[This blog post is an excerpt from a commentary published at TSI last week]

The senior central banks (the Fed and the ECB) hiked their interest rate targets over the past several days and have stated that more rate hikes will be needed to quell the inflation that they, themselves, created*. However, the pressure to stop hiking and to start cutting is building and probably will continue to do so over the next few months. This is important for most financial markets and is especially important for the gold market.

A problem facing the central banks is that they can ‘ring fence’ the banking industry, especially in the US where the major banks are in good financial shape, but they cannot protect the entire financial system without turning from monetary tightening to monetary loosening. Of particular relevance, whereas the banking system is mostly transparent (from the perspective of central banks) and can be supported by targeted measures such as the new Bank Term Funding Program (BTFP), many transactions in the so-called “Shadow Banking System” involve counterparties that are not subject to bank regulations and occur outside the central banks’ field of view. The best example is the Repo (Repurchase Agreement) market, which should not be confused with the Fed’s Reverse Repo facility.

Whereas the Fed’s Reverse Repo facility is well defined in terms of size (currently about US$2.3 trillion) and participants, and is of course within the Fed’s control, the Repo market is even bigger (we are talking multi-trillions of dollars of transactions per day) and involves hedge funds and corporations as well as various financial institutions (banks, MMFs, primary dealers, brokers, pension funds, etc.). A Repo is simply a transaction in which one firm sells securities (typically Treasuries) to another firm and agrees to buy the securities back at a slightly higher price in the future (typically the next day). The difference between the sell price and the buy price is known as the “repo rate”, which effectively is an interest rate. Normally the repo rate is very close to the Fed Funds Rate.

The Fed was forced to intervene in the Repo market in September-2019 to address a liquidity crunch that caused short-term interest rates to spike well above the Fed’s target, and again in 2020 in reaction to a sudden cash shortage caused by the COVID lockdowns. It did this by expanding its balance sheet and creating money out of nothing — a moderate amount of money in reaction to the September-2019 cash crunch and a massive amount of money in reaction to the lockdowns. Most of the time, however, the Repo market just chugs along in the background like the plumbing system that distributes water around a large commercial building.

In a nutshell, the problem for the senior central banks is that while the commercial banking system can be prevented from blowing up while monetary tightening continues, the monetary tightening eventually will lead to blow-ups among other financial operators that are big enough to disrupt the workings of the financial system. The specific major blow-ups usually can’t be identified ahead of time, but if the tightening continues they will happen (actually, there already has been more than enough tightening to set the scene for such events). And when they happen they will not only stop the central banks from doing additional rate hikes, they probably will result in emergency rate cuts and balance-sheet expansions.

The above comments are in the gold section because this is the stuff that really matters for gold. Gold is not the anti-dollar, as it is sometimes labelled. It is also not a hedge against inflation, although like many other ‘hard’ assets it has retained its value over the very long-term. Instead, it is reasonable to think of gold as the anti-bank or the anti-financial-system. As a result, gold’s price is driven by confidence in the financial system and the main official supporters of the financial system (the government and the central bank), which can be quantified to a meaningful extent using certain ratios and interest-rate spreads. Falling confidence leads to a higher valuation for gold, rising confidence leads to a lower valuation for gold.

*That’s not exactly what they are saying, in that they are not accepting blame for the inflation problem. They are saying that more rate hikes are needed to quell the inflation that has arisen due to exogenous and unforeseeable forces.

[This blog post is an excerpt from a TSI commentary published on 12th March 2023]

The financial markets have been fighting the Fed since October of last year and especially since the start of this year, in two ways. The first involves bidding-up stock prices in anticipation of a ‘Fed pivot’, which we have described as a self-defeating strategy. The second involves factoring lower interest rates into bond prices, which we thought made sense. What is the current state of play in the battle between the markets and the Fed?

Just to recap, we wrote in many previous commentaries that stock market bulls would get the monetary policy reversal on which they were betting only AFTER the SPX plunged to new bear-market lows and the economic data had become weak enough to remove all doubt that a recession was underway. In other words, a very weak stock market was one of the prerequisites for the policy reversal. That, in essence, is why bidding-up prices in anticipation of a policy reversal was/is viewed as a self-defeating strategy. Also worth reiterating is that previous equity bear markets were not close to complete when the Fed made its first rate cut. This implies that if we are still months away from the Fed’s first rate cut then we could be a year away from the final bear market low.

Regarding the other aspect of the Fed fighting, we have written that interest rates probably would move much lower over the course of 2023 due to an economic recession, an extension of the downward trend in inflation expectations and a collapse in the year-over-year CPI growth rate. This meant that from our perspective the financial markets were right to be factoring lower interest rates into Treasury securities with durations of two years or more. However, in the 16th January 2023 Weekly Update we cautioned: “…the recent eagerness of traders to push-up asset prices in anticipation of easier monetary policy has, ironically, extended the likely duration of the Fed’s monetary tightening. Therefore, while the markets probably are right to discount lower interest rates over the coming year, ‘fighting the Fed’ has created a high risk of interest rates rising over the next 1-3 months.”

Partly due to equity traders attempting to ‘front run’ the Fed, the monetary tightening has been extended and interest rates rose markedly from mid-January through to the first half of last week. The 10-year and 30-year Treasury yields have remained below their October-2022 cycle highs, but the 2-year Treasury yield, which had signalled a downward reversal late last year, made new highs over the past fortnight.

The following chart shows the surge in the 2-year Treasury yield from a multi-month low in mid-January to a new cycle high during the first half of last week. It also shows that there was a sharp decline during the second half of last week. Will the latest downward reversal stick?

We suspect that it will. It’s likely that 10-year and 30-year Treasury yields have reversed downward after making lower highs, and that the 2-year Treasury yield has made a sustainable downward reversal from a slightly higher high for the cycle. This is the case because other markets are signalling the start of a shift away from risk.

There’s a good chance that within the next few months stock market bulls will get the Fed pivot they have been betting on. However, they probably will get it with the SPX at 3000 or lower.

[Below is an excerpt from a commentary posted at TSI on 19th February. Subsequently there have been no significant changes in the data, so the conclusion remains the same.]

Cutting to the chase, the short answer to the above question is no. Here is the longer answer:

Banks becoming suspicious of each other is one of the early signs that a banking crisis is brewing. This suspicion is indicated by a rise in the average interest rate that banks charge each other for short-term financing relative to the interest rate paid by the US federal government for financing of similar duration. For example, under normal (non-crisis) conditions the spread between 3-month LIBOR, a widely used interbank interest rate, and the yield on a 3-month Treasury Bill oscillates between 0% and 0.50%, but when some banks start becoming concerned about the financial strength of other banks the spread breaks above 0.50%.

The following daily chart shows the performance of the aforementioned interest rate spread since early-2006. The Global Financial Crisis of 2007-2009 sticks out on this chart and was signalled by an initial surge above 0.50% during the second quarter of 2007. During the period covered by this chart the only other move to well above the top of the normal range occurred during the March-2020 COVID crash, but it was very short-lived as the Fed acted immediately to ensure that the economic shutdowns perpetrated by governments did not create problems for the commercial banks. Also worth noting is that there were minor signs of banking-system stress in Q4-2011, Q3-2016, Q1-2018 and the first half of 2022 that did not develop into crises.

Importantly, the chart shows that the current spread is close to zero, which means that the interbank market is as calm (lacking in suspicion) as it ever gets.

Another interest rate spread worth monitoring is the Secured Overnight Financing Rate (SOFR) minus the yield on the 1-month Treasury Bill. The SOFR is the interest rate that banks and hedge funds pay to borrow overnight money in the US Repo (Repurchase Agreement) market. It has a much shorter history than the LIBOR, but it is gaining in popularity. Like the LIBOR-Treasury spread discussed above, a substantial and sustained rise in the SOFR-Treasury spread would indicate increasing suspicion/stress in the banking system.

The following chart shows that the SOFR-Treasury spread has been far more volatile during the past 12 months than it was during the bulk of 2020-2021, but that it has oscillated around zero and currently is slightly below zero (a level indicating a general lack of concern).

Note that the huge upward spike in the SOFR-Treasury spread in 2019 was due to the “Repo Crisis” in September of that year. The Fed circumvented this crisis very quickly via emergency liquidity injections.

Unusual increases in the above interest rate spreads would warn that a banking crisis was brewing. Also, prior to a banking crisis there would be persistent and pronounced weakness in bank equities relative to the broad stock market.

The lower section of the following chart shows that there was significant weakness in the Bank Index (BKX) relative to the broad stock market (represented by the SPX) during February-March of last year, but that the BKX/SPX ratio is in a short-term upward trend and is at roughly the same level today as it was in early-April of last year.

Banking crises don’t come out of nowhere. Enough people inside and outside the banking industry see them coming and take steps to protect themselves or profit from the fallout that early warning signs emerge. Currently there are no such signs.