Tail Wagging The Dog?
US markets continue to ramp higher, with all three major indices – the S&P, Dow, and Nasdaq – notching new all-time highs today after minutes from the last Federal Reserve meeting reinforced expectations of another rate hike in December.
I can’t help but feel like the market is the dog and the Fed is the tail…and guess who I think is wagging whom?
For the stock market to gain on news of monetary tightening is backwards. This long, strong bull market happened because years of ultra low interest rates made credit easily available and pushed dollars into equities rather than bonds.
Indeed, loose monetary policy plus oodles of quantitative easing did indeed create inflation – of stock prices.
So the end of this era should be a negative for stocks. Higher rates should strengthen the dollar, which pushes money out of stocks and into bonds and creates headwinds of US firms trying to sell goods abroad, and reduce the availability of capital to grow businesses.
And yet the markets love the idea of tightening. All three major indices jumped today after the Federal Reserve Open Market Committee released the minutes from its September meeting, which reinforced the idea of a December hike.
Why? Because a hike supposedly means a strong economy. If the Fed is hiking, the economy must be doing well, right? And a strong economy justifies an epic bull market in equities, right?
That’s the tail-wagging-the-dog that I keep seeing.
Rate hikes should happen because the economy is strong, but hikes themselvesshouldn’t be the evidence thereof. The evidence should come from strong GDP and wage growth plus inflation, for starters, but those are missing.
Nevertheless the market is using rate hikes as proof that the economy is strong and therefore the bull market justified…even though it should be the other way around: the stock market should be reflecting economic strength and the Fed should be using economic data and stock market performance to decide whether to hike.
In this case I think Yellen et al have other reasons to want to hike.
- Yellen presided over an extraordinary period of monetary policy. A strong economy today justifies that course of action; rate hikes suggest the economy is strong. Her term is almost over and she’d like to leave with things looking good.
- If the economy turns south, the Fed wants to be able to cut rates. Hikes create that ability.
- As much as the Fed actively avoids talking about equity prices, Fed members have to be concerned about stock valuations. Raising rates could therefore be as much about cooling the stock markets as about tempering inflation (which is nonexistent).
- The dollar lost 11% from January through to early September. Some greenback weakening was needed but I imagine the Fed was getting a touch concerned about dollar weakness, which rate hikes counter
So those are the reasons why hikes have been happening. And for now team Yellen is hammering home the hike message, which has lifted expectations for a December rate hike to 86%.
But I can also create a list of reasons why Yellen is not likely to actually raise in December.
- While she has been saying she will ignore the lack of inflation, she cannot do so. Hikes strengthen the dollar and thus reduce inflation; hiking into weak inflation can easily turn the environment deflationary. And no one likes deflation, especially an outgoing Fed Chair who justified her extraordinary actions via promises of future growth.
- Yellen is a very cautious person. She supposedly always gets to airports at least three hours before her flight – even for domestic trips! – because caution is simply her nature. Hiking into weak GDP growth and very weak inflation does not fit.
- If expectations of a hike are having the effect of encouraging equities, then reason #3 from above gets stricken from the list. The stock bull market is undoubtedly a concern and she will not want to fuel it farther.
Gold’s response to today’s news is also a good example, of how reactions are so backwards these days. The gold price traded down in the hours leading up to the release of the Fed minutes, out of concern the message would be one of hikes.
When that is exactly what the message contained, the gold price responded with a strong move upwards.
It doesn’t make sense on its own, but the last two Decembers provide good analogies.
Leading up to the Fed meetings in December 2015 and 2016 the gold price fell, out of concern the Fed would raise rates. Both times they did and both times gold jumped on the decision.
The explanation is that gold investors priced in the hike – and then some – ahead of time. It’s the old Buy the Rumor, Sell the News concept, but a little more complicated. The complication comes from today’s extraordinary monetary environment, levels of debt, and unstable geopolitics.
A rate hike is seen as endorsing economic strength and the dollar, so initially or in expectation stocks rise and gold falls. But rate hikes also suggest inflation, which lifts gold. Then there are the impacts of real rates (rise with rate hikes and decline with inflation) and extreme levels of government and corporate indebtedness, which are complex to incorporate. Geopolitics are the icing on the confusion cake, pushing stocks or gold up or down depending on the news of the day.
In other words, there is no straightforward or obvious response to a rate hike.
As we head towards December, at this point I think we’re looking at a repeat of the last two years…whether rates rise or not.
Gold will decline into the meeting because of the expectation of a hike. Then…
If Yellen does raise rates, oversold gold will rise in a rebound manner, just as it did in December 2015 and 2016. I also don’t think Yellen would raise unless inflation readings improve at least a bit from their September reading of 1.7%. A quarter point rate hike would put rates at 1.4%; subtract inflation and you still have real rates right near zero, which is the fundamental gold bull driver.
If Yellen does not raise rates, gold will jump as hawkish betters unwind their positions and safe haven investors, concerned about economic weakness and the broad bull market, buy the yellow metal.
Gold’s strength today suggests the yellow metal has darn good support. Believers buy when the opportunity presents. It probably helped that the Chinese returned to the market this week after a weeklong holiday, the buyers of gold that they are.
Add to that the multimetal strength that remains very evident – copper is above US$3 per lb. and zinc has stayed right near US$1.50 per lb., both very good prices – and I remain optimistic about the outlook for the mining markets…as long as you’re willing and able to withstand the day to day gyrations!
Thank you so much for this excellent Maven letter. Your market analysis and logic is again exceptional. Your insights, knowledge and feel have given me a wonderful couple of hours. I am now planning my activity. I look forward to seeing you tonight on the Virtual Metals forum, I am pleased that you start first as I am a morning not a night person.
I hope you and your family stay well.
What distinguishes you from the rest is candor and honesty. You have a genuine concern for your subscribers that exceeds the other publishers I know. IMO that's more important than geological knowledge or even performance.