inflation is this high would be around 7%. So if inflation and an unexpectedly strong economy is the real danger, you can see just how fast the Bank of England would have to hike rates to catch up.

Raising rates that fast would definitely plunge the economy back into recession. So the Bank and the Fed would err on the side of caution. But that would give inflation the chance to get really out of hand. And that would drive gold higher too.

This precious metal could be a good bet

All eyes will be on Bernanke's first press conference on 27 April to get a clearer idea of what his plans are for QE. But I'd happily stick with gold here.

And in the meantime, if you think the boom has further to go for now (or if Bernanke finds a way to keep QE going), there's one metal I'd suggest is worth a look platinum. Unlike silver, the 'other' industrial / precious metal has done very little in recent months.

Now, that's partly because platinum has never been used as currency. But with the gold price rocketing, it's rapidly approaching parity with platinum (which is trading at around $1,800). In the past, that's tended to mark a low point for platinum so if any metal has room to play catch-up, it's probably this one.

You can get physically-backed exchange-traded funds that play the platinum price, such as ETF Securities Physical Platinum (PHPT), but bear in mind that it's denominated in dollars, so there is exchange-rate risk for sterling-based investors.

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