Authored by Alasdair Macleod via GoldMoney.com,

In the first part of this report, we highlighted that observed gold prices have significantly detached from our model-predicted prices. While this has happened in the past, prices always converged eventually. However, the delta between the observed and the model predicted price has now reached a record high of around $400/ozt. We thus ask ourselves whether it is reasonable to expect that model-predicted and observed prices will converge again in the future, or, whether we witness a shift in paradigm and the model no longer works. 

In our view, the only reason for gold prices to sustainably detach from the underlying variables in our gold price model is if central banks (particularly the Fed) lose control over the monetary environment. Thus, it seems that the gold market is now pricing in a significant risk that the Fed can’t get inflation back under control. As we highlighted in Part I of this report (Gold prices reflect a shift in paradigm – Part I, 15 March, 2023), this is happening in the most unlikely of all environments. The Fed has aggressively hiked rates at the fastest pace in over 50 years and it is signaling to the market that it will do whatever it takes to get inflation under control. So why is the gold market still concerned about inflation?

The issue is that so far, it has been easy for the Fed to raise rates sharply to combat inflation. Despite the sharp move in the Fed Funds rate, one may get the impression that nothing has happened yet that would jeopardize the Fed’s ability to raise rates even higher. For starters, the unemployment rate remains stubbornly low (see Exhibit 8). 

Exhibit 8: The US unemployment rate remains stubbornly low despite the sharp rate hikes

Source: FRED, Goldmoney Research

Equity and bond prices have sharply corrected in the early phases of the Fed’s rate hike cycle, but since then equity markets have partially recovered their losses. While equity prices are not the real economy, large downward corrections can impact the real economy nevertheless due to the wealth effect. When people become less wealthy, they spend less, which in turn has an effect on the economy. The impact of this reduction in wealth might also not be meaningful so far as the correction came from extremely inflated levels. The S&P 500, for example, has corrected almost 20% from its peak, but it is still 14% higher than the pre-pandemic highs in 2019 (see Exhibit 9).

Exhibit 9: Even though US equity prices have corrected sharply, they are still well above the pre-pandemic highs….

Source: S&P, Goldmoney Research

The real estate market has slowed down significantly, but so far prices haven’t crashed (see Exhibit 10), and even though there are a lot of early warning signs, the Fed historically had only become concerned when a crumbling housing market started to affect the banks. While we certainly saw turmoil in the banking sector over the last few days, it was not related to the mortgage business so far. 

Exhibit 10: …and home prices – despite the clear rollover – have not crashed yet

Source: S&P, Goldmoney Research

Hence, at first sight, it appears there is little reason for the gold market to price in a scenario where the Fed loses control over inflation. However, there are plenty of warning signs that things are about to change. In our view, the correction in the equity market is far from over. When the last two bubbles deflated, equities corrected a lot lower for longer (see Exhibit 11).

Exhibit 11: the last two bubbles saw much larger corrections in equity prices

Source: S&P, Goldmoney Research

This alone will start to put a strain on the disposable income of not just American consumers, but globally. We are seeing signs of this in all kinds of markets. For example, used car prices had skyrocketed until about a year ago on the back of supply chain issues combined with excess disposable income. But since the Fed started raising rates, used car prices have retreated somewhat (see Exhibit 12). Arguably this is good for people wanting to buy a car with cash, and it will also have a dampening effect on inflation numbers, but the reason for it is not that all the sudden a lot more cars are being produced, but that higher rates make it more expensive to finance cars, and thus demand is weakening. 

Exhibit 12: Manheim used car index

Source: Bloomberg, Goldmoney Research

Certain aspects of the housing market also show more signs of stress than the correction in real estate prices alone suggests. For example, lumber prices have completely crashed from their spectacular all-time highs and are now back to pre-pandemic levels (see Exhibit 13). 

Exhibit 13: Lumber prices have come back to earth

Source: Goldmoney Research

Similar to the development in the used car market, while this may be good for people trying to build a new home, it is indicative of the material slowdown in construction activity. This can be directly observed in housing data. New housing starts are 28% lower than in spring 2022 (See Exhibit 14). 

Exhibit 14: New Housing Start data shows a material slowdown in construction activity

Source: FRED, Goldmoney Research

Moreover, mortgage costs have exploded. A 10-year fixed mortgage went from 2.5% a year ago to 6.3% now (see Exhibit 15). This will undoubtedly dampen the appetite for home purchases and strain disposable income as previously fixed mortgages must be rolled over. Given current mortgage rates, it is surprising that the housing market has not yet corrected a lot more.

Exhibit 15: Mortgage rates have exploded over the past 12 months

Source: Bankrate.com, Goldmoney Research

There is a myriad of other indicators, from crashing freight rates (see Exhibit 16) to layoffs in the trucking and technology sector as well as languishing oil prices despite record outages and inventories, that indicate that the Feds (and increasingly other central banks) ultra-hawkish policy is impacting the real economy, both domestic and globally. 

Exhibit 16: Freight rates had skyrocketed in the aftermath of the Covid19 Pandemic but are now back to normal

Source: Goldmoney Research

The result will be a period of global economic contraction. The Fed may view this decline in inflation as confirmation that their policies are working to fight inflation, even though it will only reflect a crashing economy. Importantly, once the recession kicks in, we will soon see rising unemployment. Once unemployment starts rising, the Fed will have to slow down its rate hikes and eventually stop. However, the underlying cause of inflation – over 8 trillion in asset buying by the Fed – will only have reversed a tiny bit by that point. This means that once the fed will have to make a decision, to either fight unemployment or inflation. 

We believe that the most likely explanation for the recent rally in gold prices against the underlying drivers of our model is that the market is increasingly pricing in that the Fed, once it is forced to stop hiking, will lose control over inflation. Faced with the choices of years of high unemployment and a crumbling economy or persistent high inflation, the gold market thinks the Fed will opt for the latter. This would mark a true paradigm shift, and from that point on, gold prices may start to price in prolonged high inflation (and our model may not be able to capture this properly).

The crash of Silicon Valley Bank (SVB) a few days ago has created significant turmoil in financial markets. While the Fed jumped in and announced a new lending program that effectively bailed out the bank, it also led to a sharp change in market expectations for the Fed. Before the bailout, Fed fund futures implied that the market expected several more Fed hikes this year, and only a gradual easing thereafter. One week later and the market is now pricing in that the Fed will only hike until May, and then pivot and start cutting rates (see Exhibit 17). 

Exhibit 17: The crash and subsequent bailout of SBV led to a sharp reassessment of the Fed’s ability to raise rates

Source: Goldmoney Research

The gold market is still pricing in a much more dire outlook with higher and persistent long-term inflation Only time will tell whether this view is correct. In our opinion, it is quite forward-looking, and gold seems to be the only market that is that forward-looking at the moment. 10-year implied inflation in TIPS, for example, is at a laughably low 2.2%. For the model-predicted prices to match observed gold prices, 10-year implied inflation would have to be around 1.5% higher, at 3.75%. This doesn’t seem to be completely unfeasible. However, even if the gold market turns out to be ultimately correct, it will take a while until the rest of the market agrees with that view, and most likely there will be a period of sharply declining realized inflation in the meantime. That said, as equities look even more fragile in this scenario, and bonds and cash are unpopular asset classes during periods of high inflation, gold may simply be the only game in town until its time as the ultimate inflation hedge is coming. 

Authored by Kenneth Rogoff, op-ed via The Financial Times,

The Fed’s expansive actions to prevent the Silicon Valley Bank collapse from becoming systemic, followed by the Swiss National Bank’s massive lifeline to troubled Credit Suisse, left little doubt this week that financial leaders are determined to act decisively when fear starts to set in. Let us leave moral hazard for another day.

But even if risks of a 2023 financial Armageddon have been contained, not all the differences with 2008 are quite so reassuring.

Back then, inflation was a non-issue and deflation — falling prices — quickly became one. Today, core inflation in the US and Europe is still running hot, and one really has to strain the definition of “transitory” to argue that it is not a problem. Global debt, both public and private, has also skyrocketed. This would not be such an issue if forward looking, long-term real interest rates were to take a deep dive, as they did in the secular stagnation years prior to 2022.

Unfortunately, however, ultra-low borrowing rates are not something that can be counted on this time around.

First and foremost, I would argue that if one looks at long-term historical patterns in real interest rates (as Paul Schmelzing, Barbara Rossi and I have), major shocks — for example, the big drop after the 2008 financial crisis — tend to fade over time. There are also structural reasons: for one thing, global debt (public and private) exploded after 2008, partly as an endogenous response to the low rates, partly as a necessary response to the pandemic. Other factors that are pushing up long-term real rates include the massive costs of the green transition and the coming increase in defence expenditure around the world. The rise of populism will presumably help alleviate inequality, but higher taxes will lower trend growth even as higher spending adds to upwards pressure on rates.

What this means is that even after inflation abates, central banks may need to keep the general level of interest rates higher over the next decade than they did in the last one, just to keep inflation stable.

Another significant difference between now and post-2008 is the far weaker position of China. Beijing’s fiscal stimulus after the financial crisis played a key role in maintaining global demand, particularly for commodities but also for German manufacturing and European luxury goods. Much of it went into real estate and infrastructure, the country’s massive go-to growth sector.

Today, however, after years of building at breakneck speed, China is running into the same kinds of diminishing returns as Japan began to experience in the late 1980s (the famous “bridges to nowhere”) and the former Soviet Union saw in the late 1960s. Combine that with over-centralisation of decision-making, extraordinarily adverse demographics, and creeping deglobalisation, and it becomes clear that China will not be able to play such an outsized role in holding up global growth during the next global recession.

Last, but not least, the 2008 crisis came during a period of relative global peace, which is hardly the case now. The Russian war in Ukraine has been a continuing supply shock that accounts for a significant part of the inflation problem that central banks are now trying to deal with.

Looking back on the past two weeks of banking stress, we should be thankful that this did not happen sooner. With sharply rising central bank rates, and a troubled underlying economic backdrop, it is inevitable that there will be many business casualties and normally emerging market debtors as well. So far, several low-middle income countries have defaulted, but there are likely to be more to come. Surely there will be other problems besides tech, for example the commercial real estate sector in the US, which is hit by rising interest rates even as major city office occupancy remains only about 50 per cent. Of course the financial system, including lightly regulated “shadow banks,” must be housing some of the losses.

Advanced economy governments are not all necessarily immune.

They may have long since “graduated” from sovereign debt crises, but not from partial default through surprise high inflation.

How should the Federal Reserve weigh all these issues in deciding on its rate policy next week?

After the banking tremors, it is certainly not going to forge ahead with a 50 basis point (half a per cent) increase as the European Central Bank did on Thursday, surprising markets. But then the ECB is playing catchup to the Fed.

If nothing else, the optics of once again bailing out the financial sector while tightening the screws on Main Street are not good. Yet, like the ECB, the Fed cannot lightly dismiss persistent core inflation over 5 per cent. Probably, it will opt for a 25 basis point increase if the banking sector seems calm again, but if there are still some jitters it could perfectly well say the direction of travel is still up, but it needs to take a pause.

It is far easier to hold off political pressures in an era where global interest rate and price pressures are pushing downwards. Not anymore. Those days are over and things are going to get harder for the Fed. The trade-offs it faces next week might only be the start.