While risk assets show signs of slippage, gold remains firm.
After hawkish realities helped upend the S&P 500 and crude oil on Dec. 16, sentiment has shifted dramatically across the financial markets. But, with gold, silver and mining stocks rallying, they’re behaving as if all is well on Wall Street. Yet, while they assume that a calmer USD Index and weaker U.S. Treasury yields are bullish, their misguided optimism should end in disappointment.
To explain, we wrote on Apr. 20:
The next leg higher for the U.S. 10-Year real yield may occur for the opposite reasons. For example, we noted above that we don’t need nominal yields to rise for real yields to rise.
Moreover, while the U.S. 10-Year Treasury yield was undervalued in 2021 and was poised to move higher, the U.S. 10-Year breakeven inflation rate is overvalued in 2022 and is poised to move lower.
Please see below:
The U.S. 10-Year breakeven inflation rate ended the Apr. 19 session at 2.93%, only slightly below the all-time high of 2.95% set in March. However, like the PMs, investors’ long-term inflation expectations remain in la-la land.
With the Fed on a hawkish crusade to stifle demand and reduce inflation, the central bank can achieve this goal. The only question is how much economic pain officials are willing to tolerate to get the job done.
To that point, with the U.S. 10-Year breakeven inflation rate sinking to a new 2022 low of 2.13% on Dec. 16, the fundamentals continue to unfold as expected.
Please see below:
So, while the PMs see a consolidating USD Index and lower nominal interest rates and assume the fundamental backdrop has improved, the reality is that the U.S. 10-Year real yield has risen materially in December.
Previously, the metric declined from its 2022 peak of 1.74% on Nov. 3 to a low of 1.08% on Dec. 2. Coincidently, the PMs rallied during this period as the USD Index also came under pressure. In contrast, the metric ended the Dec. 16 session at 1.35%, which marks a 27 basis point increase in two weeks.
Also, while the PMs behave as if the U.S. 10-Year real yield is still declining, the S&P 500 has noticed, as it’s down by 5.4% from its Dec. 2 close; and while momentum investors believe the PMs are a safe place to hide, prior periods of ignoring the fundamentals culminated with substantial drawdowns. As a result, it’s likely only a matter of time before the next iteration unfolds.
Furthermore, while the crowd has been buying dips all year amid misguided hopes for a dovish pivot, CNBC’s Jim Cramer – a staunch permabull – finally acknowledged reality on Dec. 15:
Please see below:
Source: CNBC
But, we warned in the spring that the Fed’s inflation fight would rattle risk assets and halt a medium-term uprising. We wrote on Apr. 6:
Please remember that the Fed needs to slow the U.S. economy to calm inflation, and rising asset prices are mutually exclusive to this goal. Therefore, officials should keep hammering the financial markets until investors finally get the message.
Moreover, with the Fed in inflation-fighting mode and reformed doves warning that the U.S. economy “could teeter” as the drama unfolds, the reality is that there is no easy solution to the Fed’s problem. To calm inflation, it has to kill demand. As that occurs, investors should suffer a severe crisis of confidence.
In addition, with more Fed officials sounding the hawkish alarm, the gold price should suffer from these developments in the months ahead. For example, San Francisco Fed President Mary Daly said on Dec. 16:
“I don’t quite know why markets are so optimistic about inflation. We don’t have the luxury of pricing for perfection because we have a price stability mandate, and so we have to imagine what the risks to inflation are, and to me they still are on the upside.”
As such, Daly noted that her peak U.S. federal funds rate (FFR) projection is higher than the ~5% expected by the futures market.
Please see below:
Source: Bloomberg
Likewise, Cleveland Fed President Loretta Mester said on Dec. 16:
“The level of inflation is still way too high” and “we need to continue to bring up interest rates into a restrictive stance. We did a lot of work this year,” but the FFR will need to remain restrictive for “quite a while in order to get inflation on a sustainable downward path.”
Thus, she also expects the FFR to peak north of 5%.
Please see below:
Source: Bloomberg
Making three of a kind, New York Fed President John Williams said on Dec. 16:
“To me, the question of how high we have to get to is really going to depend on what we see in inflation and the supply-and-demand imbalance…. Where inflation is still high is in these core-services areas that are probably going to be more persistent and really reflect the imbalance between supply and demand. We definitely need to see it coming down to get to that 2% inflation goal.”
So, while Williams falls on the dovish end of the spectrum, he also admitted that the peak FFR could surpass 5% in 2023.
Please see below:
Source: Bloomberg
On top of that, while the reality check has rattled the consensus, we have been consistent in our view that the FFR should march higher and the liquidity drain should upend several risk assets, including gold. We wrote on Dec. 1:
The narrative pushing the gold price higher is built on a faulty foundation; and despite the notion that the Fed is near a pivot, the reality is that the FOMC’s peak FFR projection keeps increasing.
As such, while sentiment is powerful in the short term, the medium-term fundamentals remain highly alarming. With growth, inflation, employment and consumer spending still extremely resilient, the consensus underestimates this inflation fight. Consequently, our 2023 FFR estimate of 4.5% to 5.5% should prove too low when it’s all said and done.
Overall, the fundamentals continue to unfold as expected. Throughout 2022, investors incorrectly attempted to call the peak FFR and the death of inflation. However, the fundamentals influence the Fed, not the other way around; and with the fundamentals still bullish for the FFR, it’s no surprise that Fed officials keep increasing their projections.
Therefore, while the gold price ignored the ramifications on Dec. 16, the liquidity drain should catch up to the PMs in the months ahead.
Alex Demolitor
Precious Metals Strategist