While a hawkish Fed and higher interest rates were the first part of our bearish fundamental thesis, the second part is yet to come.
While the crowd assumed the Silicon Valley Bank (SVB) debacle would elicit a Fed pivot, we warned throughout the drama that the ‘crisis’ was much different than the bank failures from 2008. Moreover, while the crowd screamed recession on several occasions throughout 2021 and 2022, we noted how long-term interest rates were too low to create the demand destruction necessary to eradicate inflation.
And with gold benefiting from the false narrative, we emphasized on Apr. 6 that the dovish re-pricings would not last. We wrote:
It was only a month ago that investors couldn’t sell bonds fast enough. Now, they’re tripping over one another to get back in. In the process, the positioning shift has weakened the USD Index and helped uplift gold, silver and mining stocks.
Please see below:
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, with the metrics performing hawkish 180s, our bearish fundamental thesis has played out as expected.
Please see below:
To explain, the three lines’ movement on the right side of the chart highlights how rate-hike expectations (the black line) rose dramatically, which helped uplift the USD Index and the U.S. 10-Year Treasury yield (the red and green lines). Thus, silver’s plight was far from unexpected, and the financial markets are much more aligned with fundamental reality.
Yet, while the crowd was caught out of position by too low long-term interest rates, the opposite should occur in the months ahead.
Inflation Is Old News
No one was more bullish on inflation than us throughout 2021, as we warned that higher commodity prices, rental prices, and consumer spending would push the headline Consumer Price Index (CPI) higher. However, with the leading data moving in the opposite direction now, the anxiety uplifting U.S. Treasury yields is misguided. Although, the recent rate surge should only worsen the economic outlook and create a recession that pushes the PMs to their final lows.
For example, the Shelter CPI accounts for more than 30% of the headline CPI’s movement. And with the former coming in at 7.2% year-over-year (YoY) in August, inflation looks highly problematic. In contrast, while oil prices initially celebrated the inflation reacceleration, the strength is much more semblance than substance.
Please see below:
To explain, the purple and blue bars above track the month-over-month (MoM) percentage change in the Apartment List’s rent index. If you analyze the behavior in 2021, you can see why we were so bullish on inflation. On the flip side, the bars on the right side of the chart have decreased dramatically, and rental prices declined by 0.5% MoM in September.
Add it all up, and Apartment List’s rent index is down by 1.2% YoY in 2023 (the purple line below), which means the rent CPI has plenty of room to fall (the blue line below).
Please see below:
Even more revealing, when the crowd bought the transitory narrative in 2021, we warned that Costco – the second-largest retail company in the U.S. – was sounding the alarm. And with the warnings continuing throughout 2022, Costco CFO Richard Galanti said on Sep. 23, 2022:
And surprise, surprise, the headline CPI was in the 8% range YoY in September 2022.
Please see below:
Conversely, what a difference a year makes. Costco released its fourth-quarter earnings on Sep. 26, and Galanti painted a much different portrait of the inflation backdrop.
Please see below:
So, while the crowd remains fixated on inflation, they’re likely behind the curve once again. And what does this mean for the PMs? Well, with nominal rates rising and inflation poised to fall, the U.S. could confront higher real yields than expected, which is bullish for the USD Index. Moreover, the developments could push the U.S. into recession and worsen the outlook for risk assets.
Finally, the second act (recession) of the bearish fundamental thesis could take months to develop. And that’s why the technicals are so useful because they allow us to trade around our medium-term bearish view. Furthermore, with a buying opportunity likely to present itself soon, there is plenty of fuel for precious metals upside.
Please see below:
To explain, the blue line above tracks CTAs’ (algorithms) gold exposure. If you analyze the right side of the chart, you can see that the quants are extremely short, which should result in a squeeze higher at some point. As a result, while we remain patiently short for the time being, we eagerly await the opportunity to become short-term bulls.
Overall, interest rates have battered the S&P 500, as nearly all risk assets suffer when bonds offer higher future returns. But, with the growth and inflation outlooks turning bearish, the next major moves lower for the PMs and stocks could occur with rates falling, which is common throughout history. Thus, it’s crucial to remain vigilant in the weeks and months ahead.
We’ve booked 10 profitable trades in a row, and our 11th is already in the green. To be the first to know when we adjust the position, subscribe to our premium Gold Trading Alert. The technicals are better than the fundamentals at predicting reversals, and we believe a major opportunity is on the horizon. You don’t want to miss out.
Alex Demolitor
Precious Metals Strategist