The Fed Paves the Way for Running a “High-Pressure Economy” (Along with Higher Inflation)

Since the beginning of last year (see my February 4, 2015 commentary “U.S. Inflationary Pressures Remain Muted” and my March 1, 2016 Forbes commentary “Why Federal Reserve Tightening Is Still A Distant Event“), I have consistently asserted that the Fed’s ultimate tightening schedule would be slower than expected–from both the perspective of the Fed’s original intentions, as well as those of the fed funds futures market. Indeed, the most consistent theme since the beginning of the 2008-09 global financial crisis has been this: The tepid recovery in global financial conditions and global economic growth has consistently forced the Fed to ease more than expected; and since the “tapering” of the Fed’s quantitative easing policy at the end of 2013, to tighten less than expected. E.g. the October 2008 Blue Chip Economic Indicators survey of America’s top economists predicted the fed funds rate to rebound to 4.0% by late 2010. Subsequent forecasts were similarly early.

According to the CME Fed Watch, the probability of a 25 bps Fed rate hike on December 14 is now over 70%. I expect the December 14 hike to occur as the Fed has been prepping the market for one 25 bps hike for months; however–similar to what I asserted last year–I do not believe this rate hike will signal the beginning of a new rate hike cycle. Rather, the timing of the Fed’s third rate hike will again be data-dependent (more on that below). Fed funds futures currently peg the Fed’s third rate hike to not occur until more than a year from now, i,e. at the December 13, 2017 FOMC meeting. This is the most likely timing for the third rate hike, for the following reasons:

1. U.S. households remain in “deleveraging” mode. Haunted by the 2008-09 global financial crisis, record amounts of student loans outstanding (currently at $1.3 trillion), and a shorter runway to retirement age and lower income prospects, U.S. consumer spending growth since the bottom of the 2008-09 global financial crisis has been relatively tepid (see Figure 1 below), despite ongoing improvements in the U.S. labor market;

Fig1PCE.png

2. The developed world & China are still mired by deflationary pressures. While the Fed had not been shy about hiking rates ahead of other central banks in previous tightening cycles, the fact that all of the world’s major central banks–with the exception of the Fed–are still in major easing cycles means the Fed has no choice but to halt after its December 14, 2016 hike. Even the Bank of England–which was expected to be the first major central bank to hike rates–was forced to reverse its stance and renew its quantitative easing policy as UK policymakers succumbs to the rise of populism. In a world still mired by deflationary pressures, the U.S. could easily succumb to another deflationary cycle if the Fed prematurely adopts a hawkish stance;

3. The Fed is no longer in denial and finally recognizes the uniqueness of the 2008-09 deleveraging cycle that is still with us today. In a June 3, 2016 speech (titled “Reflections on the Current Monetary Policy Environment“), Chicago Fed President Charles Evans asserted why this isn’t a normal recovery cycle and because of that, argued why the Fed should foster a “high-pressure” economy (characterized by a tight labor market and sustained inflation above 2%) in order to ward off downside risks in both economic growth and inflation. Quoting President Evans: “I view risk-management issues to be of great importance today. As I noted earlier, I still see the risks as weighted to the downside for both my growth and inflation outlooks … So I still judge that risk-management arguments continue to favor providing more accommodation than usual to deliver an extra boost to aggregate demand … One can advance risk-management arguments further and come up with a reasonable case for holding off increasing the funds rate for much longer, namely, until core inflation actually gets to 2 percent on a sustainable basis.

President Evans’ speech was followed by similar dovish sentiment expressed by Fed Governor Daniel Tarullo in a September 9, 2016 CNBC interview, Fed Governor Lael Brainard in a September 12, 2016 speech at the Chicago Council on Global Affairs, as well as the September 2016 FOMC minutes. Finally, Fed Chair Janet Yellen explored the potential benefits of running a “high-pressure economy” after a deep recession in her October 14, 2016 speech at a recent conference sponsored by the Boston Fed. Quoting Chair Yellen:

If we assume that hysteresis is in fact present to some degree after deep recessions, the natural next question is to ask whether it might be possible to reverse these adverse supply-side effects by temporarily running a “high-pressure economy,” with robust aggregate demand and a tight labor market. One can certainly identify plausible ways in which this might occur. Increased business sales would almost certainly raise the productive capacity of the economy by encouraging additional capital spending, especially if accompanied by reduced uncertainty about future prospects. In addition, a tight labor market might draw in potential workers who would otherwise sit on the sidelines and encourage job-to-job transitions that could also lead to more-efficient–and, hence, more-productive–job matches. Finally, albeit more speculatively, strong demand could potentially yield significant productivity gains by, among other things, prompting higher levels of research and development spending and increasing the incentives to start new, innovative businesses.

Bottom line: The Fed continues to back off from committing to an official tightening schedule. After the December 14, 2016 rate hike, probability suggests the next rate hike to not occur until the December 13, 2017 FOMC meeting. Until the year-over-year PCE core rate rises to and maintains a rate of 2.0% or over, the Fed will not recommit to a new rate hike cycle. This also paves the way for higher U.S. inflation; as such, clients should continue to underweight U.S. long-duration Treasuries and overweight gold.

Revising Our Price Target of Gold to $950-$1,100 an ounce

We first became bearish on gold prices in August 2011, when gold traded at $1,848 an ounce.  Even though we understand systemic risks in the Euro Zone were real, we thought gold was highly overbought at the time. We subsequently became even more bearish on gold prices in late 2012, when it became apparent to us that the year 2013 was shaping up to be an “anti-climatic” year as global and European systemic risks began to dissipate. We articulated our bearish views on gold in our January 25, 2013 global macroeconomic issue–when gold traded at $1,660 an ounce–sticking our neck out with a 12- to 18-month $1,100-$1,300 price target. Our call was made several weeks ahead of similar calls by Goldman Sachs and Credit Suisse.

Over the last 18 months, we have reiterated our bearish views on both gold prices and gold miners; in our July 7, 2013 commentary (“A Technological Revolution in the Making – The U.S. Giant Awakens“), we further lowered our price forecast to $1,000-$1,200 an ounce as gold production remained high despite the decline in gold prices. Recent developments suggest that deflation and increasing production efficiencies remain alive and well in the gold mining industry. As such, we are lowering our price target range for gold yet again to $950-$1,100 an ounce. We believe this target will be hit over the next six months. Figure 1 below shows our calls on the price of gold during and post the 2008-09 global financial crisis.

CBcapitalcallsongold

From a classic economic standpoint, gold production should be declining given the decline in gold prices over the last 18 months. But this has not happened in the gold mining industry, for two reasons: 1) almost all gold miners had a bloated cost structure going into the recent price decline; as such, many gold miners were able to cut production costs and stay marginally profitable even as gold prices declined, and 2) some gold miners–post production cost cuts–had to produce and sell more gold to stem cash flow problems.

As the cost of production declines, miners are able to produce more gold at lower prices. According to the World Gold Council, mine production hit 765 tonnes during Q2 2014, a 4% year-over-year increase from Q2 2013, despite an average market price of $1,288 an ounce, or a decline of $125 an ounce from Q2 2013. Figure 2 below shows that global supply of gold has remained steady despite the decline in gold prices in the last 18 months.

QuarterlygoldsupplyQ22014

Interestingly, at the September 15-17, 2014 Denver Gold Forum, some gold miners are indicating a higher allocation of capital for development projects, such as Goldcorp (Cerro Negro, Eleonore, and Cochenour), Newmont (Merian), New Gold (Rainy River), and Eldorado (Skouries). With the exception of the Eldorado project, all of these projects are expected to come online with an all-in-sustaining-costs (AISC) of $1,000 an ounce or below. This means almost of these projects will remain profitable (taking into account regular future capex and maintenance costs) even if gold falls below $1,000 an ounce in the long-run. At the same time, many gold miners indicated that cost-cutting remain their main objective. The combination of more ambitious expansion plans and ongoing cost-cutting initiatives suggest that mine production (i.e. gold supply) will continue to increase even if gold prices continue to fall. We thus do not believe gold miners will curb production significantly until gold falls to below $1,100 an ounce and stays there for at least several months.

Finally, we assert that from a sentiment and psychological standpoint, gold is oversold but still not sufficiently oversold for us to buy. In our July 7, 2013 commentary–when gold traded at $1,220 an ounce–we stated that the two most reliable indicators for at least a tradeable bottom were absent. Quoting our July 7, 2013 commentary:

The two most reliable psychological indicators for a tradeable bottom in any asset class are: 1) Panic, or 2) Indifference. The best time to invest in any asset class is after years of investors’ indifference. That–along with other screaming buy indicators–was the reason why I invested in physical gold and unhedged gold miners at under $275 an ounce in late 2000.

One sentiment indicator that we track is the change in the holdings of the gold ETF, GLD. Holdings in GLD are highly indicative of marginal/short-term demand given its daily liquidity and the types of speculators it attracts. As shown in Figure 3 below, GLD holdings peaked at 45 million ounces (orange line; right axis) in early January 2013, and have since declined to 25 million ounces, a drop of 44% over the last 18 months.

GLD 9-26-14

While a 44% drop in GLD gold holdings is dramatic, keep in mind that all of this drop occurred from January 2013 to December 2013. Since the beginning of 2014, GLD gold holdings has actually remained steady–suggesting that retail investors have neither capitulated nor panicked into selling their GLD just yet. We do not believe that gold prices will bottom until there is another selling panic similar to that in April 2013 (when the price of gold dropped by $200 an ounce in just two weeks).

The combination of steady/higher gold production and the lack of investor panic in GLD suggest that gold prices have more downside to go. Bottom line: We reiterate our bearish stance on gold. New evidence suggests that gold production is more resilient and less sensitive to lower gold prices than we believed as gold miners continue to cut costs to achieve higher efficiencies . This is leading us to revise our target range downwards to $950-$1,100 an ounce over the next six months. Stay short gold.