As the yellow metal surged more than 5 percent last
week, gold fever quickly broke out and captured the emotions of both
speculators and spectators alike. Leading the clarion charge from the stands
after the rally was none other than the former big-league slugger and
soothsaying market strategist, Jose Canseco – who in his (or his
accountant/social media manager’s) own words, tweeted - “With gold minus storage cost
becoming greater than cash returns could be a long rally.”
- Contemplative pause -
In a world more than ever flattened and converged
in the discourse of ideas – both good and bad, who are we to deny the big man
the public spectacle of pontificating on gold’s long-ball motivations? Granted, our thoughts on what fills gold’s sails here are a bit more nuanced, and
perhaps not as succinct as Canseco appears to profess... But be that as it may, we’d frame it that as nominal
yields fell sharply since the start of the year, inflation has fallen less. The
net effect is that real yields (nominal yields minus inflation) have begun to
fall – which historically is a sweet spot for gold to rally in.
This is the
polar opposite dynamic of what transpired after the taper tantrum in May 2013, where
nominal yields surged and inflation remained weak. And while St. Louis Fed
President James Bullard (see Here) recently raised concerns that long-term
inflation expectations may be falling – as the five-year/five-year forward
breakeven rate and oil might suggest; we tend to agree more with his southern
colleagues in the Atlanta Fed who quickly refuted Bullard's anxieties the following
day (see Here) with a clear description of why
breakevens have correlated so tightly with oil and why long-term inflation
expectations have remained stable over the past year.
Looking back at the cycle for perspective, real
yields began to rise shortly after the US dollar and short-term yields troughed
in 2011, and began a correlated ascent over the next several years.
As the dollar strengthened with short-term yields, assets like gold and
commodities became highly unattractive as inflation turned down and shorter-term
yields rose. This critical differential created a “virtuous” market environment
that strongly favored equities, as disinflation is generally a welcomed
condition for stocks by boosting growth and price/earning multiples and
kryptonite for commodities as investors chase securities with actual yields.
That said – and as evident in the markets over the
past year, a stronger dollar will eventually eat into profits of US
corporations that do business overseas, as well as flame global anxieties through
perceived capital imbalances that can reinforce the moves in the currency
markets with often unwanted consequences. It is this reflexive market behavior
that always poses significant risks, as trends can extend well beyond
expectations – for both participants and the Fed.
Keeping that in mind, we remain firmly in the camp
that believes the best days for the dollar are in its past, despite heightened
anxieties that there’s more to come from US dollar strength. Although the
cyclical rise in the dollar culminated with a push to a relative performance
extreme last year, the notion that the buck is under a more secular persuasion
flies in the face of the long-term yield cycle, which continues to follow a
proportional retracement decline that would indicate a lower for longer market
environment - perhaps much longer than most would suspect (see Here). It remains our suspicion that until the next
secular growth cycle commences and yields begin to rise, the dollar will
continue to follow yields lead back into the trough of its own long-term cycle,
which should engender another pulse of inflation to move through the system.
Ironically, despite the considerable uncertainty
surrounding the financial markets this year, ultimately, a weaker dollar (i.e.
rising inflation/falling real yields) could create the smoothest transition
during this period of atypical policy normalization, where conventional methods
of stabilizing the economy and markets are not readily available for the Fed -
or as we've seen recently with the idea of negative interest rates, far too
controversial to be reasonably effective.
Just this past week the Federal
Reserve Bank of San Francisco – Chairwoman Yellen's old stomping ground,
published an Economic Letter that ruminated on the idea that by allowing
inflation to overshoot the Fed's 2 percent target, it would achieve the greatest
decline in real interest yields and hence stabilize economic activity fastest.
Standard monetary theory states that the short-term nominal interest rate should be lowered to stimulate the economy whenever there is low inflation or economic slack—that is, when economic resources are not being fully used to their most efficient level. However, the nominal interest rate has a lower bound that is typically around zero. In theory, Eggertsson and Woodford (2003) showed that when the zero lower bound is binding, it is desirable to allow inflation to overshoot its target to promote a faster recovery in real economic activity.
At the heart of the Eggertsson-Woodford argument is the idea that economic slack increases with the real interest rate, which is the nominal short-term interest rate minus the expected future inflation rate. If prices and wages were able to adjust to economic conditions instantaneously then the economy would operate at its efficient level and there would be no economic slack. However, in normal conditions, prices and wages take some time to respond to changes in economic conditions, which leads to economic resources being underutilized. If this so-called economic slack is substantial—for example, following a financial crisis that restricts credit and pushes down consumption and investment spending—then according to the normal policy prescription policymakers would lower the short-term nominal interest rate. In turn, this would bring down the short-term real interest rate to stimulate the economy and reduce the slack. However, this policy prescription becomes ineffective if the nominal interest rate is at the zero lower bound. Because of this constraint, policymakers cannot engineer a decline in the short-term real interest rate to stabilize economic activity, and economic slack ends up larger than it would otherwise be. In other words, the real interest rate would still be too high. To make matters worse, elevated economic slack puts downward pressure on inflation and inflation expectations, which pushes the real interest rate up further, triggering even more slack.
Despite the zero lower bound, policymakers can still bring about a lower short-term real interest rate if they can generate higher inflation expectations. One way to do this is by communicating that the central bank intends to keep the nominal short-term interest rate low for longer than would otherwise be dictated by economic conditions; this has been a motivation behind the Federal Reserve’s forward guidance policy in recent years. Expecting a more expansionary monetary policy in the future should help boost future inflation and thus raise current inflation expectations, translating into a lower real short-term interest rate. Taking this theory a step further, by allowing future inflation to temporarily rise above target, the central bank can bring about a greater decline in the real interest rate and stabilize economic activity faster. - Is There a Case for Inflation Overshooting?
Although the idea of loosening financial conditions
through a weaker dollar and falling real yields flies under the radar of more
conventional structural easing initiatives, we still believe it's the Fed’s best bet and most
likely outcome – precisely because of their presumed reluctance to unwind the
move off of ZIRP this past December. This doesn’t imply that we foresee US equities
regaining the outperformance they held over the last several years - far from
it – but that the idea that the Fed is left impotent here is greatly
overstated. Moreover – and where the rubber meets the road for investors, their
apparent recognition of these conditions reinforces the belief that assets like
gold and silver that had fallen so far out of favor with rising real yields,
will see another market environment blessed by the Fed that could generate significant
returns.
As we've described in the past, we follow and trade
gold and silver not as harbingers of financial armageddon, but primarily as
volatile proxies for commodities and inflation expectations. From our
perspective, they are very much acting their part and leading commodities out
of their respective cycle lows as the dollar begins to crack and
real yields decline.
Gold took the pole position modestly over silver (+18.75%
vs +16%) in their first leg up as global markets came under significant
pressure. Being the higher beta asset, silver tends to either outperform or
underperform gold based on speculative appetites of traders. Considering the broader market environment since
the start of the year, silver has actually displayed relative resilience in
our opinion. Our suspicion is that as markets get a better grasp on 1) the
direction of the dollar, 2) the Fed, and 3) inflation expectations - risk appetites
should gravitate towards the higher beta asset.
As we've shown in the
past, the silver:gold ratio has been a leading indicator for major pivots in
inflation expectations and the long-term chart of the ratio has been showing a
positive momentum reversal over the past several months. While the reversal has
yet to materialize in the ratio itself, it's not that surprising considering
current market conditions. Longer-term, we expect silver to outperform, as long
as the dollar continues to decline and global markets stabilize.
Taking a look at last weeks charts of our yen
comparatives with gold (see Here), gold followed the move in the yen from
the start of the year and explosively broke above its highs from last fall. And
while the shine quickly came off by the start of trading this week, gold
continues to follow the yen's lead by testing and perhaps expanding the range
break. That said, should the pattern continue, a much larger shakeout
potentially lies ahead before gold’s uptrend resumes. Based on the pattern in
the yen, a move below this week’s low would point towards this outcome.
