This week belonged to the Fed, as officials finally knocked some sense into overzealous investors. For example, it began with Brainard, George, Daly, and Williams sounding the hawkish alarm, and ended with the FOMC minutes that shook the financial markets. Moreover, while the bearish fundamental implications of the Fed’s rate hike cycle are slowly being grasped by investors, I’ve been warning for weeks that a reality check would unfold. To explain, I wrote on Mar. 22:
While the PMs seem to think that the Fed’s inflation fight won’t impact their medium-term prospects, the reality is that higher real interest rates are needed to reduce inflation. And with commodity investors failing to comply, the merry-go-round of higher input prices leading to higher output prices will continue. As a result, the downside risk confronting the PMs is enormous at this point.
Remember, the Fed can only slow inflation by slowing the U.S. economy. That's why Powell keeps referencing a "soft landing" when describing the tradeoff between calming inflation and maintaining growth. However, with continued inflation of 8%+ likely to push the U.S. into recession, Powell knows that doing nothing is as bad as doing too much. As a result, investors should eventually learn that Powell's dovish days are over.
To that point, while the S&P 500 and the NASDAQ Composite have gotten the memo in recent days, the PMs still remain relatively elevated. However, while the Russia-Ukraine conflict keeps the PMs’ hopes alive for now, their medium-term fundamentals are growing more bearish by the day.
For example, the Fed released the minutes from its Mar. 15/16 policy meeting on Apr. 6. The report revealed:
“Many participants noted that – with inflation well above the Committee's objective, inflationary risks to the upside, and the federal funds rate well below participants' estimates of its longer-run level – they would have preferred a 50 basis point increase in the target range for the federal funds rate at this meeting.
“A number of these participants indicated, however, that, in light of greater near-term uncertainty associated with Russia's invasion of Ukraine, they judged that a 25 basis point increase would be appropriate at this meeting.”
However, while the Fed initially balked at a 50 basis point rate hike, the policy initiatives that should materialize over the next several months are even more bearish. For example, the report added:
“Many participants noted that one or more 50 basis point increases in the target range could be appropriate at future meetings, particularly if inflation pressures remained elevated or intensified. A number of participants noted that the Committee's previous communications had already contributed to a tightening of financial conditions, as evident in the notable increase in longer-term interest rates over recent months.”
If that wasn’t enough, the FOMC made it clear that selling assets on the balance sheet will occur at “a more rapid pace” than in 2017-2019, with a combined ~$95 billion of U.S. Treasuries and agency mortgage-backed securities (MBS) set to hit the open market each month.
Please see below:
Source: U.S. Fed
In addition:
Source: U.S. Fed
The Mid-Week Fundamental Roundup
As a result, there are those buzzwords again. With Fed officials repeating the terms “rapid” and “expeditiously” recently, investors ignored the warnings at their own peril. However, while the minutes moved markets on Apr. 6, the release didn’t include anything materially different from what Fed officials have already said over the last few weeks.
Moreover, remember what I wrote on Dec. 16 about Chairman Jerome Powell’s press conference?
As one of the most important quotes of the press conference, he admitted:
“My colleagues were out talking about a faster taper, and that doesn’t happen by accident. They were out talking about a faster taper before the president made his decision. So it’s a decision that effectively was more than entrained.”
While Powell sounded a little rattled during the exchange, his slip highlights the importance of Fed officials’ hawkish rhetoric. Essentially, when Clarida, Waller, Bostic, Bullard, etc., are making the hawkish rounds, “that doesn’t happen by accident.” As such, it’s an admission that his understudies serve as messengers for pre-determined policy decisions.
However, while investors were in la la land, the dynamic was on full display. With more than 10 Fed officials making the hawkish rounds recently, they made it clear that inflation was Public Enemy No. 1. Furthermore, Philadelphia Fed President Patrick Harker reiterated the message on Apr. 6. He said:
“Inflation is running far too high, and I am acutely concerned about this. Russia’s invasion of Ukraine will add to inflation pressure, not only hiking oil and gas prices but other commodities, like wheat and fertilizer, as well.”
As a result, he used two sentences to sum up the Fed minutes and what every other Fed official has said over the last month.
Please see below:
Source: Bloomberg
In addition, while the S&P 500 and the NASDAQ Composite suffered on Apr. 6, they still remain materially overvalued. Moreover, the PMs have somewhat side-stepped the volatility and also remain in denial of what’s likely to unfold over the medium term. However, I warned on Apr. 6 that Fed officials should continue to pound away at the financial markets until investors finally fulfill their hawkish wishes. I wrote:
Please remember that the Fed needs to slow the U.S. economy to calm inflation, and rising asset prices are mutually exclusive to this goal. Therefore, officials should keep hammering the financial markets until investors finally get the message.
Moreover, with the Fed in inflation-fighting mode and reformed doves warning that the U.S. economy “could teeter” as the drama unfolds, the reality is that there is no easy solution to the Fed’s problem. To calm inflation, it has to kill demand. As that occurs, investors should suffer a severe crisis of confidence.
Thus, while negativity reigned supreme on Apr. 6, we’re likely in the early innings of this thesis. For more context, I wrote on Apr. 5:
To explain, the orange line above tracks the number of rate hikes priced in by the futures market, while the blue line above tracks Goldman Sachs’ Financial Conditions Index (FCI). If you analyze the movement of the former, futures traders expect roughly nine rate hikes by the Fed in 2022.
However, if you focus your attention on the right side of the chart, you can see that the FCI has declined materially from its highs. Therefore, financial conditions are easier now than they were before the March FOMC meeting.
Please remember that loose financial conditions impair the Fed’s ability to achieve its inflation goal. As such, we should expect tighter financial conditions over the medium term, and the FOMC made that point clear in the minutes.
Please see below:
Source: U.S. Fed
Therefore, please remember that loose financial conditions are bullish for the PMs, while tighter financial conditions are bearish. With Fed officials actively trying to push the blue line above higher, several asset classes should suffer from the Fed’s hawkish disposition. In a nutshell: lower stock and commodity prices and a stronger U.S. Dollar help the Fed achieve its inflation goal. The opposite does not.
Also noteworthy, with inflation a political liability for the Biden Administration (which I’ve noted on several occasions), the chances of a dovish pivot are slim to none. Thus, is it wise to fight the Fed?
Please see below:
To explain, the Kaiser Family Foundation’s (KFF) poll released on Mar. 31 stated that “more than half of the public (55%) say inflation and rising prices is the biggest problem facing the U.S. right now, more than three times the share who say the same about any other issue included in the survey.”
As a result, the Fed has the political authority to reduce inflation by any means necessary. If history is any indication, the power struggle should light plenty of fireworks over the medium term. To explain, I wrote on Mar. 23:
When Fed officials dial up the hawkish rhetoric, their “messaging” is supposed to shift investors’ expectations. As such, the threat of raising interest rates is often as impactful as actually doing it. However, when investors don’t listen, the Fed has to turn the hawkish dial up even more. If history is any indication, a calamity will eventually unfold.
Please see below:
To explain, the blue line above tracks the U.S. federal funds rate, while the various circles and notations above track the global crises that erupted during the Fed’s rate hike cycles. As a result, standard tightening periods often result in immense volatility.
However, with investors refusing to let asset prices fall, they’re forcing the Fed to accelerate its rate hikes to achieve its desired outcome (calm inflation). As such, the next several months could be a rate hike cycle on steroids.
In addition, while I noted that we’re likely in the early innings of this thesis, a slow shift is already unfolding. Moreover, once the PMs realize that they are as vulnerable as the S&P 500, investors’ sentiment should follow.
Please see below:
Source: Bloomberg/Zero Hedge
To explain, the four charts above depict various shifts in financial conditions. Whether its inflation expectation spreads, the Chicago Fed’s National Financial Conditions Index, or bond market volatility, the Fed’s message is slowly seeping in. However, with equity volatility (the purple line) quite muted relative to bond volatility (the blue line), the former should crack as the Fed continues its hawkish stampede.
Finally, please note that the PMs often move inversely to U.S. real yields, and with the U.S. 10-year real yield hitting another 2022 high of -0.30%, the Fed’s “rapid” liquidity drain should lift the metric toward 0% over the medium term.
The bottom line? While the Fed’s hawkish disposition aligns perfectly with my expectations, investors’ denial of the fundamental ramifications has delayed the PMs’ likely drawdowns. However, as the financial market impact of the Russia-Ukraine conflict subsides and the Fed’s rate hike cycle takes its toll on the U.S. economy, commodities’ fervor should dissipate. Moreover, the fundamental constraints confronting the PMs now are even worse than they were at the end of 2021.
In conclusion, the PMs declined on Apr. 6, as a sea of red flooded Wall Street. However, with rising real yields and a stronger USD Index akin to fundamental Kryptonite, gold, silver, and mining stocks face many economic headwinds. As such, while the short term remains uncertain, the bearish medium-term thesis is becoming clearer by the day.