Rates, Debt, the Dollar, and Gold
After sliding last week, gold started this week with a jump, propelled by news that North Korea took Trump's tweets as a declaration of war. The move erased the losses that followed last week's Federal Reserve meeting, where the committee decided to leave rates unchanged but start 'normalizing' the balance sheet.
Both decisions were totally expected. Traders had, in fact, overly priced them in, which is why the dollar gained following a decision to not raise interest rates.
In the Maven Letter editorial, snipped below, I look at that reaction. And I assess the suggestion that the Fed will hike three times next year, in the context of immense personal, corporate, and government debt.
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No Hike… (Snipped from The Maven Letter: September 20, 2017)
Just as the market predicted, Janet Yellen and co. did not raise interest rates today. In response, the US dollar gained almost a percent.
If that doesn’t make sense to you, you’re not alone.
Higher rates encourage the dollar, while low rates prompt investors to put their money into alternatives offering better returns. So the decision to not raise rates should go against the greenback.
Then again, we have to remember that the post-QE world is a different place. Since the Fed deserves credit for the bull market in stocks (low rates encouraged equities, active buying by the Fed of bonds and even stocks added momentum), investors now pay ridiculously close attention to every Fed move – and usually try to act ahead.
The market had decided several weeks ago that there would be no September rate hike. The chart below, from Sept 14, shows literally no one expected an increase.
Traders act on expectations. The old adage “Buy the rumour, sell the news” has become new again in its applicability to today: traders buy or sell the dollar ahead of Fed announcements and then unwind after. It creates the kind of situation we saw today, with the dollar gaining on the no-hike news.
There was another aspect of the Fed news that helps put a pro-dollar response in context: the bank will start to reduce its massive balance sheet starting next month. During QE the Fed bought bonds – lots and lots of bonds – with money it created out of thin air. As a result, its balance sheet ballooned to $4.5 trillion (from less than $1 trillion prior).
The Fed stopped adding to its bond position a few years ago but it continued support by reinvesting the proceeds of matured bonds back into the bond market. That is what will now change, albeit slowly.
Starting in October, the Fed will NOT reinvest proceeds from $10 billion worth of bonds each month. That amount will increase by $10 billion every three months to a maximum of $50 billion not reinvested each month.
The money that is not reinvested disappears. Poof, gone. Seriously. It was created out of thin air and to thin air it will return. As a result the monetary supply will shrink as will excess bank reserves. Those changes are theoretically good for the dollar and should force the Fed funds rate higher.
I say theoretically because the amounts are very small, at least to start, so the monetary base impact will be small. Nevertheless it is a form of tightening, and the market took that and ran with it.
Yellen also suggested that a December rate hike was on the table, though she couched that by noting the need to see higher inflation. The famous Dot Plot, which lays out rate expectations from each member of the rate-setting committee for the next three years, showed 11 of 16 officials want to end 2017 with rates a quarter point higher than they are currently.
I’ll believe that when I see it. The chart I like in this conversation is below and is affectionately nicknamed the Fireworks chart.
This version of the chart is a bit out of date, but the story remains the same: every year the FOMC gets all optimistic on the economy and predicts all manner of rate hikes and then every year reality catches up and hikes hardly happen. Things have been a bit different of late, with three hikes between November 2016 and July 2017 (the dashed line showing the actual Fed Funds rate should be up at 1.16%), but even that increase still leaves rates well below all those lofty expectations.
Our collective obsession with the Federal Reserve has investors focused on inflation and unemployment when contemplating rate hikes, but those are not the only factors. A third fundamental factor is overall debt.
Sprott Asset Management created this chart of interest payments from household, corporate, and federal government debt in the US. Debt has now reached a level where interest payments alone eat up $641 billion a year. That represents 90% of US GDP growth, which totals only $708 billion. Doesn’t leave much to power anything else!
Growth aside, think about higher rates in the context of that kind of debt service burden. All those debtors could perhaps handle slightly higher rates, but a lot higher and defaults are going to rocket while spending and growth disappear.
And so I end up in my usual position: seeing the Fed unable to raise rate significantly for years, barring dramatic economic acceleration. That keeps real interest rates low or negative, giving gold the fundamental fuel it needs to keep climbing.
That climb did take a big of a step back in the last two weeks. Today it was the dollar’s gain that hurt. Earlier it was consolidating after gaining 5% in two weeks.
Big moves like that happen in context and generate reaction.
In terms of context, some of gold’s gains were a catch-up play on the dollar’s decline, happening all of a sudden after geopolitical prompts (North Korea). Credit also goes to Fed members who made it clear tightening was off the table in the near term and to that weak August jobs report, amongst other not-so-great data releases.
In terms of reaction, when major currencies make big moves – the dollar is down almost 10% this year while the Euro is up 15%, for example – the repercussions are felt far and wide. Certainly there is much debate over where the US dollar is ultimately going, but right now a 10% slide feels darn big and so traders – who had been shorting the stink out of the dollar – are now unwinding those positions at least a bit.
For gold, all the speculating and debating over the greenback’s slide is making it just a bit harder for the masses to have confidence in the yellow metal.
Confidence in gold will develop. As I concluded in my Metals Investor Forum talk on Friday, what the gold market needs is interest from generalist investors. That could come from a major market crash or correction, or it could come steadily as investors get increasingly anxious about the state of the US markets, the dollar, and growth. By contrast, gold stocks – mining stocks in general – offer will offer value and security.
When that rotation starts to happen, the leverage we’ve been lacking will return. For now, it’s a patience game. Gold tested its support at $1300 today; hopefully it holds tomorrow. If not, the next key support is around $1285 per oz. I still think we’re in for some positive action this fall; let’s watch and see if I’m right!