FISCAL/MONETARY REPORT – THE FED IS RAPIDLY LOSING CREDIBILITY, AND DAY TO DAY “ELABORATIONS” ONLY CREATE VOLATILITY. YESTERDAY MAY HAVE BEEN A “TELL” FOR GOLD RELATED SECURITIES
Volatility in the Capital Markets remains a fact of life, as fluctuating interest rates reflect expectations of inflation. At the same time, it is increasingly clear that the Fed not only predicts poorly, but has basically lost its ability to successfully influence (let alone control) the situation. The situation is not as complex as Jerome Powell, assisted by 250 economic PHDs, make it out to be.
Future inflation will be largely determined by whether current interest rates are higher or lower than the expected inflation, which inform the “real” interest rate. If interest rates are higher than inflation (a positive “real” return), capital will be saved rather than spent and inflation will be subdued. Conversely, If the “real” rate is negative, capital will be spent, fueling ongoing inflation. For 10 years now the inflation (from 2%-9%) has been a lot higher than the interest rates, which were close to zero and now are all the way up to 3-4%. Right now most commentators refer to ongoing negative “real” rates of 4%-5% (inflation of 8% over the last twelve months less the current interest rates between 3% and 4%). Confusion results, though, when certain commentators, including President Biden and some economists, say that real interest rates are now positive, indicating that inflation will abate. The latter conclusion is based on the month to month change in CPI, July being 0.1% less than June, so “there is now no inflation“.
We have consistently made the argument that there is not the political will to raise interest rates sufficiently to reduce the finally unleashed inflation that is basically the result of too much money chasing a relatively fixed amount of goods and services. The change in prices over the last year is primarily the result of almost $9 trillion in the US and close to $20 trillion worldwide being printed out of thin air by central banks since 2008. The Covid and the Russian attack on Ukraine and the supply channel disruptions and the energy shortage are representative of “the tide going out” so we could “see who’s swimming naked”. The margin for error in a worldwide leveraged economy, with lots of capital mis-allocated over a decade of minimal interest rates, was just too small to tolerate relatively short term economic distortions.
US Fed activity has so far been more talk than action. Interest rates are well above the zero bound of the last ten years but still very low historically. The Fed Balance Sheet, at $9T, has been reduced by about $190B from its peak early in 2022. This is far from reversing the $5T of Quantitative Easing in just the last few years. Though actual action has been minimal, stock and bond prices have already corrected materially and there is already a growing chorus of economists and politicians and commentators calling for a slowdown of the Fed activity. Marketplace expectations change materially almost day to day, but the upswing in the stock market and a pullback from the peak of interest rates the last few days seems to indicate a consensus that the 75 basis point Fed Funds Rate monthly adjustments will be scaled back. In essence, the worst is ever and the 2nd derivative of the change in rates is now improving, meaning the rate of change is decreasing. We don’t know exactly what rationale Jerome Powell will provide as the logic behind backing off from the current tightening policy. He might possibly suggest that the month-to-month inflation rate has become the rate to be expected (2% of thereabouts) and a 3.5-4.0% Fed Funds rate is sufficient to control inflation going forward. Keep in mind that Alan Greenspan, Ben Bernanke, Janet Yellen, and now Jerome Powell have consistently demonstrated their lack of foresight.
We expect that inflation, understated, as it is by the CPI, will likely come down, affected by the sharp decline in the housing, autos and other interest rate sensitive industries. Household savings, as a percent of discretionary income, is now running at a new recent low of 3.5% (down from over 30% at the beginning of the Covid) and credit card debt just made an all time high. On the other hand, wages only go up, energy costs are moving up again and the US Strategic Energy Reserve must be rebuilt at some point, utility and insurance expenses are higher (for example), rents are much higher than a year ago and will be firm because young families cannot afford to carry a 6-7% mortgage, and housing represents about 25% of the CPI. Accelerated inflation abroad, caused by recent rounds of easing in Britain, Japan and China will raise the price of our imports, which may or may not be offset by the relative value of the US Dollar.
Overall, we expect the year-to-year inflation rate to come down to 5-7% over the next six months, still materially higher than expected short term rates of about 4%, providing a negative return of about 2%. That is a long way (400 bp) from the necessity of a positive real rate of at least 2% to put further pressure on the inflation rate. Recall that Paul Volcker raised Fed Funds rate to 18% to squeeze out 13.5% inflation. Also keep in mind that sovereign debt around the world is too large ($31 trillion in the US) to gracefully tolerate materially higher rates. Some economists suggest that today’s economy is not similar to the 1970s and they are right. Today’s debt and deficits in the US, adjusted for the size of the economy, are 4-6x larger than in the 1970s (and no better worldwide). A serious recession from 1980 to 1983 was the result of removing the monetary punch bowl of the 1970s. Since the current addiction to easy money is an order of magnitude larger, we can assume that the discomfort of withdrawal would be proportionate.
We expect continuing volatility in the capital markets as influential commentators (such as current and former Federal Reserve officials) express their opinions, but it is (literally) day to day “noise”. The worldwide economy is clearly in the “stagflation” that we foresaw many months ago. We will be fortunate if this period is no worse than in the 1970s.
Our readers know that we have long favored gold related assets to protect purchasing power inn these turbulent financial times. Gold bullion has in fact proven to be a relatively safe haven, very long term, over the last twenty years, even in the last twelve months. Gold mining stocks have not, generally down about 75% from their highs ten years ago, today representing a true “value” play. Both were down modestly until the last few months when interest rates and the US Dollar spiked upward, putting them under even more short term pressure. Over the last ten trading days, both recovered (about 5% for bullion and 15% for the gold miners, as the US Dollar and interest rates retreated from their highs. Yesterday’s price action in gold and the gold mining stocks may have been an important turning point. Interest rates and the US Dollar were strong, and strong and gold related assets went UP. That’s the best relative trading action we have seen for gold related assets in a very long time. Along with the fact the Federal Reserve is so quickly losing credibility, which is also a major plus for the “real money”, the price performance of our favorite asset class may from this point forward justify our long term conviction.
Roger Lipton