Brace, Gold Bulls: The Fed Will Keep Its Hawkish Word
2022.05.04 19:06
The Fed has to react firmly with the U.S. economy still on fire and inflation galloping. It’s a decision day for the Fed, as a 50 basis point rate hike is likely a done deal. Moreover, while Precious Metals (PMs) may record a short-term relief rally, their medium-term fundamentals continue to deteriorate.
What will happen to gold after the dovish stance changes?
For example, I’ve been warning for some time that higher interest rates would manifest amid rampant inflation, and – surprise, surprise – the U.S. 10-Year Treasury yield has continued its ascent. Furthermore, while the Treasury benchmark eclipsed 3% intraday on May 3, a close above the key psychological level should occur sooner than later.
Please see below:
U.S. 10-Year Treasury Yield Daily Chart
To explain why, I wrote on Apr. 20:
Fed Funds Rate Historical Chart
Speaking of real yields, with nominal interest rates rising and breakeven inflation rates falling, the U.S. 10-Year real yield closed at 0.18% on May 2 and 0.15% on May 3. As a result, the PMs confront a fundamental time bomb that should blow up their performance over the next few months.
Please see below:
Gold/10-Year Real Yields (Inverted)
To explain, the gold line above tracks the price tallied by the World Gold Council, while the red line above tracks the inverted U.S. 10-Year real yield. For context, inverted means that the latter’s scale is flipped upside down and that a rising red line represents a falling U.S. 10-Year real yield, while a falling red line represents a rising U.S. 10-Year real yield.
For more context, I wrote on Apr. 11:
To that point, while gold has suffered in recent days, the current price is still well above its medium-trend-based value. Likewise, since the GDXJ ETF is much more volatile than the yellow metal, and therefore, should decline even more, epic drawdowns should materialize if (once) the two lines reconnect (not necessarily in the immediate aftermath of the rate hike, as PMs could rally based on the move-on-the-rumor-reverse-on-the-fact tendency).
For example, while these events take time to unfold, history shows that the “this time is different” crowd ends up losing more than just their pride. I first highlighted the epic divergence between the U.S. 10-Year Treasury yield and the U.S. 10-Year breakeven inflation rate on May 11, 2021. I wrote:
U.S. 10-Year Treasury Yield/U.S. 10-Year Breakeven Inflation Rate
Therefore, while the fundamental thesis didn’t materialize overnight, the two lines eventually reconnected; the U.S. 10-Year Treasury yield surpassed the U.S. 10-Year breakeven inflation rate, and the U.S. 10-Year real yield turned positive.
However, now it’s the gap between gold and the U.S. 10-Year real yield that makes 2011 look like an appetizer, and the same outcome should occur. As a result, the prospect is profoundly bearish for the PMs.
From Negative to Positive
Conversely, with bonds oversold and the stock market nearing a breaking point, investors continue to ask: “Where is the Fed put?” For context, put options are like insurance contracts, and they protect investors when drawdowns occur. In a nutshell: investors expect the Fed to step in, turn dovish, and save stock market investors from their poor valuation decisions.
However, the prospect is far-fetched, and here is why. Following the global financial crisis (GFC), the Fed ran to the rescue whenever the stock market threw a tantrum. As such, investors with short memories assume that the post-GFC script is the right analog. Yet, they fail to realize that the year-over-year (YoY) percentage change in the headline Consumer Price Index (CPI) peaked at 3.81% in September 2011. Thus, the Fed could ease without worrying about stoking inflation.
Conversely, with the headline CPI at ~8.6% YoY now, the game has completely changed.
Please see below:
CPI Long-Term Chart
Second, the other half of the Fed’s dual mandate is maximum employment. With U.S. job openings hitting an all-time high of 11.549 million on May 3 (March results), the data is extremely bullish for Fed policy. For context, the consensus estimate was 11 million.
More importantly, though, another resilient report means that there are now 5.597 million more job openings in the U.S. than citizens unemployed, also an all-time high.
Please see below:
U.S. Job Openings Minus Unemployed Citizens
To explain, the green line above subtracts the number of unemployed U.S. citizens from the number of U.S. job openings. If you analyze the right side of the chart, you can see that the epic collapse has completely reversed and the green line is at a record high. Thus, with more jobs available than people looking for work, the economic environment supports normalization by the Fed.
Again, please consider the CPI data above with the job openings spread post-GFC. The period had well-anchored inflation and unemployed citizens outnumbered job openings until 2018. That’s nothing like the current environment. Furthermore, can you notice how the spread’s outperformance helped spur the Fed’s most recent rate hike cycle?
JOLTS Spread/Fed Funds Rate
To explain, the green line above tracks the job openings spread, while the red line above tracks the U.S. federal funds rate. If you analyze the relationship, you can see that the spread’s move toward neutral was a hawkish indicator.
Likewise, with the spread positive and at an all-time high, the data alone justifies several rate hikes. However, as mentioned, we also have a YoY headline CPI that’s at its highest level since the 1980s. Thus, if investors assume the Fed lacks the ammunition to follow through with its hawkish promises, they should suffer the same fate as the “transitory” camp did in 2021/2022.
Finally, S&P Global released its U.S. Manufacturing PMI on May 2. The report revealed:
“Operating conditions improved markedly across the U.S. manufacturing sector, according to April PMI data from S&P Global…. New orders increased at a marked pace at the start of the second quarter, and at a rate broadly in line with that seen in March. Companies reported stronger demand conditions, with some noting that new sales expanded despite substantial rises in prices. Meanwhile, new export orders grew at the fastest rate for almost a year.”
Also noteworthy:
“Manufacturers recorded a solid rise in employment in April. Workforce numbers grew following greater production requirements and in response to staff leaving voluntarily. Some firms also stated that job creation was linked to the filling of long-held vacancies. Labor shortages continued to be mentioned as a weight on growth, however.”
More importantly, though:
The bottom line?
While investors continue to pray for a dovish pivot, they’re likely in for a rude awakening. The U.S. labor market remains abnormally hot, and the latest PMI data shows that inflation is still accelerating. Moreover, while real yields have turned positive, they have done little to cool a U.S. economy that’s flooded with too much stimulus. As a result, with a hawkish Fed poised to push the U.S. 10-Year real yield even higher over the medium term, the PMs should suffer mightily as the drama unfolds.
In conclusion, the PMs rallied on May 3, as sentiment doesn’t die easily. However, while the technical backdrop could support a short-term rally, the PMs’ medium-term technicals and fundamentals are profoundly bearish. Therefore, investors’ optimism should turn to pessimism over the next few months.
