The Hawkish Fed Pivot Escalates

The “Welcome to 2022” party this week was a decidedly downbeat affair. The first five trading days of the new year saw an across-the-board decline in the Dow, S&P, Nasdaq, and Russell 2000 small cap index. The damage ranged from modest to heavy. The Dow fared best, down only 0.29%. Then came the S&P with a substantial 1.87% decline. The Russell 2000 took an even harder shot, losing 2.87%. But no index suffered the slings and arrows of outrageous sellers more than the growth-rich, tech-heavy Nasdaq, as evidenced by its 4.53% weekly drubbing.

The foul mood in markets settled in as the story of the week increasingly became the intensifying of the US Federal Reserve’s “hawkish” pivot. On Tuesday, Minneapolis Federal Reserve Bank President Neel Kashkari said he expects the Fed to need to raise interest rates two times in 2022. While markets already expect more than two hikes, Kashkari’s statement was noteworthy because he is one of the most dovish officials within the Fed family. Previous to this week, Kashkari had long been of the view that interest rates near zero would need to be maintained until 2024 or later. In comments posted on Medium.com, Kashkari said, “I brought forward two rate increases into 2022 because inflation has been higher and more persistent than I had expected.” The abrupt shift in Kashkari’s position highlights the increasing concern within the Fed community over high inflation remaining persistent and becoming embedded.

Kashkari went on to illustrate the dilemma facing the Fed as long as problematic inflation is a factor. He said, “If the macroeconomic forces that kept advanced economies in a low-inflation regime are ultimately going to reassert themselves, the challenge for the FOMC will be to recognize this as soon as possible so we can avoid needlessly slowing the recovery, while at the same time protecting against the risk of entering a new, high-inflation regime.” So, as long as inflation is a problem, the Fed is in a bind: Address inflation via policies that will likely threaten economic growth and the recovery, or risk entering a new regime of high inflation.

Kashkari’s Tuesday pivot offered cause for concern among members of “team transitory,” and foreshadowed the main event of the week: Wednesday’s release of minutes from the December FOMC meeting. The minutes revealed that, given high inflation and strong economic growth, the Fed may need to chart a more aggressive path toward policy normalization than previously expected. According to the minutes, “Participants generally noted that, given their individual outlooks for the economy, the labor market, and inflation, it may become warranted to increase the federal funds rate sooner or at a faster pace than participants had earlier anticipated….” This escalation in Fed rate-hike rhetoric was unsettling enough for markets, but the minutes went further.

Back in mid-December, Federal Reserve Governor Chris Waller first publicly floated the idea that a Fed “balance sheet run-off” could help in the fight against inflation. Rather than merely tapering and ending additional stimulative asset purchases (quantitative easing), balance sheet run-off means outright reversing the accommodative policy by actually shrinking the Fed’s balance sheet with a new policy of quantitative tightening. Sure enough, this week’s minutes revealed that the idea of a policy enacting a balance sheet run-off is gaining momentum within the FOMC and could be implemented sooner rather than later. According to the minutes, “Some participants also noted that it could be appropriate to begin to reduce the size of the Federal Reserve’s balance sheet relatively soon after beginning to raise the federal funds rate….” Despite the fact that Fed Governor Waller had already teased this possibility while speaking independently in New York City weeks ago, the prominent featuring of the idea within the minutes surprised and spooked markets.

The reason for market concern? The concerns relate to what Bank of America estimates to be the outsized relationship between changes in the Fed’s balance sheet and market prices. As HAI has noted previously, BofA estimates that since 2010, changes to the Fed’s balance sheet alone now account for 52% of market returns. So, according to BofA, market valuations are now primarily derived from and dependent upon increases and decreases in the Fed’s balance sheet. If correct, in addition to the restraining effect on economic growth that will come from tighter financial conditions, a “balance sheet runoff” will directly translate to a dramatic reduction in market valuation.

Market participants’ desire to pick on the Nasdaq this week demonstrates that markets are starting to take the threat of a hawkish Fed more seriously. The Nasdaq’s definitive characteristic is that it is technology-heavy. Tech’s defining characteristic is that many of its component companies typically offer the possibility of higher growth rates than companies in other sectors. A company with the potential for high future growth rates has the potential for rapidly growing streams of future cash flows. Future cash flows that a company “may” realize are less valuable than present actual cash flows. There is always risk that cash flows expected in the future may never materialize or may fall short of expectations. As such, those future cash flows must be valued at a discount. How much of a discount gets applied to future cash flows depends, in large part, on interest rates. When interest rates are extremely low, more value can be attributed to future cash flows. When interest rates increase, those future cash flows become less valuable. What we saw this week in the Nasdaq was, in anticipation of higher interest rates, the market selling interest rate sensitive growth far more aggressively than other segments of the market.

For months, the stress of a possible inflation-triggered rate-hike cycle has been building within the Nasdaq. The Nasdaq is down 7.87% from its peak in November, and has been significantly underperforming the Dow and S&P in that time frame. Internally, however, weaker and more speculative companies within the index have already suffered much more dearly.

According to Sentimenttrader.com, “After Wednesday’s post-FOMC selloff, more than 38% of stocks trading on the Nasdaq are now down 50% from their 52-week highs.” Sentimenttrader points out the index has exceeded that figure in only 13% of trading days since 1999. In a particularly ominous example of the extensive remaining downside potential in the Nasdaq, Sentimenttrader observes that, “When at least 35% of stocks are down by half, the Composite has been down by an average of 47% from its 3-year high.” As mentioned, currently, the Nasdaq is not off even 8% from all-time highs.

An additionally troubling point of reference for the Nasdaq is its value relative to the S&P 500. The historical ratio of the price of the Nasdaq to that of the S&P 500 demonstrates the valuation-inflating impact of over a decade of artificially low interest rates on the Nasdaq in particular. When the bloated value of the Nasdaq versus the S&P peaked in February of 2021, it did so at the very same inflated record-high ratio set briefly during the towering heights of the 2000 Nasdaq dot-com bubble. As the bubble burst, the ratio utterly collapsed in just as spectacular form as it had inflated.

Expanding beyond the Nasdaq, the selling pressure and risk-off tone this week remained prevalent throughout markets. Consumer staples outperformed consumer discretionary stocks, and the VIX volatility index was higher for the week. Notably, Treasurys tanked, and the yield on the 10-year Treasury surged by 24 basis points. Additionally, the 10-year Treasury yield had an important week technically. The 10-year yield broke out above trendline resistance that had been in place since 2019, and at the same time closed the week at the highest level since before the Covid crisis struck in March of 2020. Commodities were mixed. Oil and natural gas both had strong weeks. Copper was lower but held up relatively well, while a more hawkish Fed and the specter of rate-hikes caused a reactionary sell-off in the precious metals complex.

Delving a little deeper into precious metals, gold reacted to the FOMC minutes by breaking below the key $1,800 level and closing the week below both its 50- and 200-day moving averages. As the increasing likelihood of imminent central bank rate hikes gained traction this week, pressure on gold materialized. However, despite its worst week since late November, gold bounced higher off the $1,780 level and still remains in an uptrend off the August 2021 low of $1675. 

Interestingly, despite the typical knee-jerk sell-gold-on-rate-hike reaction, the history of recent rate-hike cycles actually suggests that gold has performed well in such environments. Perhaps this is evidence that the market is starting to clue in to the reality that when the Fed hikes rates and becomes less accommodative, the clock starts ticking on the emergence of the next market crisis that inevitably calls the Fed back into interventionist mode on an ever-greater scale. Until the Fed finally retires its strategy of ever-escalating interventions, the forward-looking gold market may continue to remain resilient as it sniffs out further future doses of Fed “medicine.”

An interesting sign of this apparent character change within the gold market appears to be increasingly evidenced by positioning reflected in the weekly Commitment of Traders (COT) reports. Recent commentary by gold analyst Chris Rutherglen highlights a subtle shift within COT positioning that may be significant. Typically, the majority of long futures contracts in the gold market are held by what the COT report classifies as “managed money.” This managed money cohort consists largely of commodity trading advisors (CTAs) and hedge funds. The defining tendency of this group of gold market participants is that they are trend followers. They increase their allocation to gold as prices rise, and sell when prices are falling. In other words, they are not buying long-term value in the form of attractively low gold prices, they are instead buying short-term momentum. Hence, the trading character of this group leads to greatly elevated volatility. It often accentuates steep declines in the price of gold by vigorous selling when prices fall.

However, what we have seen emerge since the Covid episode of March 2020 is a new leadership cohort in gold futures market allocation. What the COT categorized as the “other” category of gold holders is comprised by investors such as pension funds, university endowments, insurance companies, and other similar entities with a very different ownership tendency than the managed money group. This other category of owners tends to be long-term, value-focused investors. They buy when price is low and attractive on a long-term investment basis. They tend to sell after major price moves higher are mature in anticipation of the opportunity to buy back later at lower prices. They sell when the momentum traders are pilling in, and buy after momentum traders have abandoned ship. Ever since March 2020, this longer-term, value-oriented other category has become dominant within the COT categories. 

Before March 2020, this other category averaged between 5–25% of the ownership of gold futures market long contracts. Since, March 2020, however, it has dramatically increased its presence in the market, and has held between 30–40% of long contracts. Despite the elevated gold prices during this period, the other category has bought long contracts aggressively, and is not selling. They are maintaining historically unprecedented allocation. 

This longer-term, strong-hand money is moving into the gold market to a degree and with a character divergent from historical president. Moreover, it seems that this other group is increasingly taking delivery of the metal rather than opting for the less expensive normal course of rolling forward futures contracts. If this trend continues, the implications may be very significant. This character change by the other category may indicate that an extremely important longer-term, value focused market cohort is wise to the gold bull thesis. It may continue to hold its newly dominant market footprint until the Fed’s pattern of ongoing and serially escalating market interventions is truly withdrawn.

While this current hawkish pivot may be the start of a lasting shift towards a less interventionist, more free-market Fed regime, market expectations seem to assume that this hawkish pivot is merely a half-measure that will prove to be a prelude to the next, and larger, Fed intervention. With that said, for free markets advocates, the Fed’s even talking about backing away temporarily from inflation as policy is appreciated and encouraging. Famed economist Milton Freidman said that he believed that societies oriented around the central value and principal of freedom “shall be able to preserve and extend freedom…” though they be under threat. But, he added, “we shall be able to do so only if we awake to the threat that we face, only if we persuade our fellow men that free institutions offer a surer, if perhaps at times a slower, route to the ends they seek than the coercive power of the state.” While the interventions upon freedom by the Fed and the power of the state may be well intended, Freidman spoke wisdom when he observed that, “Concentrated power is not rendered harmless by the good intentions of those who create it.”

As for weekly performance: The S&P 500 was down 1.87% this week. Gold was off by 1.71%, silver fell 4.03%, platinum was down 1.00%, and palladium managed a 0.50% gain on the week. The HUI gold miners index was down 6.00%. The IFRA iShares US Infrastructure ETF was lower by 0.29% for the week. Energy commodities were higher. WTI crude oil gained 4.91%, and natural gas gained by 4.99% on the week. The CRB Commodity Index was up 1.19%, while copper was down 1.21%. The Dow Jones US Real Estate Index was down 4.81% on the week, while the Dow Jones Utility Average Index was off by 1.29%. The US Dollar Index was up modestly this week by 0.13% to close the week at 95.72. The yield on the 10-year Treasury surged by 24 bps to close the week at 1.76%.

Have a great weekend!

Best Regards,

David McAlvany
Chief Executive Officer
MWM LLC