While the bulls put all their faith in the Fed, the central bank is unlikely to lead them to salvation.
The gold price remains in a celebratory mood, as a weaker USD Index and lower real interest rates enhance the yellow metal’s fundamental appeal. Likewise, with Fed speakers signaling a slowdown in the pace of future rates hikes, the consensus believes the tightening cycle is nearing an end.
However, with interest rates far from the levels required to actually curb inflation, the crowd should regret its misguided optimism.
For example, Ven Ram, a cross-asset strategist at Bloomberg, wrote on Dec. 1:
“Inflation-adjusted policy rates are now around -90 basis points, a far cry from levels where the Fed will look to stop. In other words, if key surveys about short-term inflation expectations stay around current levels, there is just no way the Fed can afford to stop before rates get to 5.25%.
“ And that would probably be the lowest possible level. In other words, the current terminal rate of around 4.90% is not quite where it needs to be. In fact, the Fed has never really been able to wind down its tightening before real rates went significantly higher – which has been circa 200 basis points on average.”
Please see below:
To explain, historical Fed rate hike cycles ended when the short-term real rate averaged roughly 200 basis points. Moreover, the -20 basis points recorded in 2018 occurred with a peak headline Consumer Price Index (CPI) of 2.90%. As such, the current inflation backdrop is materially different.
Furthermore, the other historical periods cited (1994 on) also occurred with inflation much lower than today. So, while market participants may assume that the Fed can curtail inflation with negative short-term real yields, the prospect contrasts history and economic reality.
To that point, while the notion seems ridiculous when presented in context, the crowd believes that the Fed is about to make history.
Please see below:
To explain, the red line above tracks the year-over-year (YoY) percentage change in the core CPI (which excludes the inflationary impact of food and energy), while the green line above tracks the U.S. federal funds rate (FFR). As you can see, the FFR has eclipsed the peak YoY core CPI in every inflation fight since 1961.
Also, please remember that the YoY core CPI peaked (for now) at 6.66% in September 2022. Therefore, the historically-implied peak FFR is at least 6.67%; and with the crowd assuming that ~4.5% will hit and then rate cuts will commence soon after, would you bet your money on the Fed achieving something it never has?
In addition, investors don’t realize that their bullish actions actually derail their pivot odds.
Please see below:
To explain, the blue line above tracks Goldman Sachs Financial Conditions Index (FCI). When the blue line rises, it means that financial conditions are tightening, and higher interest rates, lower stock prices, wider credit spreads and a stronger U.S. dollar can help reduce inflation.
Yet, the sharp decline on the right side of the chart shows how financial conditions have loosened materially since the October CPI print was released on Nov. 10. Thus, investors’ pivot optimism only encourages more inflation , and their actions erode the small amount of progress that occurred recently.
Likewise, the U.S. Bureau of Economic Analysis (BEA) released the Personal Consumption Expenditures (PCE) Index on Dec. 1 (October print). For context, the core PCE (which also excludes food and energy) is the Fed’s preferred inflation gauge. So, while the metric came in at 5% YoY and met expectations, little progress was achieved even though financial conditions were tighter in October.
Please see below:
To explain, the red line above tracks the YoY percentage change in the core PCE. If you analyze the right side of the chart, all of the Fed's rate hikes have only had a minor effect on bringing the metric down. Consequently, with financial conditions loosening in November, the backdrop will help uplift the core PCE Index in November, December, January, .etc., until financial conditions tighten once again.
Overall, investors don't realize that they're riding an inflation merry-go-round. The more they exude optimism, the more financial conditions loosen and support inflation. Furthermore, this is why eliminating inflation has been so tough historically.
Whenever a small bout of progress materializes, the crowd assumes the battle is over and easing can commence. Then, when inflation reaccelerates, pessimism reigns as the Fed has to push the FFR higher once again. As a result, while the current sentiment assumes that if you believe it, you can achieve it, historical reality suggests otherwise.
Alex Demolitor
Precious Metals Strategist