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Reality Has Repercussions

From the Maven Letter: January 13, 2022
By Gwen Preston

Inflation means the Fed really is ending QE and raising rates. Last week bond traders finally accepted that reality…and then dumped bonds before the market loses a massive and totally price-insensitive buyer (the Fed). It made for a volatile and negative week that could be a preview of what’s to come. Also…with the first rate hike now likely in March, gold’s seasonal run has been squeezed out. I expect range-bound movements (like we’ve had for a year already) until the first hike sets gold going again.

One of the things I love about my job is that, to understand metals markets, I must understand the macroeconomic landscape.

Sometimes the landscape stays stable for weeks, months, even years. Such was my first metals bull market experience: the China growth story emerged in the early 2000s and pushed metals – base and precious – upward for years. It was supply and demand in an inflation and growth environment. Then the Great Financial Crisis blew everything up but before that – and for gold also after – commodities had a stable set of year.

Stability isn’t quite how I would characterize things today. Instead, every few months something happens that requires me to rethink my entire thesis.

It happened again last week. The yield on the 10-Year Treasury is a good visual.

It moved higher last fall as inflation set in, but by January that move was in place and the yield was about 1.5%.

But last week yields jumped. By January 7th the yield on the 10-Year was at 1.77%.

Why all the selling? (Yields rise when prices fall. Prices fall when traders sell bonds.) Because enough evidence piled up to convince bond traders that the Fed really is going to end QE as quickly as possible and then hike 3 or 4 times in 2022, and might even start selling assets (quantitative tightening or QT).

The bit of evidence that finally convinced the masses was the minutes from the Fed’s December meeting. It’s a long-standing notion that people need to hear something three times to absorb it, which perhaps explains why minutes from a meeting where the discussion had already been made public via a press conference and a dot plot had such an impact.

But human nature is also to blame. People don’t want the party to end and so they ignore the last call and the thinning crowd until the lights come on and they find themselves almost alone amidst the post-party mess. The same applies to all the fiscal supports the Fed has provided since the Great Financial Crisis, which were of course hugely enhanced in the COVID crash: traders don’t want the support to end.

And the setup is strange enough that they could convince themselves it wouldn’t. Surely another variant would extend the need, or slow reopening would demand support, or employment challenges following such an upheaval in who does what would require more.

All those holdout hopes aside, by September last year the combination of strong inflation, low unemployment, and falling COVID numbers made it clear the party would indeed end. The Fed laid out a path to step back its bond purchases over half a year and then consider raising rates.

But then inflation really ramped, jumping to levels that demanded action. After spending years convincing the market he wouldn’t do anything without lots of warning, Fed Chair Jerome Powell suddenly had to accelerate his carefully-charted path.

After the weirdness of the last two COVID years, after being told repeatedly that the Fed will never surprise us again, after getting used to immense levels of fiscal and monetary support, after watching the Fed backtrack on its last effort to raise rates in late 2018 because stocks corrected, and after enjoying huge gains from an insanely long-lived stock bull market (that got a lot of its fuel from all those supports), it’s fair enough that investors did not want to accept change.

Even inflation at 6.8% wasn’t enough to convince many that something had to change. Now they are convinced. Long dry pages of minutes from a meeting six weeks ago for the win! 🙃

So what happened when reality finally hit? Bond traders hit sell.

That was about the depth of my understanding until I read this Twitter thread from Jim Bianco of Bianco Research. I’ll try to summarize.

Bianco says the best metric to understand bond market moves is total return, which encompasses price change and forecast yields. He then presented charts of weekly total 4 returns for 30-Year and 10-Year bonds. The 30-year chart goes back to 1973 and last week’s 9.35% loss was the worst weekly total return in 49 years.

For the 10-year it was the worst week in 42 years, with a total return loss of 4.24%. The only bigger weekly loss happened in February 1980, when Volcker inflation panic was rampant and the Fed Funds rate was shooting up to 21%.

He then pointed to the Treasury Inflation-Protected Securities chart. TIPS are treasuries that rise in price to protect holders from inflation (the principal is protected). TIPS should indicate inflation expectations. But Bianco sees something more sinister at play.

Weekly total return for the Bloomberg 10+ TIPS Index was down 6.09%, the third-worst week ever (on par with the week Lehman Brothers failed, the week the repo market blew up, the height of the taper tantrum, and peak COVID panic).

Bianco then, thankfully, explains why he thinks last week was so dramatic.

Traders had been watching TIPS to feel better that the Fed would not tighten so fast. TIPS hadn’t been rising dramatically, so inflation expectations weren’t really that strong, so the Fed wouldn’t really tighten that much. Right??

But Bianco posits that TIPS doesn’t say anything much about inflation expectations anymore. The Fed bought so much of this market in its COVID QE that it now owns 25% of the TIPS market, up from less than 10%. They bought more TIPS than the Treasury issued in the last two years.

As a result…

I don’t mean to get highly technical here. The point is that the Fed has been a HUGE buyer of Treasuries in the last two years. They are leaving that game; they are even threatening to start selling their Treasury holdings.

During this massive QE operation, the yield on TIPS – indeed on all bonds – has been less about inflation expectations than about bottomless Fed buying. Now the Fed is getting out of the game and its departure will leave a gaping hole.

If this rationale is correct (and I asked several economist friends to negate; none did) then simply ending QE (which is happening) will hurt the bond market. And don’t fall into the trap of thinking that bonds matter less than stocks. It’s the opposite and the bond market always leads the stock market, into tops and bottoms.

So have wee seen the top? That is one of many questions yet to be answered.

  • Will inflation persist or ease like it did in China, where COVID impacts are about six months ahead of the rest of the world? China is now stepping rates back and reintroducing supports as growth slows and inflations disappears
  • Can goods consumption remain so strong in the US or has buying ahead been a force that will drop off? Will services spending step up and have the same inflation impact?
  • Will China’s Zero COVID approach keep inflation stronger for longer (lack of supply, supply chain issues for longer)?
  • What will tightening do to stocks and bonds???

The biggest question of all is where the Fed will end up focused. Inflation is the thing today. But as the questions above reveal, we don’t know where inflation is heading.

What we do know is that rate hikes and QT hinder growth, which undermines a bull stock market. So as this red-hot inflation situation evolves, the biggest question will be how the Fed balances its conflicting mandates of controlling inflation, promoting growth and employment, and supporting the stock market (that last one isn’t part of official policy but might as well be).

Smooth sailing, for stocks and growth, will require the Fed to thread the needle, restraining inflation without crimping growth.

And last week might have provided a preview of how that might play out. The stock market’s most speculative corners – think profitless tech companies, recent IPOs, and cryptos – all plunged.

I am far from alone in wondering whether the Fed can thread this needle. It’s the talk of the town. The Fed is trying to engineer a ‘soft landing’ by bringing inflation under control without inducing a recession. It bears noting that the Fed’s record for engineering soft landings is, as John Maudlin noted in a recent Thoughts From The Frontline, “essentially 0 for (number of attempts).”

Maudlin led into that comment with these words, which I thought worth quoting.

Bond traders are selling because the biggest and most reliable buyer of the last two years is exiting, quite suddenly, and might even start selling. Bond market instability/weakness is (1) a 8 harbinger of things to come for stocks and (2) concerning for companies that need new debt to grow, since higher yields means money costs more.

Debt servicing costs are at a generational low and have been falling through this stock bull market. Having to spend more servicing debt will dent earnings. You know what are very strongly correlated? The SPX and earnings per share.

So can earnings per share continue to rise? It’s safe to say they can’t rise forever. Can they rise if yields climb in a bond market lacking its biggest buyer, pushing debt servicing costs up?

I don’t have the answers but volatility and uncertainty seem guaranteed. In that kind of environment, gold makes sense. I can’t say investors will for sure turn their attention to the yellow metal, but I can say they might.

Here’s a thought on that, from a friend in the mining space whose ideas I heed.

  • Here’s another thought for you though: I think that the market’s extreme and growing short-term focus means that, when attention does turn, it will be abrupt. The wait is painful but I don’t think it is worth the risk missing out on what’s to come. Investors caught short oil equities (which seem to be suffering the same existential questions as a gold equites) sure missed out last year.

    You may not view gold equities as comparable to oil equities but what about the relatively recent sharp moves in uranium or fertilizer equities? Or think how quickly the market moved on dot.coms and cannabis companies. When the market moves, it seems to me that it happens much more quickly and forcibly these days.

There are a lot of possibilities here. And even more factors feeding into those possible outcomes. And even more opinions on how each factor impacts those possibilities.

That mess – of opinions on factors that lead in criss-crossing ways to myriad outcomes – creates a few certainties.

  1. Gold will probably be range-bound until the first rate hike. Sigh. When I thought the first hike wasn’t going to happen until May, it seemed there was room for a JanuaryFebruary seasonal run before gold sank into the hike…but the Fed meeting minutes pulled the expected first hike forward to March. That doesn’t give enough time for a seasonal run and so gold is at the mercy of data points and opinions on how those data points impact Powell’s plan.
  2. It is very hard to know how data will be taken in this complicated, Fed-focused environment. Take yesterday: we learned that CPI rose 7% year-over-year in December, up from 6.8% in November. Gold held its ground but could just have easily gained or fallen. (In the ‘help’ column, gold is an inflation hedge and inflation keeps real rates negative; in the ‘hurt’ column, strong inflation increases conviction that rates hikes are coming and soon.) It will be similarly hard to predict responses to all matter of data points over the next few months.

  3. If gold loses some ground in the next two months, it will be pricing in real rates rising as inflation eases. Remember, falling inflation means higher real rates. Real rates will stay negative for a long time – even four hikes would put the Fed Funds rate at 1% and I doubt inflation is going to plummet from 7% to 1% in a year – but they will increase. If gold declines over the next two months, it will be the market pricing that in. And then…
  4. Gold being sideways-to-down as we head into the first hike should set it up for the reliable part of the cycle, which is gaining alongside rate hikes. That correlation doesn’t last forever but it’s reliable early in a rate hike cycle because rates rise when (1) inflation is strong and therefore real rates are likely negative and (2) growth is driving commodities as a whole, which reinforces the gold argument.
  5. Threading the needle would be best for base metals, where demand is directly aligned with growth. That said, between tight supply-demand setups for several metals (including copper, where copper stockpiles currently represent just three days of demand) and clear momentum in the green energy paradigm shift, there are reasons to believe base metals would survive a short recession without much long-term damage.

Those things are as certain as I get at this point. As for Powell ‘s whole plan – ending QE and then raising rates repeatedly while starting to sell bonds – I still don’t see him getting very far.

The bond market’s actions last week support my thesis that tightening won’t be tolerated. Rate Rage could manifest as bond market mayhem or a stock market slide; either would likely prompt the Fed to pause and re-assess whether it is indeed threading the needle.

Threading needles is hard. You need good light and eyesight. For the Fed to thread this needle it would need good data and tools…but good data is hard to find amidst all the fiscal and 11 monetary supports, supply chain issues, and consumer changes of COVID and central banks have only the blunt-est of tools.

There’s the new outlook folks. Sorry it took ten pages to explain.

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