It looks like the Fed is getting ready to start cutting the supply of money. This could be terrible news for gold bugs, because they've been betting that inflation would spiral out of control and gold would be the only way to protect against it. But now the Fed is talking to bond dealers about selling them $1 trillion of so-called reverse repos that would remove $1 trillion of cash from the financial system.

That $1 trillion is a significant amount when you consider that before the financial crisis began, the Fed had a mere $800 billion worth of assets. But when Bear Stearns collapsed, the Fed became the financial sponge for huge amounts of Wall Street's toxic waste -- bulging out to $2.14 trillion in bad assets that were sinking the banks.

With the reverse repos -- short for reverse repurchase transactions -- the Fed would sell securities to its 18 primary dealers for a specific period, which would decrease the amount of money available in the banking system. If it issues $1 trillion worth of reverse repos, the Fed would be able to use the cash to restore its balance sheet part of the way back to its pre-August 2007 condition.

What does this mean for investors? It could mean that the Fed is seeing signs of inflation as a result of an economy that it believes is emerging from a recession thanks to all that money it poured in. As a result, the Fed is preparing the groundwork for cutting back on the money supply.

But watch out if you're betting on a weak dollar and rising commodity prices -- including gold. That's because one of the surest bets in the last few years has been that rising U.S. debt would weaken the dollar -- particularly when borrowers were using their money to short the dollar and go long on commodities futures.

If the Fed drains $1 trillion out of the swamp, those bets are off. And investors who were fortunate enough to have placed such bets when, say, oil was trading near $30 a barrel this January should take their profits.

Peter Cohan is a management consultant, Babson professor and author of eight books including, You Can't Order Change. Follow him on Twitter.


Increase your money and finance knowledge from home

What is Short Selling?

Make a profit when stocks prices fall.

View Course »

Portfolio Basics

What are stocks? Learn how to start investing.

View Course »

Add a Comment

*0 / 3000 Character Maximum