The precious metals sector moved sharply higher yesterday, and I received quite a few questions about this move, so I decided to send you a message before the next week starts.
In short, the inflation statistics were terrible. The major headline from Yahoo! Finance was:
“Stocks crushed after inflation hits 40-year high: Nasdaq falls 3.5%, S&P 500 suffers worst week since January”
So, it was the inflationary scare that fueled yesterday’s rally. Additionally, one could read in various places that the Fed won’t be able to contain the inflation. Other headlines were like this:
“How soon will the Fed flinch? (...)”
“It’s best to have gold as Fed won’t tame inflation”
“The U.S. and Europe have enough gold for a gold standard; (…)”
That’s in tune with what I’ve been describing in the fundamental parts of the recent Gold & Silver Trading Alerts. The investors are expecting the Fed to reverse its course, or at least to be ineffective when dealing with inflation. Especially when the stock market declines, the prevailing narrative is that then the Fed will reverse its course.
And it all sounds believable until one focuses on four key factors:
- Investors and traders are usually very good following the latest news, but very bad at putting this news into proper context. Investors tend to forget about the long-term cycles and analogies and focus on the short term only. It’s so bad that the financial professionals have coined a name for this phenomenon: short-termism.
- The very long-term interest-rate/inflation chart that I’ve been featuring in recent Gold & Silver Trading Alerts and its implications remain up-to-date regardless of yesterday’s inflation reading. Namely, if the Fed wants to tame the inflation, it will likely need to raise the interest rates above it. Anything other than the above would be an attempt to rewrite historical cycles.
- Inflation got political. Incredibly so. Not dealing with inflation or at least not seriously attempting to fight it, will make anyone look weak and nobody will want them in charge of anything. And we have the U.S. elections later this year… No pressure, right? Of course, monetary authorities are independent from politics… In theory. In practice, not so much, at least that’s not what history tells us, especially recent history.
- (And this is perhaps what is most blatantly ignored.) The people making the decisions are not REALLY avoiding recession. They are not REALLY avoiding inflation. They are REALLY avoiding… Blame. Blame costs votes. Votes cost power.
Let’s start with the last point. How to avoid blame in this situation? It will be difficult, but probably the best attempt that the authorities have for this is to appear as if they had done all they could. Based on yesterday’s data, it’s clear that whatever was done so far, was not enough. If the authorities are going to repeat publicly that fighting inflation is their top concern (as they already do, since that’s what the voters are most concerned with), they have to eventually put actions behind the words, or else their talk will backfire as they will completely lose their credibility (thus votes, and thus power).
We’ve heard a lot of hawkish talk recently, but we haven’t seen enough action. At least that’s what yesterday’s numbers told the investors.
If inflation wasn’t so political and timing wasn’t so critical (elections!), I might have had doubts regarding the next Fed’s moves. But given the above, I have very little doubt that the Fed will be aggressively hawkish, at least until the elections, and at least we see improvement in inflation statistics. The stated goal will be to avoid inflation, and they will present themselves as courageously fighting the biggest enemy. In reality, though, it will be a desperate attempt to avoid blame whatever happens.
Besides, the inflation was not tamed – as yesterday’s statistics showed – and what did the stock market do? It declined. So, the Fed just got the final green light for more hawkish approach – if they don’t raise the rates or they just raise them as they had indicated (the market remembers what they said recently), stocks are going to sink, anyway.
Also, remember when they said that declining stocks are not the Fed’s goal, but it’s something that might happen as a result of what needs to be done to tame inflation?
That was the early hedge against blame, as they know exactly what’s coming.
But if they know that stocks are going to slide based on the rate hikes and quantitative tightening, then why would they continue?
Points 2, 3, and 4 explain it. The foremost concern right now is not the valuation of stock indices, and it’s not the unemployment. It’s inflation, and other concerns are not even close. Since that is the main concern, that’s what will be fought. That’s the key thing to keep in mind right now.
And when the s**t hits the fan, and stocks are already much lower and people will complain about it (and that is a polite way to put it), the authorities will simply say that it was what had to be done in order to fight what people wanted them to fight. They will emphasize that they simply did what was their job, and what people expected of them. Blame avoided? Perhaps, perhaps not, but the above approach appears to minimize it.
Also, please remember about point 2. Authorities can use the analogies to the past to explain what had to be done to really tame inflation, emphasizing that they only did what was necessary.
Ok, but what does all this have to do with gold, and the rest of the precious metals sector?
Everything. First of all, how does soaring gold prices make the authorities look with regard to their way of handling inflation? Impotent.
Yes, gold might (and is quite likely to) get much higher, but now the Fed is probably only starting its hawkish crusade. And since elections are in November, it would be quite “convenient” if gold didn’t soar, but declined instead, wouldn’t you agree? If only politicians had friends in big financial institutions that perhaps could “help” them, triggering declines in the futures markets… If only…
In the near term, the Fed has quite a few bullets, and can raise the interest rates and drain liquidity from the market through other means. And given the above expectations (yesterday’s headlines), when investors realize that the Fed is not about to make a dovish pivot, they will likely react in the opposite way to what we saw yesterday.
A dovish pivot here would imply taking full blame for the inflation that follows, AND for the following recession. Since people are so concerned with inflation, it’s much easier to simply fight it and appear as people’s savior.
Gold price has two primary fundamental drivers: the USD Index and real interest rates.
If the Fed really starts increasing rates at a facer pace than inflation is rising (and that’s what would be required to tame inflation, or at least to appear like they mean to really fight it), the real rates will soar. And that’s likely, precisely because inflation is so political right now. It might cease to be the case in the future, when people are more concerned with other things, but for something to be more important than inflation that’s so huge as it is right now, it would really have to be major.
Also, please note that inflation affects ALL voters, while declining stock market valuations are particularly important only to voters, who actually have a lot of capital invested in stocks. The first group is definitely bigger, as not everyone has sizable share holdings.
So, rising real interest rates are very likely here.
And the USD Index? Well, we all see what’s going on. The EUR/USD pair is the biggest component of the Index, so let’s focus on it today. The ECB once again failed to increase the rates. Yes, they have a plan to increase them, but, well, the Fed is already doing that. And it might continue to do so at faster pace. One reason is the upcoming elections, and another is the fact that in case of the Eurozone, increasing interest rates might trigger severe sovereign debt problems in case of member nations. So, it’s not that likely.
In other words, the USD Index is set to soar, too.
Let’s get back to point 1. Yesterday, market participants focused on an inflation number in isolation. And the line of thinking was inflation is soaring and the Fed won’t stop it, so let’s buy gold to protect ourselves against inflation.
That’s wrong not just because data shows that gold provides hedge against hyperinflation, not against regular inflation. It’s wrong because it completely ignores the current political environment and what people are most concerned with.
The next interest rate decision is this Wednesday, and it’s probably going to be very interesting. I wouldn’t be surprised if we saw a rate hike by more than 0.5% - for example by 0.75%. This might be enough to send a message to the market that they are serious about the inflation and have positive political implications. Whether that happens or not, the following conference will likely aim to rebuild investors’ confidence in the Fed. It might or might not work with regard to confidence, but it should be enough to trigger declines in the markets (including PMs) – after all that’s how hawkish surprises work.
On a final note, please note that while gold moved to new monthly high yesterday, the GDXJ, proxy for junior miners, managed to only erase previous two days of declines. In total, the GDXJ was down by 1.37% last week.
Anyway, the medium-term trend in the precious metals market remains down, and it seems that we’ll see another – very powerful – downswing shortly. The fact that during yesterday's session PMs moved higher (while stocks decline and the USDX moved higher) is likely just that one swallow that doesn't make the summer. Please remember that we saw something similar in mid-April, right before gold's biggest decline started. If this strength continues after Fed's interest rate decision, it might indicate a change in the trend, but for now, it doesn't.
The huge profit potential for this short position remains intact regardless of Friday's rally.
As always, we’ll keep you - our subscribers - informed.
Przemyslaw Radomski, CFA