With the US economy still on fire and inflation soaring, the Fed must react decisively. What will happen to gold after the change in accommodative stance?
It’s a decision day for the Fed, as a 50 basis point rate hike is likely a done deal. Additionally, while prime ministers may record a near-term relief rally, their medium-term fundamentals continue to deteriorate.
For example, I’ve been warning for some time that higher interest rates would come amid runaway inflation and, surprise, surprise, the 10-year US Treasury yield continued to climb. Additionally, with the benchmark Treasury eclipsing 3% intraday on May 3, a close above the key psychological level should occur sooner rather than later.
To explain why, I wrote on April 20:
The red line above tracks the US federal funds rate, while the green and gray lines above track the US 10- and 30-year Treasury yields. If you analyze the connection, you can see that the bottom two often take their orders from the first. In a word: when the Fed raises interest rates, it takes several 0.25% hikes before long-term yields rebound. For example:
In 2018, the 10-year US Treasury yield peaked after about 9 rate hikes.
In 2006, the 10-year US Treasury yield peaked after about 17 rate hikes.
In 2000, the 10-year US Treasury yield peaked after about 7 rate hikes.
In 1994, the 10-year US Treasury yield peaked after about 12 rate hikes.
So, with modern history showing that the 10-year U.S. Treasury yield doesn’t peak until the Fed is well into its rate hike cycle, remember that the Fed only increased once. Therefore, with seven rate hikes as the minimum to cause a spike in the last ~28 years, the 10-year US Treasury yield should have room to maneuver, which is bullish for real yields and bearish for the gold.
Speaking of real returns, with nominal interest rates rising and breakeven inflation rates falling, the US 10-year real yield closed at 0.18% on May 2 and at 0.15% on May 3. As a result, PMs are facing a fundamental ticking time bomb that is likely to send their performance skyrocketing over the next few months.
To explain, the gold line above tracks the price recorded by the World Gold Council, while the red line above tracks the US 10-Year Inverted Real Yield. For context, inverted means the latter’s scale is reversed and a rising red line represents a falling US 10-year real yield, while a falling red line represents a rising US 10-year real yield .
For more context, I wrote on April 11:
If you analyze the left side of the chart, you can see that the US 10-year real yield soared and gold plunged during the global financial crisis (GFC). However, when the Fed launched QE and the US 10-year real yield fell to an all-time low, gold hit a new all-time high along the way.
Moreover, the current situation is a spitting image. When Fed Chairman Jerome Powell made a dovish turn in late 2018, the US 10-year real yield suffered. Then, when the Fed launched its liquidity bazooka in March 2020, it pushed the metric to another all-time low. And surprise, surprise, gold hit a new all-time high.
However, With the Fed’s normalization policy, the US 10-year real yield has jumped in recent weeks. Additionally, the Fed needs to push the metric above 0% to rein in inflation.
Thus, it is probably only a matter of time until the milestone is reached. Besides, a 10-year US real yield of 0% implies a gold price of $1,500and although the current narrative suggests otherwise, is this time really any different?
At this point, while gold has suffered over the past few days, the current price is still well above its trend-based average value. Likewise, since the GDXJ ETF is far more volatile than the yellow metal, and therefore expected to drop even further, epic declines should materialize if (once) the two lines reconnect (not necessarily immediately after the rate hike, as PM could trend-based rally go-on-rumor-reverse-on-done).
For example, while these events take time to unfold, history shows that the “this time is different” crowd ends up losing more than just their pride. I first pointed out the epic divergence between the US 10-year Treasury yield and the US 10-year breakeven inflation rate on May 11, 2021. I wrote:
To explain, the green line above tracks the US 10-year Treasury yield, while the red line above tracks the US 10-year breakeven inflation rate. If you analyze the left side of the chart, you can see that when the bond market finally crashed in 2013, the surge in 10-year US Treasury yields was fast and furious. More importantly, however, if you analyze the right side of the chart, you can see that today’s gap makes 2013 look like an appetizer. As a result, with material divergences often reversing violently, it is only a matter of time before the next earthquake strikes.
Therefore, while the fundamental thesis did not materialize overnight, the two lines eventually reconnected; the US 10-year Treasury yield rose above the US 10-year breakeven inflation rate, and the US 10-year real yield turned positive.
However, now it’s the gap between gold and the US 10-year real yield that’s making 2011 look like an appetizer, and the same outcome should happen. As a result, the outlook is deeply bearish for the PM.
From negative to positive
Conversely, as bonds are oversold and the stock market nears a breaking point, investors continue to ask, “Where is the Fed?” For context, put options are like insurance contracts and they protect investors in the event of drawdowns. In a nutshell: Investors expect the Fed to step in, get dovish and rescue stock market investors from their poor valuation decisions.
However, the prospect is far-fetched, and here’s why. Following the Global Financial Crisis (GFC), the Fed ran to the rescue whenever the stock market threw a tantrum. As such, short-memory investors assume the post-GFC script is the right analogue. Yet they fail to realize that the year-on-year (YoY) percent change in the consumer price index (CPI) peaked at 3.81% in September 2011. So the Fed could relax without worrying about fueling inflation.
Conversely, with an overall CPI at ~8.6% year-on-year, the situation has completely changed.
Second, the other half of the Fed’s dual mandate is maximum employment. While U.S. job vacancies hit a record high of 11.549 million on May 3 (March results), the data is overwhelmingly bullish for Fed policy. For context, the consensus estimate was 11 million.
More importantly, however, another resilient report means that there are now 5.597 million more job openings in the United States than unemployed citizens, also an all-time high.
To explain, the green line above subtracts the number of unemployed US citizens from the number of US job vacancies. If you analyze the right side of the chart, you can see that the epic meltdown has completely reversed and the green line is at an all-time high. So, with more jobs available than people looking for work, the economic environment supports normalization by the Fed.
Again, please consider the CPI data above with job postings distributed after the GFC. The period had entrenched inflation and unemployment outnumbered job vacancies through 2018. This has nothing to do with the current environment. Also, can you notice how the spread outperformance helped boost the Fed’s most recent rate hike cycle?
To explain, the green line above tracks the vacancies spread, while the red line above tracks the US federal funds rate. If you analyze the relationship, you can see that the movement of the spread towards neutral was a hawkish indicator.
Likewise, with a positive spread and at an all-time high, the data alone justifies several rate hikes. However, as mentioned, we also have an annual headline CPI that is at its highest level since the 1980s. So if investors assume the Fed is running out of ammunition to deliver on its hawkish promises, they should suffer the same fate as the “transitional” camp in 2021/2022.
Finally, S&P Global released its US manufacturing PMI on May 2. The report revealed:
“Operating conditions have improved markedly in the US manufacturing sector, according to April PMI data from S&P Global…. New orders rose at a healthy pace at the start of the second quarter, and at a pace broadly in line with that seen in March. Businesses reported stronger demand conditions, with some noting new sales rose despite substantial price increases. Meanwhile, new export orders rose at the fastest pace in nearly a year.
“Manufacturers recorded a solid increase in employment in April. Headcount has increased due to higher production requirements and in response to voluntary staff departures. Some companies also said job creation was linked to filling long-standing vacancies. Labor shortages continued to be cited as a drag on growth, yet.”
But more importantly:
Source: S&P Global
The bottom line? As investors continue to pray for a dovish pivot, they are likely expecting a rude awakening. The US labor market remains abnormally hot and the latest PMI data shows that inflation continues to accelerate. Moreover, while real yields have turned positive, they have done little to cool a US economy awash with too much stimulus. As a result, with a hawkish Fed poised to push the US 10-year real yield even higher in the medium term, prime ministers are set to suffer mightily as the drama unfolds.
In conclusion, the PMs rallied on May 3, as sentiment does not die easily. However, while the technical backdrop could support a short-term rally, the medium-term technical and fundamental data from PMs is deeply bearish. Investor optimism should therefore turn into pessimism over the next few months.
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