With interest rates and the U.S. dollar reasserting their dominance, will more pain confront the gold price?
With persistent inflation much more problematic than the crowd realizes, we warned on Apr. 6 that interest rates were too low for the Fed to achieve its policy goals. As a result, the rate-cut optimism that uplifted the PMs was built on a faulty foundation. We wrote:
To explain, the red line above tracks the USD Index, while the green line above tracks the U.S. 10-Year Treasury yield. More importantly, the black line above tracks the inverted (down means up) December 2023 Eurodollar futures contract.
For context, Eurodollar is a proxy for the expected U.S. federal funds rate (FFR). And since the yield moves inversely to the price, when Eurodollar rises, it means the crowd is pricing in a lower FFR.
Now, if you analyze the relationship, you can see that perceptions of a more hawkish Fed (higher black line) helped uplift the USD Index and the U.S. 10-Year Treasury yield. Conversely, the vertical gray line on the right side shows how the recent banking crisis has the crowd pricing in rate cuts by the end of December (lower black line), which has weighed on the USD Index and the U.S. 10-Year Treasury yield.
However, rate cuts are wishful thinking without a full-blown banking crisis, and a reversal of these expectations should rock the PMs in the months ahead.
To that point, gold, silver, and mining stocks have suffered sharp drawdowns recently, and the fundamental thesis has played out as expected.
Please see below:
To explain, the red line above tracks the USD Index, the green line above tracks the U.S. 10-Year Treasury yield, and the black line above tracks the inverted (down means up) December 2023 SOFR futures contract. For context, Eurodollar has been discontinued and replaced with SOFR, so that’s why it’s used in this example.
If you analyze the right side of the chart, you can see that the black line has erased roughly half of its bank-run rally, which means that rate-cut optimism has decreased and the crowd is pricing in a more hawkish Fed.
Likewise, the behavior of the red and green lines shows how the USD Index and the U.S. 10-Year Treasury yield have also shifted in hawkish directions, and the developments are highly bearish for the PMs.
The Underlying Economy
While the economic backdrop has become unfriendly to the PMs, the recent mauling should continue. For example, we wrote on Apr. 14:
The PMs confront a precarious fundamental outlook, and mining stocks are particularly vulnerable. The rate-cut optimism contrasts the realities on the ground, and market participants are overconfident because the Fed has been wrong more than it’s been right. However, we believe the QE bulls will suffer disappointment in the months ahead.
Speaking of which, the Atlanta Fed updated its Q2 GDPNow estimate on May 17. And with the metric increasing to 2.9%, a realization would mean another quarter of above-trend growth.
Please see below:
To explain, the green line above tracks the Atlanta Fed’s Q2 GDP growth estimate, while the blue line above tracks the Blue Chip (investment banks) consensus estimate. If you analyze the trajectory of the former, you can see that the Atlanta Fed’s model does not support the recession bulls’ thesis.
As such, while we warned that interest rates needed to rise to elicit the demand destruction necessary to eradicate inflation, little has changed.
As further evidence, we’ve noted repeatedly that base effects have been the primary driver of the headline CPI’s YoY deceleration. But, when those benefits end in June, resilient month-over-month (MoM) prints should push the metric higher.
Please see below:
To explain, the black area at the top of the table measures hypothetical MoM changes in the headline CPI, while the figures below represent the YoY readings. If you analyze the shaded pink/red area, you can see that the YoY headline CPI should bottom in June.
Moreover, the box/rectangle near the middle shows that if the headline CPI continues to print 0.30% to 0.40% MoM going forward, the metric will remain stuck near the 3.50% to 5% range over the next 12 months.
Furthermore, while base effects will aid the core CPI in the months ahead, MoM prints of 0.30% to 0.40% will keep it stuck in a similar range. As a result, real interest rates need to rise to normalize inflation, and a realization is bullish for the USD Index and bearish for the PMs.
Overall, the misguided narratives that uplifted the PMs have started to shift, and the fundamental realities of winning this inflation war have resurfaced. In addition, we warned throughout 2022 that the Fed has always pushed the FFR above the peak YoY core CPI – which stands well above 6%.
Thus, while the crowd assumes it’s impossible, previous Fed committees didn’t want to do it either. Yet, in order to avoid a much larger problem, they were forced to raise the FFR to levels that agitated the financial markets. If not, the bullish backdrop (one that’s still present in the stock market now) only loosens financial conditions and makes the inflation challenge more difficult. Consequently, we expect more hawkish policy in the months ahead.
Are interest rates high enough to curb inflation?
Alex Demolitor
Precious Metals Strategist