Financial markets hold their breath ahead of Powell’s speech at the bankers’ symposium. What would he have to say to change the bearish outlook for gold stocks?
Sentiment on Wall Street is relatively dormant as investors unsure how to position themselves ahead of Powell’s Aug. 26 Jackson Hole speech. As a result, PMs painted a mixed picture as they were up 0.02%, down 0.63%, the ETF was up 0.82% and the ETF was up 1.76%. Additionally, miners were helped by a 0.29% gain in the index and the index ended relatively flat up 0.06%.
Conversely, US Treasury yields continued to rise and many markets have re-rated in more hawkish directions. As such, recent strength in PMs is much more appearance than substance.
Expect the impossible
As the late summer sun offers risk assets a calm respite, the panic we experienced in June has turned to calm. As recession fears subside significantly and the Fed’s inflation battle is viewed as nearing completion, the consensus expects the Fed to work miracles and reignite another bull market.
However, the plant-wide effects signal significantly different results. For example, the Cleveland Fed is forecasting another flat month of US headline inflation, with market participants expecting the (CPI) to be on the overtake path to 2%.
However, while the outlook has helped lift the S&P 500, US breakeven inflation rose to 2.62% on Aug. 24 as more bets on the notion of a soft landing. Additionally, the metric is a long way from its peak of 3.02%. Why are April’s 10-year inflation expectations rising when the Fed is said to have won the inflation war?
10-year breakeven inflation rate
Up to this point, the GDXJ ETF often tracks the movement of the US 10-year breakeven inflation rate. Therefore, the latter’s bounce off the July lows helped lift the young miners.
To clarify, the highs and lows in the price of the GDXJ ETF over the past 12 months are quite comparable to the highs and lows set by the US 10-year breakeven inflation rate. However, if you analyze the right side of both charts, you can see that the US 10-year breakeven inflation rate has surpassed its late July high, while the GDXJ ETF has not. As a result, despite the tailwind from investors’ conflicting expectations, junior miners remain relative underperformers.
While the 10-year breakeven inflation rate was scrambling for a higher bottom, so was the US 10-year Treasury yield (closed at 3.11% on 24th August). Hence, the latter slightly outperforming the former, the real yield on US 10-year bonds remains positive and continues to rise.
Market returns on US Treasuries
Although I have warned throughout 2021 that fighting inflation will require a substantial increase in real yields, nothing has changed. While the S&P 500 remains relatively calm and the media says inflation is “old news”, the bond market is not reflecting this sentiment.
Think about it: quantitative tightening (QT) is set to double next week and the liquidation of the Fed’s balance sheet should tighten financial conditions and help ease inflation (a quasi-rate hike). Additionally, if the Fed is prioritizing the move in long-dated bonds, selling the US 10-year Treasury makes sense to fuel the action.
Conversely, if the consensus narrative is correct, the US 10-year breakeven inflation rate should not rise. With the Fed announcing more rate hikes and QT poised to ramp up tightening pressures, these tools should lower, not raise, investors’ inflation expectations. As such, The “Fed Pivot” narrative helping to lift the S&P 500, gold, silver and mining stocks is built on a flawed foundation.
As further evidence, the interest rate futures market created the pivot narrative by pricing in rate cuts in 2023. However, while the interest rate futures market had priced in a US interest rate (FFR) of 3.20% during the highest pivot expectation, it rose to 3.79%.
Source: CME
To clarify, the prices above track 30-day FFR futures for various monthly expirations. For comparison, the implied interest rate is calculated by subtracting the last settlement price from 100. Therefore, the red box above shows that market participants are pricing in an FFR peak of 3.79% in April 2023 (100-96.21). Additionally, the blue box above shows that they are still pricing in an insignificant rate cut in July 2023 (100-96.28 = 3.72%).
So while a peak FFR of 3.79% is still well below the 4.5%+ we expect for 2023, the bond and futures markets have readjusted their expectations in a deeply hawkish way. In addition, the foreign exchange market is also aligning.
To explain, the USD Index has recouped almost all of its July declines and is near a ~20-year high. As a result, All of the radical fundamental realities that turned the S&P 500 and PMs upside down in 2022 have reemerged, while only the narrative has changed.
Therefore, the important point is that many markets have repriced to reflect the difficulty of normalizing unanchored inflation. However, the PMs and the S&P 500 are not. With bulls anticipating history and positioning in the bond, futures and FX markets, gold, silver, mining stocks and the S&P 500 should all suffer when the lightbulb goes out.
A round trip
While I have warned throughout 2021 that inflation would force the Fed to act and lead to multiple rate hikes, the consensus’s reliance on the central bank is as misguided today as it was then. For example, see this Reuters headline from June 2021:
Minneapolis Fed President Neel Kashkari said at the time:
“I still don’t have any increases in the SEP forecast horizon because I think it will take some time before we really hit maximum employment and I believe these higher inflation readings will only be temporary.”
While the bulls were keen to follow Kashkari’s lead (not fight the Fed), we have had nine 25 basis point rate hikes in 2022, another 50 to 75 basis points should start in September and QT is set to double.
Additionally, since the most dovish Fed member in 2021 is now one of the most hawkish, the difference ~14 months makes is amazing.
Source: Bloomberg
He added:
“If inflation is 8% or 9%, we run the risk of dissolving inflation expectations and leading to very poor outcomes that would require us to be very aggressive – Volcker-esque – and then anchor them again. We definitely want to avoid such a situation developing. So, with inflation that high, I’m in the mood that we have to make mistakes to make sure we bring inflation down and only relax when we see compelling evidence that inflation is on the way back to 2% . .”
Although Kashkari has finally seen the light of day, not all FOMC members share his view, and certainly not the S&P 500 and PM bulls. In short, they continue to position themselves for dovish stance as Fed Chair Jerome Powell calls inflation a concern but easily solvable.
However, history suggests otherwise. remember Powell is trying to reduce peak inflation from above 9% (for now) with ~3.5% FFR. If he succeeds, he will achieve what no other Fed chair before him has achieved.
So do you think previous committees wanted to take FFR above or within ~50 basis points of CPI year-on-year (YoY)? Of course not. If they could have eased inflation without causing economic hardship, they would have. Therefore, on August 12, I warned that investors should ignore the story at their peril. I wrote:
The FFR has either eclipsed the YoY headline CPI or come within ~50 basis points of its peak in every inflation battle since 1954. So please look at the unprecedented gap on the right side of the chart. With y/y CPI topping out at 9.1% (for now) and FFR at 2.5% (the upper end of the Fed’s 2.25% to 2.5% range), the difference is 6.6 %.
As a result, The story implies that the FFR must reach at least 8.6% (which marks ~50 basis points below the current CPI high). Furthermore, while we do not expect the FFR to reach this level, the purpose is to show how ridiculous a 3.5% FFR and inflation above 9% is from a historical perspective. In reality, an FFR above 4.5% is much more realistic and the prospect is far from being priced in.
Also, notice how each rise in inflation leads to higher FFR and then recession (the gray bars)? Do you really think this time is different?
The final result
From a fundamental perspective, investment returns are driven by the difference between what is priced in and what actually happens; and with investors pricing in wildly unrealistic outcomes, the Fed will rewrite history if it lands softly. While the S&P 500 and PMs are behaving as if a Goldilocks result is inevitable (the stock market is pricing in only a 20% chance of a recession), the futures, bond and FX markets have much less confidence. As a result, the bulls only have narratives on their side at this point.
In summary, PMs were mixed on August 24 as Silver ended the day in the red. While financial markets have largely gone quiet as investors await Powell’s Jackson Hole speech, nothing he says will change the troubling fundamental realities facing financial assets in the coming months. As such, we expect the GDXJ ETF to make lower lows in the medium term, regardless of whether Powell initiates a short-term rally in the coming days.
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