ROI-Specter of Warsh Fed sparks precious metals 'debasement' crash: McGeever

By Jamie McGeever

ORLANDO, Florida, Feb 2 (Reuters) - How much of the recent mania for gold and silver was fuelled by U.S. dollar "debasement" fears? Quite a lot, judging by the crash in precious metals on Friday following U.S. President Donald Trump's announcement of former inflation hawk Kevin Warsh as his pick for the new Federal Reserve chair.

The collapse was truly historic. Platinum XPT= and silver XAG= posted their biggest one-day losses on record, falling as much as 20% and 30%, respectively, and gold XAU= plunged 10% for its steepest fall since 1983.

This partly reflects the level of speculation behind the rapid ascent of precious metals prices in recent months. Silver rose 70% in the first four weeks of the year alone. Yet this momentum-driven spike was seemingly rooted in something real: fears that the U.S. is on a ruinous path of fiscal folly, expanding money supply, and a degraded currency.

Precious metals were a hedge against this, which quickly transformed into a bubble waiting to be popped. All that was needed was a catalyst. Enter Kevin Warsh.

Views on how Warsh, a former Fed Governor from 2006-11, will lead the central bank if confirmed have been notably divided, largely because his policy stance has seemingly shifted meaningfully over the years.

As a Fed Governor, he was known as a policy "hawk," worried about the inflationary impact of the Fed's monetary experiments following the Global Financial Crisis, even as unemployment was high and inflation was a non-issue.

In fact, Warsh resigned from the Fed Board of Governors in 2011 in protest against the central bank's "quantitative easing" program, the buying of huge amounts of bonds to hold down long-term rates.

Warsh now agrees with Trump, Treasury Secretary Scott Bessent and Fed Governors Stephen Miran and Christopher Waller that interest rates should be lower, even though inflation remains above the central bank's 2% target.

Still, one thing hasn't changed. Warsh is against the Fed carrying a bloated balance sheet and wants the central bank to reduce its financial market footprint.

As recently as October, Warsh told Fox Business that the Fed should "free up the balance sheet, take money out of Wall Street."

'FUEL ON THE FIRE'

Broadly speaking, if we have a Fed that is now even more opposed to "money printing," the "debasement" trade is diminished, and 'hard' assets like precious metals lose their luster.

The dollar USD= and Treasury yields rose on the news of Warsh's nomination on Friday, but only modestly, signifying that traders aren't dramatically changing their interest rate expectations.

This combination of market moves underscores the fact that the "debasement" trade seen in recent months was not in the FX market or in bonds, but in precious metals.

Indeed, gold was the "world's favorite dollar debasement hedge" and "long gold" was the world's most crowded trade, according to Bank of America fund managers' survey last month.

Some pullback was inevitable in a trade that overcooked.

Twitchy gold and silver investors were already facing rising margin calls and the pressure to cash in, so when the Warsh news hit, they stampeded for the exits.

"It was fuel on the fire," says Brian Jacobsen, chief economic strategist at Annex Wealth Management. "It was a perfect storm."

FED'S BALANCE SHEET TRILEMMA

But news of the debasement trade's demise may be greatly exaggerated.

For starters, there is good reason to believe the Fed will not – and cannot – shrink its balance sheet much more. Doing so at current levels would risk draining bank reserves to dangerously low levels that could cause interbank-lending markets to seize up, sending money-market rates shooting higher, as occurred in late 2019.

The fear of a repeat is why the Fed stopped quantitative tightening in December and started the "reserve management purchases" (RMP) operation, which, technically, expands its balance sheet by loading up on short-dated bills rather than bonds.

So Warsh may want a smaller Fed footprint, but he will face the so-called "balance sheet trilemma." According to a Fed paper last month, the central bank can only achieve two of the following goals at once: a small balance sheet, low volatility of short-term rates, and limited market intervention.

"Put simply: a small balance sheet forces either volatile rates or frequent central bank operations; avoiding both requires a larger balance sheet," they found.

For now, the prospect of having a small-balance-sheet advocate as Fed chair appears to be cooling the debasement trade. But given these realities, the looming shadow of the president, and America's fiscal trajectory, it's unlikely to extinguish it.

(The opinions expressed here are those of the author, a columnist for Reuters)

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