Fed Gets Risky; Bulls Get Frisky

This week, MWM completed its latest quarterly client call. Thanks go out to all those who joined us, and to everyone we have the privilege to serve. In this letter, HAI will offer some market commentary and then pull back a bit for related overview thoughts on the importance of gold and associated assets at our present juncture.

Last week, HAI highlighted end-of-week comments from St. Louis Fed President Jim Bullard. Those comments were a potential indication that the Fed was reassuring tumbling markets of an always possible “Fed put.” Late that Friday, it seemed the Fed might have felt the need to pump the brakes a bit on the market’s bearish eruption. Broad market earnings estimates came under pronounced scrutiny, credit markets started to buckle, and the S&P 500 was crashing into bear market territory. Last week’s HAI was titled “The Bullard Put?” because Bullard suggested the Fed could be back to rate cuts as soon as next year. Such a suggestion understandably inspired skepticism regarding the Fed’s commitment to its ongoing tightening cycle. Bullard’s surprising comments undermined the image of “super Powell the ultra-hawk” and tempered aggressive rate hike expectations. The effect was dramatic as crashing markets reversed steep losses and closed that day in the green.

This week, Atlanta Fed President Raphael Bostic floated the suggestion of a “September pause” on further rate hikes. The idea gaining traction is that the Fed may now be moving toward a likely pause to its tightening cycle at the September FOMC meeting. This would presumably bring the benchmark overnight interest rate to a range of 1.75% to 2% by the time of the pause. This week, the notion of a September pause gained more traction after market participants reviewed Wednesday’s release of the minutes from the most recent FOMC meeting. In a note out this week, Bank of America strategists said, “We have recently seen a tenuous but remarkable change in Fed communications, where some Fed officials suggest the option of downshifting or pausing later in the year as they reach 2% given the challenging macro backdrop, tightening of financial conditions, and potentially softening inflation.”

Well, with the addition of the September pause narrative, the rally Bullard begot became turbo-charged this week. Market technical and sentiment factors had already established the conditions for a counter-trend rally to develop. This week, Bullard, Bostic, and the FOMC gang provided the catalyst. The rally in stock indexes came with strong breadth and risk-on characteristics. It was also accompanied by a strong snap-back in high yield credit. Treasury yields dropped, the dollar continued to fall, and commodities were strong.

“The $64,000 question for markets is what market and economic conditions would push the Fed to pause,” said UBS strategist Matthew Mish. According to Mish, after reviewing the 11 times the Fed has paused a rate-normalization cycle since 1960, history tells us that the Fed shouldn’t be expected to pause until its target interest rate is in excess of the annual inflation rate. Within that narrative, either market enthusiasm for a dovish pivot is unwarranted because the Fed will keep hiking and this rally will meet a rude terminus, or inflation needs to fall dramatically and immediately. However, a third possibility is that the Fed is telling us it’s trapped. It’s stuck on a one-way policy street where meaningful tightening cycles are simply no longer structurally possible.

The problem with the rationale of a dovish pivot based on a swift collapse of inflation is that market belief in the narrative inherently defeats the basis of the thesis. When the dovish narrative is embraced by markets, we get inflationary weeks like this one, where financial conditions loosen dramatically as interest rates and the dollar drop, stocks absolutely surge, commodity prices bloat further, and oil heads back above $115 a barrel. Rather than conditions that will deal a quick death blow to inflation, we’re building the fire that will keep blistering heat emanating from CPI reports throughout the remainder of the summer! 

If what we are watching, however, is indeed a Fed that is now helplessly trapped and has been fully reduced to a one-way street of easy-policy-to-infinity until the wheels fall off, then it’s nearing the time to dust off the Austrian crack-up-boom playbook. Let’s hope we’re not quite there. Nothing is certain yet, Powell may still deliver a legitimate tightening cycle, but, with the recent narrative twist, the market appears to be disbelieving of any hawkish Fed threat. As a result, the market has brewed-up a significant risk-on rally and it could carry for a bit.

If we are about to formally enter the era of an “officially” trapped, one-way Fed, and if that situation graduates from strong suspicion to widely acknowledged fact, then the next chapter in gold’s story may be rapidly approaching as well.

Now, to understand our appreciation for gold as essential, and our continued interest in various forms of precious metals investment exposure given precarious present dynamics, we need a brief review. Historically, the gold standard was the equivalent of checks and balances for the monetary system. In 1971, however, we exchanged the last remnants of the sustainable and inherently stabilizing gold standard for what we can call “the Fed standard.” 

By intentional design, the Fed standard is no substitute for the gold standard. Accountability, dependability, and sustainability were exchanged for expedience and a destabilizing, potentially dangerous flexibility in the hands of policymakers. Commenting on this development, famed economist Murray Rothbard observed that, “Having examined the nature of central banking, and having seen how the questionable blessings of central banking were fastened upon America, it is time to see precisely how the Fed, as presently constituted, carries out its systemic inflation and its control of the American monetary system.” Making matters far worse, the economic framework of choice and the resulting policy toolkit in the hands of those unrestrained policymakers is what economist Henry Hazlitt described as “an intricate network of fallacies that mutually support each other.” The entire arrangement is rather problematic.

Underscoring the concern, economist F.A. Hayek went on to warn that, “Unless we mend the principles of our policy, some very unpleasant consequences will follow.” Well, to paraphrase Hazlitt, today may be the tomorrow we were warned about yesterday. Rather than mend the principles of our policies, we continue to double down on the modern monetary toolkit. We are now seeing the negative consequences of untenable policies increasingly accrue all around us. There’s no mystery to it. The policy framework and resulting “tools” are unsustainable. Over time the aggressive use of these policies is a vicious cycle that spawns ever-increasing numbers of ever more serious problems. By contrast, the modern monetary toolkit never sustainably solves any of them.

Given the predictable dangers, as soon as the transition away from the gold standard was complete, a primary and vital role of gold immediately became one of insurance against the myriad potential systemic threats posed by the Fed standard.

At our modern moment, Fed standard risks are far higher than ever. As such, the fundamental case for higher gold prices, based on the asset’s insurance function, is extremely compelling at present.

Now, physical gold and other precious metals are far from the only attractive investment options in this environment. Hard assets broadly and commodity producing companies are all squarely in the bullish bull’s-eye, so to speak. Natural resource companies are now adding significant value to their underlying commodities. In fact, natural resource producers are now generating three times more annual free-cash-flow than at any other time in history. Even with this strong, widespread profitability spreading throughout the natural resource sector, for firms with market caps over $1 billion, no commodity producing sub-sector has better operating margins than the precious metals companies.

The primary risk for non-precious metal commodities is that with the threat of a stagflationary, GDP-growth-challenged world, faltering demand could put pressure on economically sensitive natural resources in the nearer term. Gold, however, is economically insensitive. If the gold price continues to react to ongoing and escalating central bank monetary policy malpractice, the gold mining sector may be structurally among the very best positioned sectors for the unfolding environment. If gold performs, the highest quality precious metals firms may shine and be among the leaders within the natural resource industry.

Weekly performance: The S&P 500 surged 6.58%. Gold was up 0.83%, silver gained by 1.98%, platinum was nearly flat, up 0.20%, and palladium gained 5.93%. The HUI gold miners index was higher by 1.58%. The IFRA I Shares US Infrastructure ETF was up 5.43%. Energy commodities were strong. WTI crude oil was up by 4.34%, and natural gas was up 8.01%. The CRB Commodity Index was higher by 2.16%, while copper gained 0.70%. The Dow Jones US Specialty Real Estate Investment Trust Index was up 6.10% on the week, while the Vanguard Utilities ETF (VPU) was up 4.93%. The dollar was lower by 1.43% to close the week at 101.70. The yield on the 10-yr Treasury dropped by 4 bps to end the week at 2.78%

Have a wonderful long weekend!

Best Regards,

Morgan Lewis
Equity Analyst & Investment Strategist
MWM LLC