Inflation/Interest Rates/Gold!

Inflation/Interest Rates/Gold!

In the 70s the Fed raised interest rates to 20% to fight inflation that was running about 10%.
The ‘70s and ‘80s saw excessive consumer and producer price increases but no housing nor equities inflation.
During the 90s there was a stock market bubble culminating in the dot-com crash with low inflation of, around 2-3%.
The 2000s saw a real estate bubble forming, and bursting, following the sub-prime mortgage crisis and Fed tightening.

Each previous inflationary cycle had one, at most two, aspects of inflation, but never have there been all three, as presently. Previous Fed attempts to control inflation with interest rate increases have resulted in a recession. The Fed is currently targeting a very mild raise, to 1% by the end of this year. Others are more hawkish. JP Morgan has joined Bank of America in calling for seven rate hikes in 2022. Even at 3-4%, this will not be enough to improve broad-based inflation that is currently nearing double digits or is already there. There is no way the Fed can hike interest rates to the same extent as previous Federal Reserves have because of the problem of energy inflation.
High oil and natural gas prices are causing painful increases in farming inputs like fertilizer and weed killer. This in turn is hiking the price of food.

Governments have eluded investments in oil and gas exploration, preferring to put it all into renewable energy, but this foolish intend, combined with the closure of coal plants and nuclear plants, has raised natural gas prices to record levels. Crude oil is heading to $100/bbl. and could be $150 by year’s end. For the first time ever, pumped oil supplies could fail to meet demand.

The situation we are heading into is critical. The Fed needs to act boldly to arrest inflation that is already high and moving higher. Yet the central bank is severely constrained in how much it can raise interest rates, due to the $30 trillion national debt. Each interest rate rise will mean much higher interest payments, which are already at nearly $600 billion. At a projected annual deficit of $1.3 trillion, by 2032 we could be looking at a national debt of $43 trillion. That would push interest payments on the debt well past $1 trillion.

The Fed’s dual mandate is to control inflation, keeping it under 2%, and to keep the economy humming along at near full employment. Cynics will argue that in fact, what the Fed has done over the past 13 years is to create hyperinflation among financial assets (we have long argued that quantitative easing has kept inflation at bay because it stayed within the financial system), while doing everything it can to keep “real world” inflation subdued.

There is a line of thinking out there that the Powell Fed’s intention is to go hostile, that the only way it is able to fight the level of inflation that has permeated the economy, is to “crash the market”. If you think about it, this is precisely what Paul Volcker’s Fed did in the early 1980s and it is what Powell tried to do, but failed to, in 2018, beyond a three-month stock market pullback.

And while most market observers believe we are far from a market crash, there are signs that US growth is slowing after enjoying a rip-roaring pandemic recovery. (CNN reports the US economy expanded 5.7% last year, the fastest pace since 1984).
On Monday, Feb. 14, Goldman Sachs put out a note saying that the sharp drop in risk assets (i.e. stocks) may not only be due to increasing geopolitical concerns over Ukraine, but also “the potential the economy may be slowing more than expected.”

The combination of increasing geopolitical concerns and the potential the economy may be slowing more than expected sent the VIX [the Chicago Board Options Exchange’s (CBOE) Volatility Index] back up to 24, and drove a decline in equities as investors turned to bonds and gold, both traditional investor perceived ‘safe havens’.

As if on cue, spot gold rose about $50 between Feb. 11 and Feb 15, and jumped again on Thursday, Feb. 17, soaring past $1,900, for the best performance in 8 months.

What impact will the expected Fed rate hikes have on gold? Well, initially they will be negative. Because gold does not pay a dividend or a yield, some investors will shift funds over to government bonds whose yields are already going up in anticipation of rate hikes but remember what happened when the Fed tried this in 2018. They only got to 2% when the stock market tanked, prompting them to reverse course, and re-instate low interest rates.

It’s interesting to note that gold has in fact performed quite well despite recent increases in US 10-year Treasury yields and the US dollar index DXY, both of which are strong determinants of the gold price, from multi-month lows. Why? According to Bank of America strategists, “There are significant dislocations buried beneath headline inflation, interest rates and currency moves, raising the appeal of holding the yellow metal in a portfolio and supporting our $1,925/oz average gold price forecast for 2022.”

Analysts at UBS, a Swiss bank, think the gold price is being supported by “elevated demand for portfolio hedges,” noting that gold has done better than other portfolio diversifiers including bitcoin, whose value lately is more closely correlated to stocks than previously.

The following could drive gold even higher:
- the loss of faith in central banks’ policies to fight inflation,
- a recession, either Fed-driven or through other means,
- Russia has made some big moves out of US dollars and this may be emboldening Putin on a potential invasion of Ukraine. Consider: in 2013 Russia received dollars for 95% of its exports to Brazil, India, South Africa and China. After a decade of de-dollarization, only 10% of that trade is in greenbacks. Russia has also built its own payment settlement system outside of SWIFT, that enables it to circumvent US sanctions.
- a number of US states have removed sales taxes on precious metals purchases. Ohio and Texas have gone so far as to diversify their public pension funds with gold investments.

The outlook for gold looks extremely positive!

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