[This blog post is an excerpt from a TSI commentary published about three weeks ago and covers a few general thoughts about what will happen in the financial world this year. Specific thoughts about what I expect this year from the stock, gold, bond, currency and commodity markets have also been included in TSI commentaries over the past three weeks.]

1) Early last year we predicted that the US stock market would experience greater-than-average volatility over the year ahead. This obviously happened, as there were more 2%+ single-day moves in the SPX during 2018 than in an average year.

We expect the same for this year, that is, we expect price volatility to remain elevated. The reason is that the two most likely scenarios involve abnormally-high price volatility. One of these scenarios is that a cyclical bear market began last October, and bear markets are characterised by periods of substantial weakness followed by rapid rebounds. The other scenario is that a very long-in-the-tooth cyclical bull market is about to embark on its final fling to the upside.

2) When attempting to predict when a period of economic growth will end it is futile to look more than 6-12 months into the future, because there are no leading recession indicators that can predict that far ahead with acceptable reliability. There are, however, leading indicators that can be used to determine the probability of a recession beginning within the next few quarters.

Early last year these indicators told us that a US recession would not begin during the first half of the year. They currently tell us that the US economy stands a good chance of commencing a recession this year, most likely during the second half of the year. Note, though, that if a recession does get underway this year it won’t become official until 2020, because recessions usually aren’t confirmed by the National Bureau of Economic Research until about 12 months after they start.

3) Regarding ‘cryptoassets’, at around this time last year we wrote:

“…it’s a good bet that the Bitcoin bubble reached its maximum level of inflation late last year. Also, the broader bubble in cryptoassets is set to burst during the first quarter of this year.”

And:

“By the end of 2018 it will be apparent that the public’s enthusiasm for Bitcoin and the “alt-coins” was one of history’s great speculative manias.”

This assessment looks correct.

We don’t have a strong opinion about what will happen to ‘cryptoassets’ in 2019. This is partly because there is no reasonable way to determine the fair value of these assets. For Bitcoin, for example, a price of $3,000 is no more or less sensible than a price of $30,000 or a price of $300.

Distributed ledgers can be very useful, but there should be ways to implement them without consuming a lot of resources. If so, the price of Bitcoin eventually will drop to almost zero.

A year ago we also predicted:

“Despite spectacular collapses in the prices of the popular ‘cryptoassets’ during 2018, central banks including the Fed and the ECB will firm-up plans to introduce their own blockchain-based currencies. This will be driven by a desire to eliminate physical cash, the thinking being that if there is no physical money it will be more difficult for the average person to make/receive unreported payments and escape a negative interest rate.”

As far as we know the major central banks didn’t firm-up plans to introduce their own blockchain-based currencies last year, but we continue to expect that they will — for the reasons mentioned above.

4) Regarding the Fed’s expected actions in 2018, early last year we wrote:

“Due to rising commodity prices it’s a good bet that “price inflation” will become a higher-profile issue during the first half of 2018, prompting the Fed to move ahead with its quantitative tightening (QT) and make two more rate hikes. However, both the QT and the rate-hiking will be put on hold during the second half of the year in reaction to increasing downside volatility in the stock market.”

We got the anticipated rate hikes during the first half and the increasing downside stock-market volatility during the second half of last year, but the Fed stuck to its guns. However, over the past three weeks the Fed Chairman has made it clear that the Fed will be quick to change direction if the stock market continues to decline and/or the economic numbers point to significant weakness.

For 2019 we expect one Fed rate hike, most likely in June. Also, we expect that people ‘in the know’ will explain to senior Fed members that it’s the balance-sheet reduction program (QT) that really counts, prompting the Fed to slow the pace of QT during the first half and conclude the QT program before year-end.

5) The ECB has just ended its QE program and has a tentative plan to implement its first rate hike during the third quarter of 2019. Given that nothing has been learned from the failed monetary experiments of the past few years, it’s a good bet that evidence of declining economic activity in the future will be met by the ramping-up or reintroduction of policies that failed in the past. Therefore, we predict that the ECB will not increase its targeted interest rates this year and will restart QE during the second half of the year.

6) This is not a prediction for 2019, but rather an observation that could apply for decades to come. We suspect that the age of real estate has ended.

We don’t mean that from now on it will be impossible to achieve good returns by investing in real estate, but that gone are the days when anyone could buy a house almost anywhere and likely end up with a sizable profit as long as they held for 10 years or more. From now on only astute investors will consistently make good returns from real estate, where “astute” means able to time the cyclical swings in the broad market or able to correctly anticipate future supply-demand imbalances in specific areas.

For the average person, residential property will transition from an investment to what it was prior to the 1970s: a consumer good (something bought solely for its use value).

The reason for the change is the interest-rate trend. The 3-4 decade downward trend in interest rates resulted in a 3-4 decade upward trend in housing affordability for buyers using debt-based leverage (that is, for the vast majority of buyers). There were corrections along the way, but provided that long-term interest rates continued to make lower lows there would eventually be a pool of new debt-financed buyers able to pay a much higher price.

There’s a good chance that the secular interest-rate trend reversed from down to up during 2016-2018. If so, future house buyers that don’t have good timing and/or substantial area-specific knowledge generally won’t make long-term capital gains on their residential property purchases.

The ‘true fundamentals’ began shifting in gold’s favour in October of last year and by early-December the fundamental backdrop was gold-bullish for the first time in almost a year. However, there is not yet confirmation of a new gold bull market from the most reliable indicator of gold’s major trend. I’m referring to the fact that the gold/SPX ratio is yet to achieve a weekly close above its 200-week MA. Here’s the relevant chart:

The significance of the gold/SPX ratio is based on the concept that the measuring stick is critical when determining whether something is in a bull market. If a measuring stick is losing value at a fast pace then almost everything will appear to be in a bull market relative to it. For example, pretty much everything in the world has been rising in value rapidly over the past few years when measured in terms of the Venezuelan bolivar. It should be obvious, though, that not everything can be simultaneously in a bull market. To determine which assets/investments are in a bull market we can’t only go by performance relative to any national currency; we must also look at the performances of assets/investments relative to each other.

That’s where the gold/SPX ratio comes in. Gold and the world’s most important equity index are effectively at opposite ends of the ‘investment seesaw’. Due to their respective natures, if one is in a long-term bull market then the other must be in a long-term bear market. In multi-year periods when they are both trending upward in dollar terms it means that the dollar is in a powerful bear market, not that gold and the SPX are simultaneously in bull markets.

An implication — as noted on the following chart — is that a gold bull market did not begin in December-2015. Gold cannot be in a bull market and at the same time be making new 10-year lows relative to the SPX, which is what it was doing until as recently as August-2018. At least, it can’t do that if a practical and sensible definition of “bull market” is used.

It’s possible that a gold bull market got underway in August-2018, but as mentioned above this has not yet been confirmed.

About five months ago I posted an article in response to stories that the Chinese government had pegged either the SDR-denominated gold price or the Yuan-denominated gold price. These stories were based on gold’s narrow trading range relative to the currency in question over the preceding two years, as if government manipulation were the only or the most plausible explanation for a narrow trading range in a global market. To illustrate the silliness of these stories I came up with my own story — that it was actually the Japanese government that was pegging the gold price. My story had, and still has, the advantage of being a better fit with the price data.

Just to recap, my story was that the Japanese government took control of the gold market in early-2014 and subsequently kept the Yen-denominated gold price at 137,000 +/- 5%. They lost control in early-2015 and again in early-2018, but in both cases they quickly brought the market back into line.

The following chart shows that they remain in control.

The narrow sideways range of the Yen gold price over the past 5 years is due to the Yen being the major currency to which gold has been most strongly correlated. The correlation is positive, meaning that the prices of gold and the Yen have a strong tendency to trend in the same direction. This is evidenced by the following daily chart, which compares the US$ price of gold with the US$ price of the Yen.

Moving from the fantasy world to the real world, the relationship depicted above doesn’t exist because the Japanese government is pegging gold to the Yen. It exists because both gold and the Yen trade like safe havens, meaning that they tend to do relatively well when economic growth expectations and the general desire to take-on risk are on the decline, and relatively poorly when economic growth expectations and the general desire to take-on risk are on the rise.

Gold trades like a safe haven because in part that’s what it is. The Yen is a piece of crap, but it trades like a safe haven due to the relentless popularity of Yen carry trades. These carry trades involve borrowing/shorting the Yen to finance long positions in higher-yielding currencies, and are a form of yield-chasing speculation. Periodically they have to be exited in a hurry to mitigate the losses caused by declining prices in the aforementioned high-yielding speculations. When this happens the Yen rallies, and sometimes the rallies are dramatic. Last week, for example.

Divergences or non-confirmations between gold and the Yen can create trading opportunities. However, the two markets are in line with each other at the moment, meaning that there is currently no divergence or non-confirmation worth trading.

The Fed probably will implement another 0.25% rate hike this week, but at the same time it probably will signal either an indefinite pause in its rate hiking or a slowing of its rate-hiking pace. The financial markets have already factored in such an outcome, in that the prices of Fed Funds Futures contracts reflect an expectation that there will be no more than one rate hike in 2019. However, this doesn’t imply that the Fed is about to stop or reduce the pace of its monetary tightening. In fact, there’s a good chance that the Fed unwittingly will maintain its current pace of tightening for many months to come.

The reason is that the extent of the official monetary tightening is not determined by the Fed’s rate hikes; it’s determined by what the Fed is doing to its balance sheet. If the Fed continues to reduce its balance sheet at the current pace of $50B/month then the rate at which monetary conditions are being tightened by the central bank will be unchanged, regardless of what happens to the official interest rate targets.

Another way of saying this is that a slowing or stopping of the Fed’s rate-hiking program will not imply an easier monetary stance on the part of the US central bank as long as the line on the following chart maintains a downward slope.

The chart shows the quantity of reserves held at the Fed by the commercial banking industry. A decline in reserves is not, in and of itself, indicative of monetary tightening, because bank reserves are not part of the economy’s money supply. However, when the Fed reduces bank reserves by selling securities to Primary Dealers (as is presently happening at the rate of $50B/month) it also removes money from the economy*.

I use the word “unwittingly” when referring to the likelihood of the Fed maintaining its current pace of tightening because, like most commentators on the financial markets and the economy, the decision-makers at the Fed are oblivious to what really counts when it comes to monetary conditions. They are labouring under the false impression that monetary tightening is effected mainly by hiking short-term interest rates and that the current balance-sheet reduction program is a procedural matter with relatively minor real-world consequences.

Therefore, over the next several weeks there could be a collective sigh of relief in the financial world as traders act as if the Fed has taken its foot off the monetary brake, followed by a collective shout of “oops!” when it becomes apparent that monetary conditions are still tightening.

*When the Fed sells X$ of securities to a Primary Dealer (PD) the effect is that X$ is removed from the PD’s account at a commercial bank and X$ is also removed from the reserves held at the Fed by the PD’s bank.