With recession narratives on the rise, investors remain in a dovish daydream.
Despite another down day for the S&P 500, the gold price headed in the opposite direction. Moreover, with interest rates declining as recession fears mount, the crowd can’t decide whether lower Treasury yields are bullish or bearish.
In addition, with the Bank of Canada (BoC) unsure of its next step, uncertainty has market participants in a state of confusion. For example, the BoC raised its overnight lending rate by 50 basis points on Dec. 7.
Please see below:
Source: BoC
The official press release read:
“GDP growth in the third quarter was stronger than expected, and the economy continued to operate in excess demand. Canada’s labour market remains tight, with unemployment near historic lows. While commodity exports have been strong, there is growing evidence that tighter monetary policy is restraining domestic demand: consumption moderated in the third quarter, and housing market activity continues to decline.”
As a result:
The “Governing Council will be considering whether the policy interest rate needs to rise further to bring supply and demand back into balance and return inflation to target.”
So, while the BoC cited “excess demand” and “unemployment near historic lows,” and in the next breath, questioned “whether the policy interest rate needs to rise further,” the contradiction highlights the conundrum confronting North American central banks. With some areas of their economies running too hot, while others are too cold, they want to have their cake and eat it too.
However, the reality is that supporting growth encourages inflation, and history shows the gambit ends in a recession regardless of what they do; and while the BoC (and maybe the Fed next week) thinks the overnight lending rate could peak at 4.25%, we believe the central bank materially underestimates the challenges that lie ahead.
To that point, Bridgewater Associates’ Chief Investment Strategist Rebecca Patterson said on Dec. 5:
“While there is going to be this tug of war how much the Fed will accept inflation versus force inflation to its target, how much growth pain will we get, we continue to believe that there's another shoe that has to drop, and that is the economy.”
She added:
“What's not priced in is the Fed going high, and holding. The market's anticipating right now that we get significant rate cuts starting in the second half of next year, and we think without severe economic weakness to justify that, we're going to get the Fed pausing, but not cutting.”
Thus, while Bridgewater Associates sees things from our perspective, Patterson noted that a 5% U.S. federal funds rate (FFR) should be the minimum, and a higher peak shouldn’t be dismissed.
Please see below:
Source: Business Insider
As such, while gold is priced as if rate cuts and QE are on the horizon, the opposite should occur over the medium term. Furthermore, with growth, employment and consumer spending still resilient, the outlook is bullish for the FFR and bearish for silver. For context, you can read more about silver’s reaction to the latest U.S. nonfarm payrolls report here .
In addition, while the crowd believes that a dovish pivot is a good thing, they don’t realize that real pivots occur when the U.S. economy is collapsing, not when the unemployment rate is near a 50-year low. Therefore, when the Fed finally relents, it’s profoundly bearish.
Please see below:
To explain, the blue line above tracks the FFR, while the black line above tracks the S&P 500. If you analyze the annotations, you can see that historical pivots culminated with sharp drawdowns of the index. So, while the crowd believes that the Fed can flip a switch and cure all of the financial market's ills, the sentiment is much more semblance than substance.
Yet, while the data disproves the narrative, investors continue to pour money into U.S. equity ETFs.
Please see below:
To explain, the dark blue, light blue and orange bars above track the annual inflows into stocks, bonds and money market ETFs. If you analyze the right side of the chart, you can see that the dark blue bar hit its second-highest level in the last ~20 years in 2022, and was only surpassed by 2021.
As a result, there is little fear in the financial markets, and the crowd has supreme faith in the Fed. For your reference, fundamental data have medium to long-term ramifications, so for more technical insights, please see our stock price analysis .
Overall, while the consensus expects a recession and assumes a dovish pivot will arrive soon, the price action contrasts the narrative. In reality, when dovish pivots occur, the economic outlook is so dire that asset liquidations are already underway.
In contrast, they don’t occur with a near-record-low unemployment rate, near-record-high wage inflation and ~40-year high output inflation. Consequently, while the post-GFC pivots made it seem like the Fed could solve any problem, it’s much different when inflation is ~4x the annual target.
Alex Demolitor
Precious Metals Strategist