[This blog post is an excerpt from a commentary published at TSI on 9th April]

The following chart shows that the yield on the 10-year Treasury Inflation-Protected Security (TIPS), a proxy for the real long-term US interest rate, has oscillated within a horizontal range over the past seven months. These interest rate swings may not appear to be significant, but they have had significant effects on the financial markets in general and the gold market in particular.

With regard to the effects on the gold market of the recent swings in the 10-year TIPS yield, we note that:

1. The multi-year high recorded by the 10-year TIPS yield on 3rd November of last year coincided with the end of a multi-year downward correction in the US$ gold price.

2. The short-term low in the 10-year TIPS yield on 1st February of this year coincided with a short-term peak in the US$ gold price.

3. The short-term high in the 10-year TIPS yield on 8th March coincided with the end of a short-term correction in the US$ gold price.

4. The US$ gold price rocketed upward from 8th March through to the end of last week as the 10-year TIPS yield moved back to the bottom of its range.

With the 10-year TIPS yield now at the bottom of its 7-month range, the most likely direction of the next multi-week move is upward. However, at some point there will be a sustained breakout from this range, with major consequences for the financial markets.

If the eventual breakout in the 10-year TIPS yield is to the upside, it will be bearish for everything except the US dollar. This is a low-probability scenario because it would require the Fed to either continue its monetary tightening in the face of severe economic weakness or take no action when presented with obvious evidence of deflation.

If the eventual breakout in the 10-year TIPS yield is to the downside, the consequences for asset and commodity prices will depend on whether the primary driver of the breakout is a falling nominal yield or rising inflation expectations (the real interest rate is the nominal interest rate minus the EXPECTED inflation rate). A downside breakout in the real interest rate that was driven by a falling nominal yield would be bullish for gold and probably also would be bullish for the US$ relative to other major currencies, while being bearish for most commodities and equities. This is because it likely would result from severe economic weakness. A downside breakout in the real interest rate that was driven by rising inflation expectations would be bullish for gold, but more bullish for cyclical commodities (e.g. the industrial metals) and equities. It would be bearish for the US$.

We expect that at some point within the next four months the 10-year TIPS yield will make a sustained break below the bottom of its range, primarily due to falling nominal interest rates. It could happen as soon as this month, but July-August is a more likely timeframe. It mainly depends on how quickly the economy deteriorates.

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

The US 10yr-2yr yield spread, a proxy for the US yield curve, has rebounded sharply over the past couple of weeks (refer to the following daily chart), from more than 100 basis points below zero to ‘only’ about 50 basis points below zero. Is this the start of a steepening trend for the US yield curve?

There is one good reason to believe that the recent upturn shown on the above chart did NOT mark the start of a new trend. The reason is the relationship between the monetary inflation rate (the blue line) and the 10yr-2yr yield spread (the red line) illustrated on the chart displayed below. This chart shows that the yield spread tends to follow the monetary inflation rate and that the monetary inflation rate was still in a downward trend at the end of February-2023.

Further to the above chart, a yield curve inversion is caused by a large decline in the monetary inflation rate and a major shift in the yield curve to a new steepening trend is caused by a major upward reversal in the monetary inflation rate. Currently there is no sign of an upward reversal in the monetary inflation rate.

As an aside, the 10yr-2yr spread is just one indicator of the yield curve. The 10yr-3mth spread (see chart below) is equally important and made a new inversion extreme on Monday of this week. In other words, there is no evidence of a shift towards steepening in the 10yr-3mth spread.

Perhaps it will be different this time and a yield curve shift to a steepening trend will precede a money-supply growth rate reversal, but we wouldn’t bet on it. As long as monetary conditions as indicated by the monetary inflation rate are still tightening, there will be upward pressure on short-term interest rates relative to long-term interest rates. This is because short-term interest rates will be kept relatively high by the increasingly urgent desire for short-term financing, while long-term zero-risk interest rates will reflect the expected eventual effects on prices and economic activity of today’s tight monetary conditions.

[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.