[This blog post is an excerpt from a recent TSI commentary]

The title of this discussion is a trick question. The reason is that while rising interest rates put downward pressure on some stock market sectors during some periods, it is not clear that rising interest rates bring about major, broad-based stock market declines. After all, the secular equity bull market that began in the early-to-mid 1940s and ended in the mid-to-late 1960s unfolded in parallel with a rising interest-rate trend.

The conventional wisdom that rising interest rates eventually become a major problem for the stock market exists for two inter-related reasons. First, there is a strong tendency for major equity market declines to be preceded by a sustained and substantial tightening of monetary conditions. Second, it is common for a substantial tightening of monetary conditions to be accompanied by rising interest rates.

However, a sustained and substantial tightening of monetary conditions would bring about major weakness in the stock market even if interest rates were low or falling. This, in essence, is what happened during 2007-2008. The corollary is that a rising interest-rate trend would never become a major problem for the overall stock market as long as monetary conditions remained sufficiently accommodative.

The point is that when assessing the prospects of the stock market we should be more concerned about monetary conditions than interest rates, because it isn’t a given that rising interest rates indicate tightening monetary conditions or that falling interest rates indicate loosening monetary conditions. How, then, do we know the extent to which monetary conditions are tight or loose?

One of the most important indicators, albeit not the only useful indicator, is the growth rate of the money supply itself.

Good economic theory informs us that rapidly inflating the money supply leads to a period of unsustainable economic vigour called a boom, and that the boom begins to unravel after the monetary inflation rate slows. Over the past 25 years, booms have begun to unravel within 12 months of the year-over-year growth rate of G2 (US plus eurozone) money supply dropping below 6%.

The following chart shows the year-over-year growth rate of G2 True Money Supply (TMS), with a horizontal red line drawn to mark the 6% growth level mentioned above and vertical red lines drawn to mark the official starting times of US recessions. In the typical sequence, there is a decline in the G2 monetary inflation rate below 6%, followed within 12 months by the start of an economic bust (the unravelling of the monetary-inflation-fuelled boom), followed within 12 months by an official recession.

The time from a decline in the G2 monetary inflation rate to below 6% to the start of a recession can be two years or even longer, but the broad stock market tends to struggle from the time that the boom begins to unravel. This typically occurs within 12 months of the monetary inflation rate dropping below 6%, regardless of what’s happening with interest rates.

Now, it’s likely that the unravelling of the current boom will begin with the monetary inflation rate at a higher level than in the past. However, with the G2 TMS growth rate well into all-time high territory and still trending upward it is too soon (to put it mildly) to start preparing for an equity bear market.

For the first time in a long time, the sentiment backdrop recently became supportive for the gold price. However, the true fundamentals have been trending in a gold-bearish direction since early-October of last year (after having been supportive for almost a year before that) and still constitute a headwind for the gold price.

When it comes to assessing gold market sentiment, the Commitments of Traders (COT) report provides by far the most useful data. This is because it shows what speculators, as a group, are doing with their money in the part of the market (Comex futures) that is subject to the greatest sentiment swings and that has the greatest effect on short-term price movements.

At the moment, the total speculative net-long position (the inverse of the blue bars shown in the middle section of the following chart) is at its lowest level since June-2019. This implies that speculators are now less interested in gold than at any time over the past 20 months. Of greater importance is that the open interest (the green bars shown in the bottom section of the chart) is not far from its lows of the past three years. This is important because the gold price tends to bottom when the futures market open interest is relatively low.

Chart source: http://www.goldchartsrus.com/

The COT situation tells us that speculator enthusiasm for gold is now at a low ebb relative to the past couple of years, which is bullish given that speculator sentiment is a contrary indicator. At the same time, though, the fundamental backdrop remains bearish.

In broad-brush terms, the fundamental backdrop is bearish for gold when confidence in the economy and the financial system is high or increasing and bullish for gold when confidence in the economy and the financial system is low or decreasing. Confidence may seem like a vague concept, but it can be quantified using interest-rate spreads, price ratios and other market data.

The Gold True Fundamentals Model (GTFM), a weekly chart of which is displayed below, is my attempt to quantify the fundamentals that matter to the gold market.

When the fundamental backdrop is gold-bearish the best that can be reasonably expected from the gold price is a multi-week countertrend rebound, even when the sentiment situation is supportive. That appears to be what’s happening at the moment.

I expect that the fundamentals will turn in gold’s favour within the next three months as the US economy and many other economies around the world begin to shift from strong economic rebound to “stagflation”. However, they haven’t turned yet.

[Below is an excerpt from a commentary published at TSI last week. It is our latest monthly review of the short and intermediate term prospects of the US economy. Just to be clear, a boom is defined as a period during which monetary inflation and the suppression of interest rates create the FALSE impression of a strong/healthy economy.]

We think that last year’s US recession ended in June plus/minus one month, making it the shortest recession in US history. The latest data indicate that the recovery is well and truly intact.

Of particular relevance, the following monthly chart shows that the ISM New Orders Index (NOI), one of our favourite leading economic indicators, remains near the top of its 20-year range following a pullback in January-2021 and a rise in February-2021.

The ISM NOI leads Industrial Production (IP), so it isn’t surprising that the year-over-year percentage change in IP has experienced a rapid rebound from its Q2-2020 trough (refer to the following monthly chart for the details). More importantly, based on the latest NOI number, other leading indicators and the inevitability of additional stimulus from both the Fed and the government, IP’s rebound is set to continue. The IP number for March-2021 will (not might) indicate year-over-year growth.

The performances of leading and coincident economic indicators show that we are well into the boom phase of the boom-bust cycle, meaning that the economic landscape remains bullish for industrial commodities and bearish for gold. Therefore, it’s reasonable to expect the continuation of the rising trend in the GYX/gold ratio (industrial metals relative to gold) clearly evident on the following chart. Be aware, though, that on a short-term basis this trend appears to be over-extended.

The economic strength that was predicted eight months ago by leading indicators and is starting to become apparent in coincident indicators is largely artificial. This means that it will evaporate soon after the Fed is forced by blatant evidence of an inflation problem to end the monetary stimulus.

Our thinking at this time is that the period of strong economic growth will be followed by a period of what is often called “stagflation”, that is, a period when “inflation” accelerates in parallel with slow or no economic growth, because the Fed is not going to stop creating new money at a fast pace and the US government is not going to stop spending at a fast pace anytime soon. If so, then during the post-boom period commodities could continue to do well but gold should outperform almost everything.

However, we’ve learned from bitter experience that during the boom it’s best NOT to look ahead to the inevitable economic denouement. Instead, the focus should be on “making hay while the sun shines”. Near the end of the boom there will be timely warnings in the real-time data, but at the moment such warnings are conspicuous by their absence. This means that the boom should continue for at least another three months and could continue for much longer than that.

[This blog post is a modified excerpt from a commentary published at TSI on 21st February]

The true fundamentals* have been trending in a gold-bearish direction since early-October of last year, which is a large part of the reason that the gold price has been in a downward trend for the past several months. The majority of these true fundamentals are measures of confidence in the economy and/or the banking system, the theory — which is supported by decades of empirical evidence — being that gold performs relatively well in the bust phase of the boom-bust cycle and relatively poorly in the cycle’s boom phase.

Just to be clear, if the US$ is weak enough then it certainly is possible to make gains in US$ terms via being long gold during a boom, but you will do better by being long other things including industrial commodities. Hence the use, above, of the word “relatively”.

Credit spreads are one useful measure of economic confidence, with widening spreads indicating falling confidence and narrowing spreads indicating rising confidence. This implies that the direction and level of credit spreads indicate whether the economy is in the boom phase or the bust phase. That’s why the gold/commodity ratio generally has trended up and down with credit spreads, which is exactly what it should do.

Below is a chart that illustrates the relationship mentioned above. In this case metals are being compared with metals by looking at how gold performed relative to industrial metals (represented by the Industrial Metals Index – GYX) during periods of widening and narrowing credit spreads.

Unfortunately, the data for the credit spread indicator used in this chart starts in 2007, so for the first eight years of the chart there is only the gold/GYX ratio. However, a longer-term credit-spread indicator would confirm that gold/GYX’s 2001-2002 upward trend coincided with an economic bust and gold/GYX’s 2003-2006 downward trend coincided with an economic boom.

The chart suggests that there was a major economic boom during 2003-2006 and major economic busts spanning mid-2007 to mid-2009 and Q4-2018 to March-2020. The period from mid-2009 through to Q3-2018 contained a series a relatively minor booms and busts.

My guess is that the current boom will be short by historical standards, but there is no need to guess correctly because real-time data will provide timely warnings that the transition from boom to bust has begun. Right now there is no evidence that the boom is over.

*I use the term “true fundamentals” to distinguish the actual fundamental drivers of the gold price from the drivers that are regularly cited by gold-market analysts and commentators. According to many pontificators on the gold market, gold’s fundamentals include the volume of metal flowing into and out of the inventories of gold ETFs, China’s gold imports, the volume of gold being transferred out of the Shanghai Futures Exchange inventory, the amount of “registered” gold at the COMEX, India’s monsoon and wedding seasons, jewellery demand, the amount of gold being bought/sold by various central banks, changes in mine production and scrap supply, and various manipulation stories including wild guesses regarding JP Morgan’s exposure to gold. These aren’t true fundamental price drivers. They are distractions (at best) and should be ignored.

Due to the central-banking world’s unshakeable belief that money must continually lose purchasing power and the current authority of the central bank to do whatever it takes to achieve its far-reaching goals, the greater the perceived threat of deflation the more monetary inflation there will be. That’s why the endgame for the current monetary system involves rapid “price inflation”. This has been obvious for a long time, but some well-known analysts are just starting to cotton-on.

There were examples of the aforementioned phenomenon (the greater the fear of deflation, the higher the rate of monetary inflation) during 2001-2002 and again during 2008-2009, but 2020 provided the best example yet. As evidence we point to the following chart and the fact that the quantity of US dollars created during the 12-month period ending January-2021 (4.8 trillion) is greater than the entire US money supply at the beginning of 2007.

As an aside, it would be a good thing if deflation were the high-probability outcome that many analysts/commentators still claim it is, because deflation is relatively easy to prepare for. To prepare for deflation all you have to do is be ‘cashed up’, whereas in a high-inflation environment you are forced to speculate just to avoid a large loss of purchasing power.

At the moment the world’s most influential central bankers and economists don’t see a problem with rapid monetary inflation, because according to their favourite indicators previous large increases in the supply of money over the past two decades had only minor effects on the purchasing power of money. Also and as noted at the start of this discussion, the central-banking world is labouring under the belief that the economy would benefit from more “price inflation”.

However, in response to the most recent monetary inflation surge there will be a lot more traditional “price inflation” than a) there was in response to the previous money-supply growth spurts and b) the average central banker would consider to be beneficial. This isn’t only because of the much larger amount of money creation this time around, but also because of the way the new money is being distributed.

Whereas most of the new money created in reaction to earlier deflation scares was injected into the financial markets and stayed there, via the “stimulus” programs implemented last year and that are on the cards for this year the US government is, in effect, sucking a lot of money out of the bond market and sending it to the general public. Also, there will be a huge infrastructure spending bill that will do something similar (siphon money from the bond market to the public).

The Fed technically is still injecting new money into the financial markets by purchasing bonds from Primary Dealers, which means that it is doing what it did in response to earlier deflation scares. However, for all intents and purposes it is now monetising a rapidly-expanding government budget deficit.

According to the book Monetary Regimes and Inflation, all of the great inflations of the 20th Century were preceded by central bank financing of large government deficits. Furthermore, in every case when the government deficit exceeded 40% of expenditure and the central bank was monetising the bulk of the deficit, which has been the case in the US over the past 12 months, a period of high inflation was the result. In some cases hyperinflation was the result.

At any given time there will be many investable themes ‘on the go’ within the financial markets, but due to time constraints we cannot cover all or even most of these themes at TSI. Instead, we pick out a few to focus on.

For the information of non-subscribers, here is a summary of the themes that we focused on during the second half of last year and that remain focal points of the regular TSI commentaries.

1) Aggressive monetary and fiscal stimulus will create the illusion of global economic strength (an artificial economic boom).

2) The rising trend in inflation expectations that began during the first half of 2020 will extend through the first half of 2021 and possibly for years to come.

3) The US dollar is immersed in a cyclical bear market that began in March of 2020.

4) Multi-year bullish trends are underway in industrial and agricultural commodities.

5) The electrification of transport is an unstoppable global trend that will have major bullish implications for certain commodities, especially lithium, manganese and the rare-earth elements.

6) The cannabis-legalisation trend in the US is accelerating and will enable US-focused cannabis companies to achieve rapid sales growth during 2021-2022.

7) Gold will perform poorly relative to industrial commodities until the transition to the next economic bust phase begins.

Our own account has some exposure to other themes, but the above list covers the ones we have been concentrating on as far as the TSI commentaries are concerned. We expect that all of the above will remain applicable over the coming few months, but that changes will be required at some point this year due to prices becoming too stretched to the upside or signs of an economic downturn becoming evident in our favourite leading indicators or “inflation” moving well beyond what the Fed deems appropriate.

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

We assume that everyone reading this has at least superficial knowledge of the incredible goings-on around the stock of GameStop (GME), a video game retailer. The GME situation became so extraordinary last week that it drew the attention of senior US policymakers, but more importantly it is representative of what’s happening throughout the stock market and is symptomatic of the US money supply’s Fed-driven explosive growth.

There are no ‘good guys’ in the GME saga. The small traders who banded together via Reddit to create a massive “short squeeze” in the stock of a company that was on its way to bankruptcy have no right to claim the moral high ground, because they set out to do more damage to an already-broken price discovery process in order to make a ‘quick buck’. The short sellers who were ‘squeezed’ paid a legitimate price for poor risk management. The brokers that without warning imposed restrictions on the trading of GME and in some cases forced their customers out of the stock were simply acting to limit their own exposure, in that stockbrokers can be left ‘holding the bag’ when prices go crazy and traders can’t meet margin calls. And politicians are trying to portray themselves as being supportive of the ‘little guy’ while ignoring the underlying cause.

On a side note, the problem with ‘squeezing the shorts’ in the stock of a company with very little underlying value is that if the squeeze is successful then there will be almost no buyers on the way back down. As a result, successful short squeezes are often followed by spectacular price collapses.

The underlying cause of the crazy price action is the explosive money-supply growth engineered by the Fed. This record-breaking expansion of the money supply hasn’t led to rapid rises in official measures of “price inflation” YET, but its effects are plain to see. One of the most obvious effects at the moment is the rampant speculation in parts of the stock and commodity markets.

The participants in each bubble believe that there are some fundamental considerations that make their bubble special, meaning that their bubble is believed to be not actually a bubble but a reasonable assessment of future prospects. For example, Tesla bulls believe that Tesla’s market cap makes sense considering the company’s future earnings potential, bitcoin bulls believe that bitcoin’s price rise is justifiable and is nothing compared to what’s coming, and many retail equity traders now believe that the stock market offers them a sure-fire way to make a lot of money very quickly without the need to do any real work.

However, all of the spectacular price rises are part of the same story. All of today’s bubbles are linked to what’s being done to money and they all will burst at around the same time, disabusing ‘investors’ of the notion that their favourite bubble is somehow special.

Recognising that an investment is a bubble isn’t a good reason to bet against the investment. In fact, it’s the opposite. Betting against a bubble is one of the surest ways to lose money quickly.

The goal should be to participate in a bubble while paying very careful attention to managing risk. As long as profits are harvested on a regular basis, a sizable cash reserve is maintained and debt-based leverage is avoided, astute investors/speculators can do well during a bubble without taking excessive risk. They won’t do as well as the true believers, but they won’t give back all of their gains after the inevitable collapse occurs.

[This post is an excerpt from a commentary published at TSI on 17th January 2021]

The US yield curve, represented on the following weekly chart by the spread between the 10-year T-Note yield and the 2-year T-Note yield, has been steepening since the third quarter of 2019. Moreover, the pace of the steepening is accelerating.

A steepening of the yield curve can be primarily driven by decreasing yields on short-dated treasuries or increasing yields on long-dated treasuries. The former results from a general increase in the desire to hold the most liquid and lowest-risk financial assets, such as cash and T-Bills. It is bullish for gold and bearish for commodities and most equity sectors. The latter results from a general increase in inflation expectations. It is also bullish for gold but is more bullish for commodities and certain equity sectors.

The steepening that occurred from the third quarter of 2019 through the first half of 2020 was driven by declining yields on short-dated treasuries, but the steepening that has occurred since August-2020 was driven by rising yields on long-dated treasuries, that is, by rising inflation expectations.

Given what the US government and the Fed have done and plan to do, it shouldn’t be a surprise to anyone that inflation expectations are in a rising trend and that the trend is accelerating. Of particular significance, President-elect Biden has proposed a new “stimulus” package with a US$1.9 trillion price tag, and it is well known that this spending package will be followed by an infrastructure bill that probably will involve another $1-$2 trillion of additional spending. Also, we have statements from the Fed to the effect that now is not the time to be talking about reducing the monetary accommodation and that there won’t be any tightening until an inflation problem is obvious to all.

The Fed could try to suppress one of the symptoms of a burgeoning inflation problem by attempting to control the yield curve, that is, by ramping-up its purchases of long-dated treasuries with the aim of lowering yields at the long end of the curve. However, that would amount to creating more money out of nothing in an effort to address a problem caused by creating too much money out of nothing. Even by the Fed’s own standards this would be counterproductive.

The bottom line is that there will be a lot more inflation and a further large increase in inflation fear before there is a realistic chance of a deflation scare.

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

Does the rapid rise in the bitcoin price and the slide in the gold price over the past several months indicate that bitcoin is sapping demand from gold? The short answer is no, because the performance of gold makes sense without reference to bitcoin. A longer answer requires discussing the major differences between gold and bitcoin.

The differences between gold and bitcoin are far more significant than any similarities. Neither is money in the only practical definition of the term (the general medium of exchange), but gold trades like money. Of particular relevance, the demand to hold money (and therefore gold) tends to rise during ‘busts’ and fall during ‘booms’. A consequence is that gold generally doesn’t do well when the stock market is ‘bubbling’.

Bitcoin, in contrast, trades like an illiquid commodity, because that’s what it is. No money or widely-used currency in history has ever traded the way bitcoin has traded and it’s reasonable to assume that none ever will.

The spectacular rise in the bitcoin price over the past 10 months is related to the bubble that has formed in the stock market and the associated spectacular rises in the stock prices of the companies with which the public has become infatuated. Obviously, Tesla (TSLA) is such a company. The following chart compares the bitcoin price with the Tesla share price.

Bitcoin ‘bubbled with the stock market in 2020. It also ‘bubbled’ with the stock market during 2017 and if it had been around at the time it almost certainly would have ‘bubbled’ with the stock market during 1999-2000, whereas the desire to hold money or gold diminishes when the prices of speculative assets are rocketing upward in real terms. Who wants to own gold when the record of the past 1 year, 5 years and 10 years ‘proves’ that you will do much better by owning QQQ (the NASDAQ100 ETF)?

It’s likely that the gold price will embark on its next intermediate-term advance at around the time that the bitcoin price reaches an important top. That’s not because bitcoin has been draining demand from gold, but because a top for the bitcoin price probably will occur at around the same time as a top for speculation in general and a trough in the desire to hold cash reserves.

We still could be a few months away from a major top for speculation in general, so at this time it is still better to be ‘long’ consumable commodities and speculative assets than to be ‘long’ gold.

There are a handful of leading economic indicators that when taken together have provided timely warnings of every US recession and recovery for at least the past sixty years. A monthly feature at TSI is a discussion, primarily based on these indicators but also taking into account expected monetary and fiscal policies, of the prospects for the US economy over the ensuing 6-12 months.

At the end of 2019, before anyone outside Wuhan had heard of the new coronavirus, the leading indicators we track pointed to a 60% probability of the US economy entering recession during the first half of 2020 and an 80% probability of the US economy entering recession before the end of 2020. The only reason the probabilities weren’t even higher was the possibility that the Fed’s money pumping following its 2019 “pivot” would push the recession start into 2021. The lockdowns of March-2020 eliminated any possibility that the inevitable recession would be postponed.

By early-July of 2020 it became clear, based on the same leading indicators, that the recession catalysed by the H1-2020 lockdowns was over. This informed our decision to begin favouring industrial commodities over gold.

It’s important to continue weighing new data and making adjustments in real time as required, but based on what is currently known the probability of the US economy slipping back into recession during the first half of 2021 is extremely low. There is, however, an uncomfortably high probability of the US economy re-entering recession territory during 2022.

Here’s what we wrote in our latest monthly US Recession/Recovery Watch, which was part of a commentary published at TSI last week:

We called an end to the 2020 US recession in early-July of last year, mainly due to the spectacular rise in the ISM New Orders Index (NOI) that had just occurred. This call has been supported by subsequent data and eventually should be confirmed by the National Bureau of Economic Research (NBER)*, making last year’s recession the shortest in US history. The latest ISM data, which were published earlier this week, indicate that the recovery is intact.

The following monthly chart shows that the NOI remains near the top of its 20-year range, meaning that the US economy continues to recover from the devastation caused by the lockdowns directed by the government during the first half of last year.

Based on the economic and monetary data published over the past couple of months it’s possible that later this month the US government’s statisticians will report annualised nominal GDP growth of at least 10% for Q4-2020 and likely that the US economy will achieve annualised nominal GDP growth of at least 5% during the first half of 2021. Are you long industrial commodity stocks?

The strength is largely artificial and will evaporate soon after the Fed is forced by blatant evidence of an inflation problem to end the monetary stimulus, but that is probably a story for the second half of this year and beyond. Over the next 1-2 quarters it’s a good bet that the monetary tsunami will continue, courtesy of both the Fed and the government. For example, the US federal government has just sent $600 “stimulus” checks to most Americans, but that won’t be the end of it. President-elect Biden wants to send another $2000 to every American and a massive infrastructure spending program is ‘on the cards’.

It’s amazing what the government can do when it stops pretending to care about its own indebtedness and embraces the spirt of Modern Monetary Theory (MMT).

*It can take the NBER, the official arbiter of US recession dates, a year or more to confirm a recession start/end date.