What are the odds of a bullish reversal?
With hawkish nonfarm payrolls helping to stifle gold, silver and mining stocks’ momentum, the interest rate narrative has shifted to higher for longer. Moreover, with the PMs highly allergic to higher Treasury yields, their medium-term outlooks remain ominous.
For example, rate-hike expectations continued to accelerate on Feb. 6, and the development is bad news for the precious metals.
Please see below:
To explain, the red line above tracks the peak U.S. federal funds rate (FFR) implied by the futures market, while the green line above tracks the inverted (down means up) rate cuts expected thereafter. If you analyze the right side of the chart, you can see that rate-hike expectations are back near their November highs, while rate-cut expectations are back near their November lows. As a result, the hawkish shift aligns with our expectations.
To that point, the payrolls outperformance also sent ripples across the Treasury market.
Please see below:
To explain, the colored lines above track U.S. Treasury yields ranging from the 2-Year to the 30-Year. If you analyze the movement post-payrolls, you can see that the bond bulls have been running for cover. Thus, while we warned that a resilient U.S. labor market would keep the pressure on the Fed, the pivot narrative has come under immense pressure in recent days.
Speaking of which, Atlanta Fed President Raphael Bostic said on Feb. 6:
“Job one for us has got to be to get inflation back under control; and I’m going to do all I can to see that we do that….
“Those last few tenths of a point can take a long time to be realized; and so I want to make sure that we are in the right place before we start easing off our policy because the most important thing at this stage is to get our price stability measure as close to target as possible.”
Please see below:
So, while we warned that the Goldilocks narrative – which implies rate cuts, low inflation and high corporate earnings – lacked fundamental credibility, investors’ belief has eroded. Therefore, the consensus is coming around to our expectations, and we outlined on Jan. 10 why the medium-term outlook remains highly treacherous. We wrote:
- Inflation is still highly problematic, and the consensus underestimates the difficulty of returning the metric to 2%.
- The FFR has eclipsed the peak year-over-year (YoY) core Consumer Price Index (CPI) in every inflation fight since 1961; and since the YoY core CPI peaked (for now) at 6.66% in September 2022, the historically-implied peak FFR is at least 6.67% , and the crowd is ignoring the historical lessons of where the FFR needs to go to eliminate inflation.
- Nine of the last 10 bouts of rising inflation ended with recessions, and recessions are bearish for gold. During the dot-com collapse, the GFC, and the COVID-19 crisis, gold declined substantially when panic ensued. As such, U.S. Treasury bonds and the U.S. dollar are the primary safe havens during liquidations, not gold.
- While everyone assumes that the FOMC is wrong about higher-for-longer interest rates, we believe the fundamentals support its outlook.
Furthermore, with wage inflation still problematic, the Fed must maintain its hawkish stance to win this battle.
Please see below:
To explain, the blue line above tracks the YoY percentage change in average hourly earnings (AHE) for non-supervisory employees in the mining, construction and manufacturing industries, while the red line above tracks the three-month annualized percentage change.
If you analyze the right side of the chart, you can see that the red line hit 7.4% on Feb. 3, its highest level since the early 1980s. As a result, the crowd remains woefully misguided in its belief that inflation will normalize without higher interest rates.
Remember, the Wall Street narrative proclaimed that peak inflation meant the worst was over. Conversely, we believe that peak inflation is irrelevant because while stopping the YoY rise is easy, normalizing the metric to 2% is extremely difficult. Consequently, the implications of sticky inflation should enhance volatility in the months ahead.
In addition, while hawkish re-pricings have occurred recently, there should be more room to run.
Please see below:
To explain, the blue line above tracks the Goldman Sachs Financial Conditions Index (FCI), while the orange line above tracks its 90-day rate of change. If you analyze the magnitude of the latter’s fall, you can see that sharp periods of easing have been mean-reverting since 2018, which implies a material reversal over the medium term.
As such, higher interest rates, lower stock prices, wider credit spreads and a stronger USD Index could spoil the bulls’ party, and a realization is profoundly bearish for the PMs.
Overall, while the narrative has shifted, asset prices remain decoupled from their fundamental values. With higher interest rates required to suppress demand, the Fed needs risk assets to suffer lengthy declines for inflation to abate. In the absence, the recent merry-go-round will repeat.
In September and October, recession fears helped sink asset prices and reduce inflation. Then, optimism returned and higher asset prices have the Cleveland Fed projecting a 0.63% month-over-month (MoM) CPI increase in January, which annualizes to 7.83%. So, inflation rises with each bout of optimism, and that’s why a sharp slide in risk assets is needed to normalize the metric for good.
Has the crowd finally heeded the Fed’s warning, or will dovish re-pricing occur in the weeks ahead? How prevalent is wage inflation? Where does the FCI go from here? Please share your thoughts.
Alex Demolitor
Precious Metals Strategist