While the crowd believes Fed Chairman Jerome Powell is Superman, will he fail to save the day once again?
Treasury yields were unhinged on Sep. 21, as a major bond-market sell-off helped uplift the USD Index and upend the GDXJ ETF. As a result, our short position produced even more profits, and further gains are expected in the weeks and months ahead.
Yet, it’s like déjà vu all over again. For example, unrealistic expectations were all the rage in 2021, as inflation was dismissed as transitory and Fed Chairman Jerome Powell assumed that raising interest rates was preposterous. Moreover, with the naïve optimism keeping gold uplifted and the stock market above its fair value, investors’ faith in the Fed was on full display.
Please see below:
To explain, the table above is sourced from the FOMC’s September 2021 Summary of Economic Projections (SEP). If you analyze the red rectangle, you can see that the median federal funds rate (FFR) estimate was 0.30% in 2022 and 1% in 2023. However, the FFR ended 2022 north of 4% and rose above 5% in 2023. Thus, there was little prescience in Powell’s predictions, and silver suffered mightily as hawkish re-pricings unfolded.
Furthermore, we warned that investors’ loyalty to the Fed would backfire. We wrote on Aug. 31, 2021:
With Fed Chairman Jerome Powell threading the dovish needle on Aug. 27, investors rejoiced as he downplayed the consequences of surging inflation. However, while his perpetual patience may elicit comfort in the short term, the medium-term ramifications could end up shocking the financial markets.
Case in point: while Powell allows the economy to run hot, his lack of prudence has left him far behind the inflation curve. And with one policy mistake liable to result in an accelerated rate hike cycle once the Fed finally moves, his ability to placate investors could come under immense pressure.
So, while Powell’s inflation blunder cost investors dearly, they are still buying what he’s selling.
Please see below:
To explain, the FOMC released its latest SEP on Sep. 20. If you analyze the red rectangle, you can see that the committee raised its 2024 FFR projection from 4.6% to 5.1%. In other words, the Fed expects the FFR to remain above 5% throughout 2024, with fewer rate cuts expected now than in June.
But, the expectation is highly unrealistic, and the current SEP is like September 2021 in reverse.
In reality, long-term interest rates have risen dramatically over the last several weeks, and these impact consumers’ borrowing costs, not the FFR. So, while the FFR was high throughout 2022, long-term rates’ unwillingness to rise in lockstep is why we faded the recession narrative. In contrast, long-term interest rates are doing the heavy lifting now, and the medium-term ramifications should be severe.
False Hope
This cycle is already long in the tooth, and the crowd is buying that the U.S. economy will remain strong enough to keep rates this high for the next 15 months. We believe the prospect is highly unrealistic, and assets like oil could crash if (when) a recession unfolds.
Please see below:
To explain, the 10-2 Treasury yield spread has gone negative before every recession since 1980. And the blue line above tracks the number of days it has been inverted. If you analyze the right side of the chart, you can see that the current inversion is the second-longest on record, meaning that recessions arrived sooner in prior cycles. Consequently, the idea of the inversion remaining in place for another 15 months is laughable, in our opinion.
Second, the historical movement of the FFR highlights the FOMC’s unrealistic expectations, and if (when) they go up in smoke, the USD Index should soar.
Please see below:
To explain, the black line above tracks the FFR, while the vertical gray bars represent recessions. If you analyze the movement of the former, you can see that the FFR never goes sideways for long, especially after rising off of a low base. Conversely, sharp rises and falls have been present since the 1950s, which highlights why Powell’s prediction is so unrealistic.
For example, the FFR went sideways during the mid-1990s, but it only rose by roughly 3%, so it’s not comparable to the nearly 6% of this cycle. Similarly, the FFR stayed in the 5% range for roughly 13 months before the global financial crisis (GFC). Yet, the FFR has already been above 5% for roughly five months in this cycle, which further emphasizes why another 15 months of a 5%+ FFR lacks historical credibility.
Finally, while the crowd learned nothing from the FOMC’s “transitory” misstep, soft landing expectations should suffer the same ominous fate.
Please see below:
To explain, the dark and light blue lines above track Americans’ Google Searches for “recession” and “soft landing.” If you analyze the behavior of the light blue line before the GFC, you can see that a soft landing was also popular then.
And now, the divergence on the right side of the chart shows how soft landing hopes are extremely consensus, while recession searches have collapsed. In our opinion, this mirrors the consensus view that inflation would be transitory in 2021, and another reality check should commence in the months ahead.
Overall, a recession won’t arrive overnight, but the current outlook is nowhere near as sanguine as the narrative suggests. Growth continues to weaken, and many of the metrics that caused us to remain FFR bulls in 2021 and 2022 have turned in ominous directions. Therefore, while the current weakness can be attributed to seasonality, the S&P 500 should endure a major drawdown when investors’ faith in the Fed evaporates once again.
Please note that while the fundamentals are great for medium-term analysis, you need the technicals to determine the precise levels to enter and exit positions. And with our 10-trade winning streak still intact, there has never been a better time to subscribe to our premium Gold Trading Alert. There are several additional tidbits you don’t want to miss.
Alex Demolitor
Precious Metals Strategist