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Guest Contributor: The Fed’s Impending Inflation Disaster?

by Dr. Daniel ThorntonD.L. Thornton Economics

 

Guest Contributor: The Fed’s Impending Inflation Disaster? - dollar press 28

 

The Fed engaged in a massive bond-buying spree following the Lehman Brothers bankruptcy announcement on September 15, 2008. The bond-buying program, commonly referred to as quantitative easing (QE), ended October 2014. However, the Fed pledged to maintain its balance sheet at the $4.5 trillion level indefinitely.

 

QE was intended to reduce yields on long-dated Treasuries, mortgage-backed securities, and agency debt. The effect on these yields would spread to other long-term yields through arbitrage, or what chairman Bernanke called the portfolio balance effect.

 

Guest Contributor: The Fed’s Impending Inflation Disaster? - thornton callout 22  

There is considerable debate whether or to what extent QE reduced long-term yields. But there is another effect of QE that is unassailable, although it has received almost no attention. Specifically, QE produced a massive increase in the M1 money measure. M1 increased by $1.9 trillion from August 2008 to October 2016—more than it increased during its previous 48-year history. This is shown in Figure 1 (the vertical line denotes September 2008).

 

Guest Contributor: The Fed’s Impending Inflation Disaster? - thornton impending

 

On October 3, 2008, Congress passed The Emergency Economic Stabilization Act of 2008 which permitted the Fed to pay interest on excess reserves (IOER). It was thought that IOER would enable the FOMC to control the federal funds rate, while at the same incentivize banks to hold the reserves created by QE as excess reserves in order to avoid a massive expansion of the money supply.

 

This didn’t happen. Here’s why:

FIRST

Banks had so many reserves that they no longer financed lending by issuing large negotiable certificates of deposits (CDs) and by borrowing continuously in the overnight federal funds market. Prior to QE, only a small fraction of loans were financed by reserves. Now, reserves finance nearly all bank lending.

SECOND

Banks have an incentive to make any loan with a risk-adjusted interest rate higher than IOER. This is not a difficult task. Many loans are at least partially collateralized and are made at rates significantly higher than the IOER. Hence, banks are making all high-quality loans as well as some risker loans than they would were they not holding massive amounts of excess reserves.

 

The Wall Street Journal (WSJ, July 23-24, 2016) reported that some banks were lowering the credit score requirements and making even riskier loans. Other banks were bolstering their reserves in anticipation of higher loan losses on the loans they had already made.

THIRD

The Fed has a fractional reserve system. This means every dollar of reserves can finance multiple dollars of loans and the corresponding amount of checkable deposits — the core component of M1. Total checkable deposits increased by $1.3 trillion since August 2008, more than twice the increase during the past 48 years.

 

The Fed’s highest reserve requirement, 10 percent, means every dollar of reserves could support $10 of checkable deposits. But the Fed’s system of reserve requirements is complex so the ratio is not 10. The ratio of checkable deposits to required reserves has been higher than 10 since 1991. It has trended down somewhat since August 2008 because all loans have been financed with reserves, but averaged 11.5 during the past year.

All of this means...

... that as long as banks continue to make loans, the money supply will continue to expand. The potential expansion is finite, but incredibly large! Banks still hold nearly $2 trillion in excess reserves. This means that banks would have to make additional loans of $23 trillion in order to convert all of their excess reserves into required reserves, an impossible task — the national debt is $19.3 trillion.

 

Many economists believe that banks are holding excess reserves because of the IOER. This is ridiculous. The FOMC increased the IOER to 75 basis points last week. But that won’t halt the rapid growth of M1. The IOER would have to be much higher than 75 basis points. Moreover, as George Selgin has pointed out (WSJ, Sept. 27, 2016) there appears to be a legal barrier to having the IOER high enough to achieve this objective.

 

Guest Contributor: The Fed’s Impending Inflation Disaster? - thornton callout 23

 

The Fed could prevent further growth of M1 by imposing 100% reserve requirements; banks would only be able to increase loans and the money supply by $2 trillion. But increasing reserve requirements above 12% requires amending the Federal Reserve Act. This would take time and it is unlikely Congress would do it.

 

Alternatively, the FOMC could shrink its balance sheet. It has done this to a limited extent by continuously rolling over about $400 billion in reverse repurchase agreements. But to be completely effective, the balance sheet needs to be reduced to a level where banks finance nearly all of their lending as before.

 

As long as banks have more excess reserves than they would like to hold and they can make loans with a risk adjusted rate of return higher than the IOER, they will continue to finance lending with excess reserves, and the money supply will continue to increase.

 

Some may argue that the size of M1 is not a problem because inflation is below the FOMC’s 2% target. Others might suggest that M1 is not a problem because spending is more closely tied to broader monetary aggregates, like M2. While the growth of M2 is not as dramatic, it has increased 70% over the past 8 years.

 

In any event, the recent growth in M1 is unprecedented, so we have no idea what might happen. I don’t believe its effect will continue to be reflected only in equity and real estate prices. It seems likely that it will eventually inflate a broad range of consumer prices as well. Should this happen, the FOMC will find it nearly impossible to shrink its balance sheet fast enough to avoid further large increases in M1.

 

Moreover, the FOMC will find it extremely difficult to reduce M1; draining excess reserves is one thing, draining required reserves is another. Indeed, all new lending would cease because banks would have to issue large amounts of CDs just to finance their existing loans; the multiplier works in reverse, too.

 

Consequently, the FOMC may be unable to avoid an inflation disaster.

EDITOR'S NOTE

This is a Hedgeye Guest Contributor research note written by Dr. Daniel Thornton. During his 33-year career at the St. Louis Fed, Thornton served as vice president and economic advisor. He currently runs D.L. Thornton Economics, an economic research consultancy. This piece does not necessarily reflect the opinion of Hedgeye.


Guest Contributor: Why George Soros Is Right On Investor Psychology

Takeaway: To improve ourselves as investors we must learn from our mistakes, and the best perspective to take is one of curiosity and flexibility.

by Richard Peterson M.D., MarketPsych

 

Guest Contributor: Why George Soros Is Right On Investor Psychology - brain12

 

As Brexit before it and the Italian referendum following it, November's U.S. election represents a social turning point.  Some believe the light is fading across Western democracies.  Others sense renewed engagement after a long period of public passivity.  Both camps see this as a pivotal moment in history. 

It's not only democratic engagement that's at a turning point.  This time of year, across the northern latitudes, nature is growing quiet. Plants and animals have stored away food for the cold months and months of dormancy. When the snow comes, the quiet will be even deeper. During the darkness of winter, this week's solstice marks a turning point in the season.  December's holidays symbolize the renewal of life, light, and growth from the depths of darkness.  


After the November U.S. elections a rapid shift in media sentiment strongly correlated with the rally in U.S. stock prices, and this was surprising to many market-watchers, who anticipated a large correction if Donald Trump was elected.  

 

Guest Contributor: Why George Soros Is Right On Investor Psychology - peterson callout


Both around strongly felt events and during the dark of winter, the human mind is susceptible to inertia, becomes trapped into believing narratives (E.g., "Trump/Hillary means the end of the world") or ("maybe the light will never return"), and the mind has difficulty shifting perspective.  For the seasonal darkness, societies developed light-themed holidays (Diwali, Hanukah, Christmas, Santa Lucia) to break through inertia during dark days. For individual investors, some top performers use a technique called "reappraisal" to prevent inertia.  When predicting market prices, impartial machine learning-based systems are proving to be a valuable tool when the majority of human investors are stuck in a rut.  


Today's newsletter examines sentiment shifts around events, the power of machine learning to take advantage of these, and a technique used by top investors to avoid mental inertia. 

Did Artificial Intelligence Predict the U.S. Election?

Although the darkness will continue to lengthen into the solstice this week, light will begin its return on the 22nd.  We described a similar reversal phenomenon in market prices in our last newsletter.  A sell-off into an uncertain event such as an election typically reverses in the subsequent period.  Sometimes prices reverse after the event because the sense of dread and foreboding is gone, replaced by relief that the event has passed. Sometimes prices revert upwards because of growing optimism about business conditions.  Probably both of those occurred following the U.S. election, juiced onwards by investors who had sold out in advance to reduce their risk exposure, and now jumped back in out of fear of missing out on the post-election rally.


The following image depicts our financial media-derived sentiment data versus the S&P 500 daily prices this year.  From a low point in November before the election, sentiment jumped impressively in the hours following Trump's victory.

 

Guest Contributor: Why George Soros Is Right On Investor Psychology - peterson1

 

Such rapid sentiment reversals are difficult for humans to time accurately.  We tend to become absorbed into the story around the events.  Such event-inflexibility provides an opening for machine-learning-based predictive models.

As we mentioned in our September newsletter, we've developed such a machine learning based model that makes predictions on the S&P 500, and it was extraordinarily accurate not only in the two weeks around Brexit, but also in the week of the U.S. election and the following week.  It was long the day before the election, went short the day of the election through the following opening, and was long over the following week. However, the system is not perfect.  It had periods of poor performance in October and so far in December this year - please see disclaimers below.  It especially shines around major psychology-driven events such as corrections and referenda.


Our machine learning-based model probably performs so well around uncertain events because it can impartially take advantage of the human biases that blind the majority of traders.  While these collective biases can be disabling, some top investors have found ways to reduce the impact of such vulnerabilities via a practice of "perspective-shifting."

Perspective-Shifting

In his “Belief in Fallibility" George Soros (1995) explains that to others being wrong is a source of shame. But for him, recognizing his mistakes is a source of pride. Soros explains that realizing that imperfect understanding is the human condition leads to no shame in being wrong, only in failing to correct our mistakes.  It requires remarkable courage to consider one's imperfections and mistakes impartially.  And evidence suggests that the ability to reappraise one's circumstances is an important tool for reducing common financial biases.

 

Guest Contributor: Why George Soros Is Right On Investor Psychology - soros 1

Researchers have found that cognitive reappraisal reduces the impact of loss aversion on decision making (Sokol-Hessner et al, 2009). Reappraisal refers to readjusting one's perspective of a situation along several dimensions. In an experimental condition, researchers randomly asked subjects to think of / review their individual investments in the following contexts:

 

  1. As part of a portfolio
  2. As one of many in a series
  3. As part of a routine job
  4. As expecting that losses are going to happen (“you win some and you lose some”), and
  5. As not having direct consequences for their lives.

 

In aggregate these cognitive reappraisals reduced both physiological reactions to losses (measured via galvanic skin response) and subsequent loss-aversion (biased behavior). According to Sokol-Hessner (2009), “‘perspective-taking,’ uniquely reduced both behavioral loss aversion and arousal to losses relative to gains, largely by influencing arousal to losses.” 


In summary, Soros is right.  To improve ourselves as investors we must learn from our mistakes, and the best perspective to take is one of curiosity and flexibility.  We must shift our perspective from one of "Oh no, another bad mistake!" to "Great, another opportunity to learn!"  

When approaching losses, thinking about the loss as:

 

  1. A routine part of the job of investing
  2. As one of many that one will experience over a typical career, and
  3. As not affecting one's physical life or health, will help normalize the loss and improve subsequent decision making.

Houskeeping and Closing

We are approaching the dead of winter in the northern climates.  The holidays ahead teach us to maintain hope in the darkness and to celebrate the value of persistence as we carry the light forward into the new year.  


Despite the impressive results of machine learning in financial markets, the victory of the machines is not yet at hand.  Machine learning thrives in environments where humans do not, such as around psychologically fraught events (elections, volatility, etc...).  Where humans are inflexible, machines prosper. Taking a larger view, these periods of inflexibility can teach us about our own weaknesses such as our propensity to make mistakes in markets with fast-moving prices or when we believe fixed narratives about how things should be.  

 

Always seeking new perspectives,

Richard Peterson M.D. and the MarketPsych Team

 

References


Sokol-Hessner, Peter, Ming Hsu, Nina G Curleya, Mauricio R. Delgado, Colin F. Camerer, and Elizabeth F. Phelps. 2009. “Thinking Like a Trader Selectively Reduces Individuals’ Loss Aversion.” Proceedings of the National Academy of Sciences 106 (13): 5035–5040.

 

EDITOR'S NOTE

This is a Hedgeye Guest Contributor piece written by Dr. Richard Peterson. Peterson is CEO of the MarketPsych group of companies where he leads MarketPsych's data and asset management division. He has trained thousands of professionals globally to leverage behavioral insights. He is a board-certified psychiatrist and author of Trading on Sentiment.This piece does not necessarily reflect the opinion of Hedgeye.


Guest Contributor: Is the Emerging Market Currency Plunge Really About Trade?

by Benn Steil and Emma Smith

 

Guest Contributor: Is the Emerging Market Currency Plunge Really About Trade? - em

 

Emerging market assets have taken a beating since Donald Trump’s surprise election victory on November 8.  Emerging market bond prices are down 4.4 percent, equities 4.6 percent, and currencies 4.1 percent.  But is this really, as the Financial Times proclaimed, about “fears of trade protectionism”?

 

No.  If Trump’s trade threats were the driver, we would expect a negative relationship between the size of an EM currency’s move and the country’s exports to the United States (as a percentage of GDP).  Instead, as the left-hand figure above shows, that relationship is slightly positive.  Only Mexico, whose trade surplus with the United States was a direct target of Trump’s during the campaign, shows the expected relationship.

 

So what is the driver? 

 

Expectations of more U.S. government spending, higher interest rates, and a stronger dollar.  Markets now see a steeper path for U.S. rates—three Fed rate hikes are priced in between now and the end of 2017, compared to only one before the election.  This raises the cost of servicing EM dollar-debt.  And as the right-hand figure above shows, there is a positive relationship between the size of an EM currency’s move and the country’s external debt.  Russia is an outlier, as markets expect improved U.S.-Russia relations and relaxation of trade and financial sanctions.

 

In short, markets do not see Trump igniting a global trade war.  But they do see big challenges ahead for heavily indebted emerging markets.

EDITOR'S NOTE

This is a Hedgeye Guest Contributor piece written by Benn Steil and Emma Smith and reposted from the Council on Foreign Relations’ Geo-Graphics blog. Mr Steil is director of international economics at the Council on Foreign Relations and author of The Battle of Bretton Woods. It does not necessarily reflect the opinion of Hedgeye.


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Guest Contributor: Mamma Mia! Why Italian Bank Bailouts Won't Be Enough

by Daniel Lacalle

 

Guest Contributor: Mamma Mia! Why Italian Bank Bailouts Won't Be Enough - italy image

 

In the current market environment we must distinguish between unfounded fears and structural problems. The Italian banks' Non Performing Loan (NPL) dilemma is now structural and has not been solved. In fact, the political crisis opened with the resignation of Renzi may have an important impact in an already fragile financial sector.

 

The Italian banking problem is much deeper than a matter of “perception of risk." Non Performing Loans exceed 360 billion euro  (according to PWC) and have been growing since 2011, from 194 billion euro to the current figure. It is true that the percentage relative to total loans peaked at 18% and has fallen slightly to 17%, but it is also true that many of these loans are now simply impossible to recover.

 

The problem is that Italian banks are unable to do a Bail-In as the amount of shareholder equity and secured bonds outstanding is far too small to cover a gap that has taken too long to resolve. A Bail-In would consume almost all of the capitalization of some banks. Meanwhile, as stocks plummet even further, the possibility of a radical capitalization seems remote.

 

Guest Contributor: Mamma Mia! Why Italian Bank Bailouts Won't Be Enough - italy monte

 

Italian NPLs are mostly to corporates -79% of the total- and unsecured -53% of the total. Low interest rates and high liquidity have not reduced, but increased the risk. Half are covered by real estate collateral, so they don´t have zero value.

 

The NPL problem has become so large that, years after the 4 billion euro bail-out, market rumours point to a new capital injection from the Italian State that could reach 15 billion euro. A far too small amount for a very large problem. The possibility that the Italian government might take a majority stake in Monte dei Paschi di Siena is not small, in a bank where the ratio of NPL to equity is c102%.

 

But make no mistake, a 15 billion government capital injection is far from the solution.

 

Italy needs to undertake a Financial Sector Reform similar to the one that Spain carried out. Creating a “bad bank” and carrying out an in-depth public analysis of the sector´s assets and liabilities, followed by a radical recapitalization program.

What is the good news?

The capital ratio of highest quality has improved over the years, albeit less than other banks in the Eurozone and Italian banks have been divesting and increasing capital whenever they could.

 

In 2015 more than 19 NPL transactions were made, and in 2016 that figure is expected to exceed 30 billion euro GBV (gross book value). Although it´s less than 10% of the total, it is good news for a long-overdue course of action that is expected to accelerate over the next three years.

 

But here comes the political uncertainty. Will an interim government accept a bail-out that goes against EU legislation, most of the political parties in Italy and the promises of the previous Renzi cabinet?

 

Additionally, macroeconomic data does not support the Italian economy. Italy has been showing a very poor growth rate since 1960, and remains in stagnation in the past two decades. Low oil prices have not helped despite being one of the most sensitive economies to fluctuations in crude prices in the OECD. Italy’s public debt exceeds 132% and debt to operating income of Italian corporations remains above the average of the euro zone and the OECD, according to Moody’s.

 

Guest Contributor: Mamma Mia! Why Italian Bank Bailouts Won't Be Enough - Italian bank cartoon

 

But most of the problem relies in the semi-state owned entities and municipalities. If we remove the semi-state-owned conglomerates and municipalities, Italian companies show a similar balance sheet strength to German corporates, for example.

 

The Italian banking system challenges have not created a contagion effect on the rest of the eurozone, but this cannot be considered a relief. As soon as the ECB stops or moderates its quantitative easing program, we could see an escalation of risk premiums and Credit Default Swaps.

 

The solution is possible and urgent. It should include a comprehensive plan of recapitalization, restructuring of bonds and creating a bad bank.

My biggest concern...

... is that, again, in Italy they might prefer to kick the can forward with the excuse that in 2017 inflation and the economy will sort out the problem, and that shares will rise before issuing new equity. After years making the same mistake, it is time to be realistic. The short squeeze generated by the rumours of an insufficient bail-out should not fool rational investors.

 

Editor's Note

This is a Hedgeye Guest Contributor note written by Daniel Lacalle who is an economist who previously worked at PIMCO and was a portfolio manager at Ecofin Global Oil & Gas Fund and Citadel. Lacalle is CIO of Tressis Gestion and author of Life In The Financial Markets and The Energy World Is Flat.


Guest Contributor: Are U.S. Equities The Best House In A Bad Neighborhood?

by Mike O'RourkeJonesTrading

 

Guest Contributor: Are U.S. Equities The Best House In A Bad Neighborhood? - us house

 

For the past several years, the US financial markets have been described as the “best house in the bad neighborhood” of global investing. The strengthening Dollar, an extremely resilient Equity market and a Treasury market bubble all reinforced this thinking.

 

It is no secret that over the course of the past month since the US Presidential election, market expectations have shifted dramatically. The pre-election belief that a Trump victory would have been a disaster for financial markets was erased overnight, and replaced with expectations of pro-growth policies that increase spending while reducing taxes, regulation and global trade.

Guest Contributor: Are U.S. Equities The Best House In A Bad Neighborhood? - orourke calllout

 

As such, it merits taking a snapshot of global equity markets and their relative performance versus the US equity market as investors prepare for the changing landscape. Due to the importance of currency moves in influencing returns, we have chosen to chart the relative performance of iShares of each respective country ETF’s (which don’t hedge currency) versus the SPDR S&P 500 (SPY). 

 

Guest Contributor: Are U.S. Equities The Best House In A Bad Neighborhood? - orourke 1

 

There is a table below that lists the performance of the respective iShares ETF divided by the SPDR S&P 500 ETF over various periods of time. It is interpreted as being long the iShares and short the SPDR. There are charts below illustrating the relationships over the past 3 years. The black line is the year-over-year change in this relationship.

 

It is important to note the combined performances of the equities and currencies of other global markets has been abysmal relative to the US over the past 5 years. Most of these counties have experienced year in and year out compounding underperformance versus the US over that time. Over those years, currency weakness versus the Dollar was notable.

 

Many investors were concerned about...

 

... Federal Reserve tapering and then the normalization process, which has encountered fits and starts. What should be noted is that the downward momentum has faded in many cases, and while in many cases the year over year performance is still negative, it is an improving rate and in many cases, preparing to turn positive.

 

Of the 15 different country iShares we measured relative to the SPDR, 11 are outperforming the US over the past couple of weeks. One has to consider that after 5 years of underperformance relative to the US on a combined equity and currency basis, the new confidence investors have in the US growth and the monetary policy outlook (normalization resuming) is prompting investors to go bargain hunting overseas.

Bottom Line

The “flight to safety” trade of hiding in the US equity market may be starting to unwind here. While that does not necessarily mean that US equities need to drop, we would expect capital flows to broaden out into other markets. This should slow or reverse the strength of the very narrow global leadership that has been highly focused on the US. 

 

Guest Contributor: Are U.S. Equities The Best House In A Bad Neighborhood? - orourke 22

 

Guest Contributor: Are U.S. Equities The Best House In A Bad Neighborhood? - disclaimer

Editor's Note

This is a Hedgeye Guest Contributor note written by Mike O'Rourke. Mike is the Chief Market Strategist at JonesTrading where he advises institutional investors on market developments. This piece does not necessarily reflect the opinion of Hedgeye.


Guest Contributor | Gold Sell-Off: How Low Can It Go?

by Stefan WielerGoldmoney Insights

 

Guest Contributor | Gold Sell-Off: How Low Can It Go? - goldmoney12

 

The market is currently pricing in a goldilocks scenario of stronger economic growth, stable inflation and partial normalization of interest rates. This has put upward pressure on the U.S. Dollar and downward pressure on gold prices. Importantly, this extremely optimistic scenario is also the only scenario in which gold prices can fall meaningfully. In our view, even under the most optimistic outlook, the Fed will not be able to raise rates to levels that would push gold significantly lower over the long run.

 

Since the recent US elections gold prices in USD have sold off 7% and prices are down 13% from the year’s highs. This has led some market commentators to declare this as a turning point in the renewed upward trend in gold prices that began last year. In this note we analyze the recent move in prices within our gold price framework with specific focus on three questions:

 

  1. Have gold prices moved in line with changing fundamentals (change in long-datedenergy price, central bank net purchases and most importantly, real rates)?
  2. If not, what is the market pricing in? And more importantly, if prices are in line withfundamentals, what is priced into fundamentals?
  3. How far can this go if fundamentals move further against gold?

As a first step...

We updated our energy-proof of value gold price framework. For this note we use an improved version of our model which we will introduce and explain in greater detail in an upcoming report over the coming weeks. Within our gold price framework, we find that the decline in the gold price was in line with the rise in real rate expectations.

 

The recent move in the gold price came mainly on the back of rising real-interest rate expectations (measured by 10 year TIPS yields) as longer dated energy prices remained roughly flat and central banks in aggregate have continued to increase holdings (the Russian central bank was a large buyer again in October).

 

TIPS yields had dropped to negative territory again in summer this year as the Fed kept delaying the promised interest hikes. Heading into fall, TIPS yields began to gradually move higher to around 10-15bps in October in anticipation of a Fed hike in December. However, the day after the election, TIPS yields rallied sharply to currently 50bps. The move in real-interest rate expectations came on the back of a move in nominal rates. 10 year Treasury yields climbed 100 bps since the trough in July, half of that post-election alone (see Figure 1).

 

Guest Contributor | Gold Sell-Off: How Low Can It Go? - goldmoney1

 

Hence, real-interest rate expectations have lagged the move in nominal rates by about half. The reason is that implied inflation expectations also increased by about 0.5%. We have long argued that the Fed is unlikely to raise nominal rates as long as the inflation outlook remains muted. Hence from a gold pricing perspective, any increase in nominal rates would have to be mitigated by a shift in inflation expectations to some extent, which is what indeed happened over the past few weeks.

 

Guest Contributor | Gold Sell-Off: How Low Can It Go? - goldmoney 2

 

In the context of our model, the move in gold prices is slightly larger than what would have been predicted. Our gold price model predicts roughly a USD 120/ozt drop in price from the recent peak on the back of the 60bp move higher in real-interest rates. However, prices declined by around USD 170/ozt. Consequently, current prices are roughly 5% below our model predictions (see Figure 3), roughly 1 standard deviation of the model error.

 

Guest Contributor | Gold Sell-Off: How Low Can It Go? - goldmoney 5

 

While this is within the normal error margin of the model, we also believe that the model might also not pick up the full extent of move in rates. For example, we use 10 year TIPS yields as input variable for real-interest rates expectations. Gold prices however likely reflect information over the entire rate curve. We believe that expectations further out in the future carry more weight, but the short end of the curve does matter as well. And the move in shorter maturity bonds was nothing short of spectacular, with 1-year yields reaching levels not seen since 2008 (see Figure 4). Hence we conclude that the sharp move lower in gold prices is more or less in line with fundamentals.

 

Guest Contributor | Gold Sell-Off: How Low Can It Go? - goldmoney 3

This brings us to point two:

If prices are in line with fundamentals, what exactly is priced into fundamentals? The move in the 10 year Treasury yield is large but not unprecedented. 50bp+ upward moves within such a short time-frame (10 days) have happened only five times over the past ten years. However, given that rates began near zero makes this move truly extraordinary. In relative terms, 10 year yields went up over 30% in less than two weeks, which has never happened before.

 

This market reaction to the election outcome tells us that expectations are now for a goldilocks scenario of stronger economic growth, stable inflation and partial normalization of interest rates (see “Term premia rising: The financial market implications of higher interest rate risk”, November 22, 2016).

 

One can argue that the economic agenda of president elect Trump - deregulation, tax cuts, and infrastructure spending - will promote economic growth. But the latter two will also – all else equal - increase the budget deficit and thus lead to a higher debt burden. A higher debt level combined with higher rates would put further pressure on the budget deficit. This, combined with potential government spending spree, should get market participants worried about inflation.

 

Guest Contributor | Gold Sell-Off: How Low Can It Go? - callout goldmoney 2

 

Yet while nominal rates have rallied sharply, breakeven inflation expectations have only moved toward the Fed's target of 2%. Hence, it appears that the market is currently pricing in a perfect outcome, where the interaction of all involved factors cancel out all negative effects.

 

  1. The shift to fiscal stimulus, lower taxes as well as the boost to business confidence will lead to high economic growth for years to come.
  2. The resulting increase in tax revenues will be large enough that the increase in spending (infrastructure) and loss in revenues (taxes) doesn’t meaningfully increase the budget deficit and thus debt issuance. The increase in nominal GDP will ensure that government debt/GDP actually shrinks.
  3. This allows the Fed to raise rates despite the higher debt servicing costs…
  4. which in turn keeps inflation pressures at bay that would otherwise arise from increased debt issuance and infrastructure spending

 

The result of this is that real-interest rate expectations can rise which is negative for gold prices. The problem with this scenario is that it is also the only scenario in which real-interest rate expectations can move significantly higher and thus gold lower. Aside from the obvious inconsistencies how the four arguments could interact with each other, this scenario does not allow for any exogenous shocks.

 

And the potential shocks are manifold.

 

First and foremost, the rise in rates has already pushed the USD sharply higher. The trade weighted USD broad index (26 currencies) is near an all-time high at the time of writing (see Figure 5). Even the USD main currency index, which measures the USD against a basket of the strongest currencies in the world (EU, JPY,GBP, CAD, SEK and CHF) is at the highest level since 2003.

 

In the Goldilocks scenario above, the USD would most likely become significantly stronger going forward. This not just reduces US competitiveness but also creates a real problem for many emerging markets. This would also likely not play well into the Fed's fear of deflation either, making rate hikes less likely.

 

Guest Contributor | Gold Sell-Off: How Low Can It Go? - goldmoney 4

 

Other risks are that the market underestimates the impact of higher overall debt servicing costs on economic growth as well as the government budget, a potential implosion of the monetary policy-induced asset price bubble (negative wealth effect), lower global growth, a sharp rise in commodity prices or simply a plain old recession.

 

Any of these scenarios would shatter the current prevailing view.

 

Importantly, even under the Goldilocks scenario, the downside for gold would still be limited. Assuming that economic growth plays out in a way that allows the Fed to raise rates as planned, the Fed's own forecast is currently for terminal rates of only a mere 2.85%. According to the Fed's own forecast, it will take several years to get there.

 

Arguably Fed funds rates are currently 2% below the 10 year Treasury yield and thus as the Fed continues to raise rates, 10 year Treasury yields could go much higher. But historically, when Fed Funds target rates peaked, 10 year Treasury yields were roughly at the same levels. Fed funds rates went through six cycles over the past 30 years and on average, Fed Funds target rates were just 0.25% below the 10 year yield when they peaked (see Figure 6).

 

Guest Contributor | Gold Sell-Off: How Low Can It Go? - goldmoney 6

 

Measuring over the entire period since the end of the gold standard in 1971, including the Volcker years with double digit interest rates, Fed Fund rates actually exceeded 10 year Treasury yields by 1.23% on average at their peaks. Therefore it is doubtful that the 2% premium of the 10-year yield over the Fed funds target rate will still be at the same level once Fed funds rates peak. Hence even if economic conditions allow the Fed to raise rates to its current target of 2.85% while maintaining its inflation goal of 2%, realized real-interest rates will most likely not exceed 1% much.

 

All else equal, that would imply a gold price of USD 1100/ozt. Hence, fundamentals would have to improve to the extent that the Fed would raise rates well above its current target rates in order for gold prices to drop significantly below USD 1000/ozt that some bearish commentators claim is now highly likely.

But how likely is that?

The current federal budget deficit will be around USD 540bn in 2016. Of that, USD 260bn will be federal debt servicing costs. The Congressional Budget Office estimates that federal debt servicing costs will rise to around USD 440bn by 2020 rise further to USD 690bn by 2025 as cheaper debt rolls over and needs to be replaced with higher interest-bearing debt. We find the Bureau's Fed funds rate expectations of 3.5% by 2019 too high.

 

Using the Fed's own guidance of 2.85% terminal rates implies that debt servicing costs by 2020 are likely around USD 400bn per annum but will still be rising therefore as cheaper debt rolls over. The estimates for the budget impact of Mr. Trump's plans for tax cuts and infrastructure vary between USD 4-6bn over 10 years. We go with the estimate of the Committee for a Responsible Federal Budget, a bipartisan non-profit organization, of USD 5.3tn.

 

In order for Federal Debt/GDP not to increase further, these policies need to generate enough economic growth to boost tax revenues as well as the denominator (GDP). A simple back of the envelope calculation using the Fed's 2% inflation target and the US Census Bureau’s population growth estimates reveals that even the very optimistic prognosis of 3.5-4% growth would still lead to an increase in the Federal debt/GDP level for a number of years before levelling off.

 

Guest Contributor | Gold Sell-Off: How Low Can It Go? - callout goldmoney

 

In order for the Fed to raise rates significantly above its current projections of 2.85% to let’s say 4%, without pushing the federal debt level much higher, real GDP growth would most likely have to be over 5%, for a full decade. This growth would have to be achieved not just as government debt servicing costs go up, but private debt costs would raise as well.

 

While there have been periods of prolonged extraordinary growth in the past, those periods were either associated with the industrial revolution or the recovery from the Great Depression and the US entering WWII. The chances for achieving these kind of economic growth rates look rather dim at the moment. But that is exactly what the market seems to be pricing in now. In such a scenario, gold prices could fall below USD 1,000/ozt.

 

It would pose a major problem for producers. Most would produce at a loss and gold mining output would fall sharply. But then again, the Goldilocks scenario implies that people would want to hold less gold and more fiat currency. In all other scenarios, gold prices will continue their multi -decade upward trend and likely set new highs over the coming years.

 

This doesn’t mean that gold can’t trade lower over the short run from here.

 

What the election result has really changed is business confidence. 40.9% of the respondents in the November Dallas Fed Texas Outlook Survey said that their general business outlook for the manufacturing sector for the next 6 months has improved. That is the highest level since late 2009, which back then simply reflected the fact that people werenot as pessimistic anymore as they were when the economy collapsed in 2008. The service sector confidence level started from a much lower base but the sharp uptick from prior to the election is no less impressive (see Figure 7).

 

Guest Contributor | Gold Sell-Off: How Low Can It Go? - goldmoney 7

 

The markets' euphoria over Trump's election has been the match to the tinder that was the expectation for a second – and currently highly likely – rate hike by the Fed in December. A mere two rates hikes in two years falls far short of the Fed's original optimistic outlook.

 

But in the land of the blind, the one eyed is king. Compared to the central banks of all other developed economies, the Fed looks like a superstar which has boosted US rates and thus the value of the USD. This might last for a while, keeping downward pressure on gold price. But eventually it will become clear currentrate path predictions are still overshooting the more probable reality.

 

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EDITOR'S NOTE

This is a Hedgeye Guest Contributor research note written by Stefan Wieler of 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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