While investors see sunny days ahead, recession clouds should rain on their parade in the months to come.
While the gold price remains uplifted as the materials sector outperformed the S&P 500 once again, financial assets were in limbo ahead of Fed Chairman Jerome Powell’s speech today. Moreover, while numerous Fed officials have vehemently pushed back against a dovish pivot, the loosening of financial conditions only makes the Fed’s job more difficult.
As a result, while Powell often struggles to deliver his message, higher asset prices and even looser financial conditions will only make the medium-term pain more pronounced.
For example, while every inflation fight since 1954 has ended with a recession, the crowd expects the Fed to pull off the near impossible. Therefore, immense disappointment should confront the bulls when economic reality bites.
Please see below:
To explain, the blue line above tracks the sum of the U.S. inflation and unemployment spreads. For context, the inflation spread is the difference between the year-over-year (YoY) core Personal Consumption Expenditures (PCE) Index and the Fed’s 2% inflation target.
In addition, the employment spread is the difference between the current unemployment rate and the non-accelerating inflation rate of unemployment (NAIRU) – which is the lowest unemployment rate that doesn’t provoke higher wages.
If you analyze the three blue arrows near the middle of the chart, you can see that soft landings often occur when the inflation and unemployment spreads are close to the Fed’s target levels. In contrast, hard landings often occur when the spreads are substantially above the Fed’s target levels (like in the 1970s).
So, with inflation well above 2% and the unemployment rate well below the NAIRU, both have deviated materially from where the Fed needs them to be. As such, the blue line’s ascent on the right side of the chart is another example of why the bulls’ soft landing prediction is wishful thinking.
Likewise, since investors have the propensity to over-extrapolate short-term trends, their belief that inflation is no longer problematic is shortsighted. For example, the Conference Board released its Consumer Confidence Survey on Nov. 29. The headline index decreased from 102.2 in October to 100.2 in November.
Yet, the report stated:
“45.8% of consumers said jobs were ‘plentiful,’ up from 44.8%.”
More importantly:
“Inflation expectations increased to their highest level since July, with both gas and food prices as the main culprits.”
Thus, while overall confidence remains weak, the metrics that drive the Fed’s dual mandate continue to head in the wrong direction; and while investors assume that a dovish 180 will make all of the financial market’s problems disappear, the reality is that a patient Powell will only make a bad situation worse.
Please see below:
Source: Bloomberg/ZeroHedge
To explain, the black line above tracks the 12-month inflation expectations derived from The Conference Board’s survey; and while the metric has come down from its all-time high, tighter financial conditions are necessary to prevent further upward pressure.
Therefore, the medium-term outlooks are bullish for the U.S. federal funds rate (FFR), real yields and the USD Index, and a realization is bearish for gold. So, while the price action suggests otherwise, don’t be surprised if sentiment shifts dramatically in 2023.
Alex Demolitor
Precious Metals Strategist