The Federal Reserve did just what we all expected: they doubled the pace of the taper such that the central bank will stop buying Treasuries and mortgage-backed securities by March and pulled rate hikes forward. Comments in recent weeks from Jerome Powell and others on the Federal Open Market Committee that decides on monetary moves had prepped the market for all of this. While we never know about a hike until it happens, today’s FOMC tries to prep the market for such moves through its speeches and its dot plots.
Today’s meeting produced a new dot plot and, yes, it pulled rate hike timelines forward. All of the 18 members of the committee said they could see the case for at least one rate hike next year, a noticeable change from September’s meeting when the committee was split 50-50 on any hiking in 2022. The median voice on the committee sees three 25-basis point hikes in 2022.
Whether these projections actually come to be is another question entirely. The Fed does not want to be blamed for causing a recession. The stock market is so important now, at least in perceptions of economic strength, that fear of causing a recession and fear of causing a stock market crash are one and the same. And so the Fed is just as scared of tipping the market over as it is of a real recession, and everyone knows that tipping the markets is a real possibility as rates rise. The tip could come for real reasons – tightening hindering growth – or it could come from Rate Rage – investors wanting the market to only ever go up.
Fear of tipping the markets puts the Fed in a tough position. Officials had to give themselves the option to raise rates more and sooner because inflation is at 6.8%. But they don’t want to commit. In his press conference, Powell made clear the committee still expects inflation to moderate significantly. That, my friends, means he still thinks inflation is transitory. He just stopped using that word because the market had assumed transitory meant ‘passing in a few months’ and it’s taking longer than that. But yesterday’s statement still had this line: “Supply and demand imbalances related to the pandemic and the reopening of the economy have continued to contribute to elevated levels of inflation.”
I think Fed officials gave themselves room to hike three times in 2022 and do the same in 2023 because that’s what they would need to do if inflation stays near current levels. But if they are 3 largely attributing inflation to things that will dissipate – the pandemic and supply chain issues related to reopening – then they still actually think inflation is transitory. And that means hiking less.
Powell also reiterated that full employment remains as important to the Fed as price stability and that labour force participation remains low. On this: I think employment and wage gains will become as important as inflation in 2022. The thing that would make inflation stick rather than pass is wage gains. They’re happening but haven’t been dramatic yet. If they rise and stick, the Fed will be forced to counter inflation with hikes because wages gains are the stickiest kind of inflation.
That’s looking ahead. Right now: markets rallied on the idea that the Fed will hike at a perfect rate to keep the economy gliding smoothly along. Yet the yield curve has been dropping through the fall. The yield curve is the difference in yield between Treasuries. Below we see the 10-year yield minus the 2-year yield. That it has fallen says the bond market sees higher rates in the near term (which justifies higher yields on the 2-year) but those rates not persisting.
Bottom line: it is pretty strange for the Fed to be raising rates when the bond market is signalling the economy is close to rolling over.
Powell did answer a question on exactly this in his news conference yesterday. He thinks that ultra-low yields in other major bond markets (Japan, Germany) are keeping long-term US yields anchored – foreign buyers are buying US long-dated bonds, pushing those yields down, rather than buying their own bonds because they actually have more confidence in the US.
It’s a weird world.
What did it all do to gold? In response to a faster reduction in support and sooner move to actual tightening…gold gained. First a pause, then a surge, then a sideways period, and then more buying today.
I think today was a preview, a reminder, of how gold always gains with the start of a rate hike cycle. It gets sold leading up to the announcement but then bought when it happens. Why? Because rates are hiked to address inflation. And the Fed will not get ahead of inflation; they will chase it, with questionable exuberance. So real rates will stay negative and gold is a hedge against inflation and negative real rates.
Dot plots or no dot plots, there remains lots of uncertainty about what comes next. The markets seem to have accepted tapering but it’s yet to be seen how much rate hiking traders will tolerate. For that matter, it’s yet to be seen how much rate hiking the economy will handle. Bond traders, who are often more grounded than equity players, don’t think the Fed is going to raise rates all that much. Perhaps they think the economy will stumble, perhaps they think markets will tip over, perhaps they think inflation will ease notably and reduce the rationale for raises. Whatever the reason, the yield curve keeps flattening.
All the uncertainty brings me back to what I wrote last week about gold: that it’s the everything hedge. We remain in the uncharted waters that started with the monetary actions of the Great Financial Crisis. Things had edged back towards normal when COVID hit and sent us back into unprecedented territory. We’ve never before had such levels of direct monetary support (now being tapered), interest rate support (edging lower for years and how slammed to the ground), significant debt levels, and sky-high equity valuations. Right now we have major inflation and employment oddities to add to the mix.
I feel like an everything hedge has a role to play in that setup.
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