While gold visibly outperformed the S&P 500, there may be more than meets the eye.
While the S&P 500 and crude oil collapsed on Dec. 6, the gold price ended the day in the green Moreover, with silver and mining stocks also exiting the session relatively unscathed, the precious metals largely avoided the daily carnage.
However, with recession fears uplifting the USD Index and suppressing U.S. Treasury yields, the combination creates a mixed fundamental picture for the PMs. For example, JPMorgan CEO Jamie Dimon – who heads the largest U.S. bank – said on Dec. 6:
“Inflation is eroding everything, and that trillion and a half dollars [of consumer bank deposits] will run out sometime midyear next year. When you’re looking out forward, those things may very well derail the economy and cause a mild or hard recession that people worry about.”
But, with the recession narrative contrasting the data, gold’s medium-term drawdown should be driven by a higher U.S. federal funds rate (FFR), not an unprovoked collapse of the U.S. economy.
To explain, a recession is bullish for the USD Index and bearish for the FFR, while a resilient U.S. economy is bullish for both. Therefore, while we’ve warned repeatedly that every inflation fight since 1954 has ended with a recession, and we expect one to materialize in late 2023, timing matters.
Furthermore, with the current and historical data contrasting the collapse calls, financial conditions need to tighten dramatically to curb inflation and create the necessary demand destruction to induce a recession. So, the FFR should seek higher ground, and the liquidity drain should continue to haunt the PMs.
Please see below:
To explain, the red line above tracks the U.S. 10-2 spread, which subtracts the U.S. 2-Year Treasury yield (2Y) from the U.S. 10-Year Treasury yield (10Y). In a nutshell: when the 2Y exceeds the 10Y, it's the bond market's way of warning about a forthcoming recession; and the development occurs because the 2Y is pricing in a higher FFR, while the 10Y is pricing in weaker economic growth.
Also, with yield curve inversion (10Y < 2Y) the talk of the town in recent days, the narrative proclaims that a recession is imminent. But, that's not what we see.
For example, if you analyze the right side of the chart above, you can see that the 10-2 spread has surpassed -0.80% and is at its lowest level since the 1980s. As a result, the bond market is screaming recession.
However, the three arrows in the middle show that the 10-2 spread moved from negative to positive before the last three recessions occurred; and this happens because the 2Y falls by more than the 10Y, as investors start pricing in Fed rate cuts. For context, the 1980s was a mixed picture, as two recessions had the spread moving in and out of positive territory.
Thus, the important point is that the 10-2 spread is becoming more negative, and the last three recessions did not occur when the spread was declining.
To that point, the 10-2 spread turned negative in December 1988, and the recession arrived in July 1990 (~20-month lag). The 10-2 spread also turned negative in February 2000 and the recession arrived in February 2001 (~12-month lag). In addition, the 10-2 spread turned negative in February 2006 and the recession arrived in December 2007 (~22-month lag).
For context, the 10-2 spread briefly turned negative in August 2019, and the COVID-19-induced recession occurred in February 2020. However, we excluded that example because the pandemic was a health and not an economic crisis.
In any event, the moral of the story is that the 10-2 spread needs to turn positive before recession fears are valid; and this means the 2Y needs to demonstrate substantial weakness, where economic carnage causes bond investors to bid the 2Y Note in anticipation of the Fed cutting interest rates. Yet, this is far from the current backdrop.
Please see below:
To explain, the red line above tracks the 2Y, and if you analyze the right side of the chart, you can see that the metric remains in consolidation. Therefore, its behavior does not add credibility to the recession rhetoric.
To compare, please see its movement in 2007:
Remember, we noted above that the recession began in December 2007, and as you can see, the 2Y's substantial decline from its peak meant the economic death knell had been ringing for several months.
Likewise, please see the 2Y's behavior during the February 2001 recession:
Again, the metric had already declined substantially from its peak before the recession began, and that dynamic is not present today.
Making three of a kind, the July 1990 recession also culminated with the 2Y suffering a material drop from its high before the economic malaise unfolded.
Please see below:
As further evidence, potential GDP growth also contrasts the recession narrative. For example, the Atlanta Fed’s Q4 real GDP growth estimate had dipped from north of 4% to below 3%. However, the report stated on Dec. 6:
“The GDPNow model estimate for real GDP growth (seasonally adjusted annual rate) in the fourth quarter of 2022 is 3.4 percent on December 6, up from 2.8 percent on December 1.
“The nowcasts of fourth-quarter real personal consumption expenditures growth and fourth-quarter real government spending growth [rose] from 3.2 percent and 0.8 percent, respectively, to 3.7 percent and 1.1 percent, respectively, [and] were slightly offset by a decrease in the nowcast of fourth-quarter gross private domestic investment growth from 2.0 percent to 1.7 percent.”
Please see below:
To explain, the green line above tracks the Atlanta Fed’s Q4 real GDP growth estimate, while the blue line above tracks the Blue Chip consensus estimate (investment banks). If you analyze the right side of the chart, you can see that the green line remains relatively uplifted. As such, while the projection will change as new data arrives, the current state is far from recessionary.
Overall, while fears of an economic climax have spooked investors in recent days, the data does not signal demand destruction. Consequently, while the gold price would benefit from a lower FFR and more QE, it would require an unprovoked economic collapse to elicit a dovish pivot, and that narrative contrasts the fundamentals.
So, while the storytellers may proclaim that we’re nearing the end of the Fed’s rate hike cycle, inflation, the 2Y, history and economic reality suggest otherwise.
Alex Demolitor
Precious Metals Strategist