Fed credibility is slipping and it's not funny. It's getting downright scary.
Yesterday’s sell off in gold has led to concerns that the >20% year-to-date rally in gold prices could begin to reverse. In our view this is primarily the reaction to renewed expectations that the Fed is indeed prepared to raise rates again, which has led to large sell orders and pushed gold below a key technical level at USD1302/ozt.
However, the asymmetry in the gold price outlook remains clear. There is very little downside to prices from here even if the Fed raises rates multiple times over the coming year or two. Indeed, we see several triggers that could push gold prices sharply higher from here over that time horizon.
The sharp price decline came on the back of hawkish comments from Federal Reserve Bank of Richmond President Jeffrey Lacker today and Federal Reserve Bank of Cleveland President Loretta Mester yesterday. Mr. Lacker said today in Charleston:
“While inflation pressures may seem a distant and theoretical concern right now, prudent preemptive action can help us avoid the hard-to-predict emergence of a situation that requires more drastic action after the fact,” thus urging the Fed to raise rates before year-end.
On Monday, Cleveland Fed President Mester said in a Bloomberg TV interview that the economy is ripe for rate hike and highlighted that the November Fed meeting should be considered a “live” meeting (although she added that she considers all meetings as “live”) and a November rate hike compelling, despite its close proximity to the US presidential elections.
These comments have sent real-interest rate expectations as measured in 10-year TIPS sharply higher which pushed gold prices sharply lower (see Exhibit 1). Tuesday saw unusually high activity in the gold futures market. The hawkish Fed talk triggered large sell orders, which pushed gold prices below the key technical levels of USD1300-1302/ozt, exacerbating the sell-off. This is something we have witnessed before.
The Fed has tried to appear hawkish while the actual policy outlook has in fact become ever more dovish. At the end of 2015 there were 4 rate hikes expected and telegraphed by the Fed in the Fed dot-plot. The Fed dot-plot shows the forecasts of each of the 16 members of the FOMC. Each dot represents a member’s view of where interest rates should be at for various timeframes, including a “long run” projection which represents where members think interest rates will be at the end of a hiking cycle.
For 2016 the FOMC members expected 4 hikes (not including the first hike at the end of 2015). So far there have been none, and the Fed members have continuously revised down their projections not just for this and next year, but also for the terminal (long run) rate. But every time after markets were disappointed by another zero round, some FOMC members came out with hawkish statements, and sometimes the Fed minutes suggested that the FOMC became more hawkish.
Every time the market reacted the same way: It pushed real interest rates higher and gold lower, and every time so far it was only temporary. Gold moved gradually higher, reflecting weaker interest rate projections.
So what happens to gold when the Fed actually raises rates?
We think not much. The reason is that real-interest rates can’t really move much higher from here even if the Fed raises rates. The Fed’s own projection for terminal rates is now just 2.85%. The Fed will most probably only raise rates if inflation reaches or exceeds its own target of 2%, which would imply that real-interest rates (currently at 0.04%) are capped at 0.85% over the long run.
This upside limit on real interest rates sets the floor for gold prices and explains why its price outlook is skewed to the upside. Yes, if everything goes perfectly and the Fed gets the chance to raise rates to its target over several years (without encountering any economic slowdown along the way) while maintaining a 2% inflation rate, then gold prices have a little bit more downside, but less than 10% (see Exhibit 4).
In fact, there are many more potential drivers to the upside.
For gold to go higher from here it doesn’t need any Malthusian thinking. None of the scenarios above require a renewed global meltdown of financial markets or an even bigger event, such as a full blown currency crisis. The Fed itself has simply set the floor for gold prices by revising its own guidance for rates to a point where the most hawkish scenario is that real-interest rates can only move marginally higher from here.
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This is a Hedgeye Guest Contributor research note written by Stefan Wieler for Goldmoney Insights. Wieler is a Vice President at Goldmoney Inc. He was previously an Executive Director and senior commodity strategist at Goldman Sachs. This piece does not necessarily reflect the opinion of Hedgeye.
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Takeaway: Europe's Bond Bears get paid if the continent's growth accelerates. That ain't happening.
Yesterday, rumors were floated that the ECB would wind down ("taper") its €80 billion per month bond-buying stimulus. European bond yields backed up on the news (see chart below). As Hedgeye CEO Keith McCullough wrote in a note to subscribers earlier this morning:
"It wasn’t just a U.S. Dollar/U.S. Treasury ramp yesterday, it was another bounce (to lower-highs) in European Yields too on some ridiculous rumor that “the ECB is going to taper” – the ECB denied that, obviously, this morning but there are plenty of 2016 Bond Bears out there looking to get Fed. Winter is coming. And they’re starving…"
Bond Bears get fed if European growth accelerates. That ain't happening. (Note: One of our 3Q16 Macro themes is #EuropeImploding.)
Maybe the Bond Bears should go back into hibernation...
Takeaway: We say keep buying Long Bonds (TLT) and ignore hawkish chatter from regional Fed heads.
The market is giving you another opportunity to buy LONG BONDS ($TLT).
Yesterday, Richmond Fed head Jeffrey Lacker said he sees a "strong case" for raising interest rates. He even suggested rates could rise a lot. The market took him at his word. The 10-year Treasury yield is at 1.69% today.
As you can see in the chart below, with every rate hike freakout (rising yields) it's been a great call to buy bonds. In other words, the Fed has wanted to hike rates all year but we continue to get #GrowthSlowing data. As a result, the Fed takes rate hikes off the table and bond yields fall. (TLT is up 12% year-to-date versus 5% for the S&P 500)
In short, stop hyperventilating. Stick with what's worked all year.
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