Will the reality check continue, or will a rebound follow?
Despite our repeated warnings that the economic data contrasted the pivot narrative, sentiment continued to diverge from the fundamentals. However, after another wake-up call on Feb. 3, the bullish narrative should shift in the months ahead. To explain, we wrote before the opening bell:
While the crowd assumes that inflation will decline smoothly to 2%, its propensity to jump around should collapse this narrative and enhance volatility. Again, it’s not that inflation will hit new highs; it’s that it won’t return to 2% without immense demand destruction; and since that demand destruction is not present now, interest rates need to rise to suppress consumption and rebalance the U.S. labor market.
To that point, with U.S. nonfarm payrolls smashing expectations on Feb. 3, the fundamentals continue to unfold as expected.
Please see below:
To explain, the U.S. added 517,000 jobs in January, which was well above the consensus estimate of 185,000. Thus, while we have been bullish on the U.S. labor market for many months, it’s another indication that the U.S. federal funds rate (FFR) is not high enough to suppress demand.
Furthermore, with employment outperformance present for the last several months, the crowd’s calls for demand destruction have been unwisely premature.
Please see below:
To explain, the blue line above tracks realized nonfarm payrolls, while the green line above tracks the consensus estimate. If you analyze the right side of the chart, you can see that the blue line has remained above the green line for many months, which indicates how the consensus has been too bearish on the U.S. labor market.
In contrast, we have warned on numerous occasions that the material supply/demand imbalance is bullish for wage inflation, which in time, should uplift the FFR, real yields and the USD Index.
Speaking of which, average hourly earnings (AHE) also outperformed expectations on Feb. 3.
Please see below:
To explain, AHE came in at 4.4% year-over-year (YoY) versus 4.3% YoY expected, and average weekly hours also outperformed, which means higher pay and longer work weeks. As such, with the resilient results coinciding with the U.S. unemployment rate hitting its lowest level since 1969, the pivot narrative did, and still does, lack credibility.
As further evidence, permanent and temporary layoffs also moved lower in January.
Please see below:
To explain, the blue and orange lines above track permanent and temporary job losses. If you analyze the right side of the chart, you can see that both metrics are historically low, and when you compare the blue line’s current performance to 2008, these are not the kind of readings that occur alongside dovish pivots.
Piecing it all together, the hawkish employment outperformance on Feb. 3 resulted in a material increase in rate-hike expectations.
Please see below:
To explain, the red line above tracks the peak FFR implied by the futures market, while the green line above tracks the inverted (down means up) number of rate cuts priced in thereafter. If you analyze the right side of the chart, you can see that the payrolls print helped push the implied FFR peak from below 4.90% to above 5%. Likewise, rate-cut expectations also declined, as evidenced by the green line moving higher.
So, the end result was a hawkish re-pricing of Fed expectations, and we warned on Jan. 20 that a reality check was forthcoming. We wrote:
Please see this Bloomberg headline from Jan. 19:
…. Silver remains uplifted because the crowd has placed ‘big bets’ that the Fed will pivot in the months ahead. Yet, their optimism contrasts inflationary history, and the current economic conditions also signal a much different outcome. Consequently, we expect risk assets to re-price substantially over the medium term.
Ironically, if you analyze the peak FFR expectations chart above, you can see that Jan. 19 essentially marked the bottom in dovish re-pricing (the low red line). Therefore, with the technicals and the fundamentals continuing to align with our expectations, more downside should confront gold, silver and mining stocks in the months ahead.
Also noteworthy, S&P Global released its U.S. Composite PMI on Feb. 3; and with the data bullish for the FFR, interest rates should continue their ascent before this bear market ends. An excerpt read:
“Employment across the service sector increased further during January, thereby extending the current sequence of job creation that began in July 2020. That said, the pace of growth slowed to only a slight pace.”
In addition:
“Cost pressures intensified in the opening month of 2023, thereby bringing an end to a seven-month sequence of easing input price inflation. Higher cost burdens were often
linked to increased material prices, but service providers also commonly mentioned upticks in wage bills.”
As it stands, while output inflation did not rise to the same extent as input inflation (but should later as businesses adjust), employment growth continued and companies noted further wage pressures.
Conversely, the Fed needs the unemployment rate to rise to normalize wage and output inflation, and that’s not happening.
If you analyze the FOMC’s latest Summary of Economic Projections (SEP) below, you can see that in December, the median participant expected the unemployment rate to hit 4.6% in 2023. Although, the metric fell to 3.4% on Feb. 3. As such, it’s moving in the opposite direction, and these are not the kind of results that eliminate wage inflation.
Overall, the fundamental backdrop is bearish for the PMs because the FFR is not high enough to stifle demand. We warned that despite the misguided narrative, the U.S. labor market was resilient, consumers were flush with cash and the Sticky CPIs kept hitting new highs; and today, little has changed. So, while inflation may not hit new highs, the crowd materially underestimates the demand destruction required for it to hit 2%.
How does the FOMC reconcile its 2023 unemployment rate projection with the current figure? Can inflation hit 2% without the unemployment rate rising? Where do you expect the FFR to peak?
Alex Demolitor
Precious Metals Strategist