Gold tumbled as bond yield surged on hawkish Fed jawboning

Wall Street Futures and gold were already under stress, while USD/US bond yield surged since the Fed’s more hawkish than expected hold on 20th September and subsequent hawkish comments by various Fed policymakers, indicating a higher for longer stance. Fed is now insisting that one more +25 bps hike for a terminal repo rate +5.75% is not a big issue and will not cause an outright recession, but the Fed is now evaluating the duration of such terminal rate before going for any appropriate cuts in line with any meaningful fall in core inflation. This coupled with less hawkish talks by the ECB, BOE, and BOJ is boosting USD/US bond yields.

Overall, the Fed is not in a hurry to cut rates in H1CY24 and the market is now expecting two rate cuts of -25 bps each in September’24 and December’24, contrary to earlier perceptions of -50 bps rate cuts each in H1 and H2CY24, totaling -100 bps cuts in 2024. Fed has indicated only -50 bps rate cuts in 2024, stressing higher rates for a longer stance, which is affecting risk trade sentiment of Wall Street; boosting USD/US bond yields, dragging gold and stocks. Subdued discretionary consumer spending may affect corporate earnings significantly amid higher cost of living, higher cost of borrowing, and lingering macro-headwinds.

Apart from the concern of higher borrowing costs, Wall Street Futures were also affected by growing political and policy paralysis for the Biden admin, which is now running a minority government effectively after losing the House to Republicans in the Nov’22 mid-term election. Republicans are now planning another government shutdown and even an impeachment motion against President Biden. Moody's said: “A US government shutdown would underscore institutional and governance weakness, and would be credit negative for the US sovereign.” ‘Capitalist’ Wall Street is concerned about Biden’s ‘socialistic’ approach to striking UAW/auto workers; politics is getting priority over economics.

On Wednesday, Fed’s Kashkari again popped up and said:

·         A government shutdown and auto strike may slow the economy

·         There is a risk interest rates might have to go higher, but it's hard to know

·         The resilience of the US economy has been surprising

·         I expect the Fed to hold rates steady next year

·         The Fed is not trying to create a recession

·         Hopefully, the Fed has done enough on rates, but we don't know

·         Higher oil prices won't alone warrant more rate hikes

·         The Fed has made a lot of progress on inflation

·         The neutral rate may have moved up

·         We are allowing the data to drive Fed decisions

·         Economic data suggests the Fed is not as restrictive as it appears

·         Consumer spending has stayed robust

·         I don't know if Fed policy is restrictive enough

·         I don't know yet if the Fed is done or needs to go higher

·         I am open to the possibility that we may need more than one hike

After Fed’s ultra-hawkish St. Louis Fed President Bullard quits mid-August, it seems that the Minneapolis Fed President Kashkari, another known hawk has taken over Bullard’s role, who has advocated for a terminal rate around 5.50-5.75%, if not +6.00% to bring U.S. core inflation back to +2.00% targets in a sustainable way by 2024-25.

On Tuesday, Fed’s Kashkari published an article/essay titled: Policy Has Tightened a Lot. Is It Enough?

“---In the ensuing time, inflation climbed further but then fell dramatically, in part due to policy tightening by the FOMC. Although annual inflation remains well above our target, there is no question we have made a lot of progress towards our 2 percent goal. And after climbing last year, near-term inflation expectations have returned to levels broadly consistent with their levels before the pandemic. This suggests market participants believe the inflation fight will soon have been won.

Financial markets have responded to the FOMC’s moves, with the 10-year real rate continuing to climb, indicating that the overall stance of monetary policy has likely tightened further. But as I explained in my prior essays, ultimately the overall stance of monetary policy is determined by the position of long real rates relative to the neutral real rate, which is uncertain.

In the previous essays, I noted that prior to the pandemic the 10-year real yield was about zero, which I estimate was roughly a neutral policy stance at that time. In response to the pandemic, the FOMC acted aggressively to support the economy by driving the federal funds rate to the effective lower bound and massively expanding our balance sheet. Those combined effects drove the 10-year real yield to roughly -1 percent. Since we first tightened policy over 18 months ago, 10-year real yields have fully retraced their pandemic decline and are now approximately 2 percent. So, we are in a contractionary stance relative to pre-pandemic levels. Is that high enough?

Unfortunately, I know of no theoretical framework that can tell us how much we will need to tighten long real rates to get inflation back to target in a reasonable time frame.

As a point of comparison, in the June 2022 essay, I noted that the Minneapolis Fed staff’s best estimate is that when the FOMC raised the policy rate by 300 basis points in the 1994 tightening cycle, it translated into an increase of about 200 basis points in the 10-year real rate. Coincidentally, the resulting level of the 10-year real rate was also estimated to be about 200 basis points above the then-neutral 10-year real rate. So in that tightening cycle, policymakers drove the 10-year real rate about 200 basis points above neutral to bring inflation back down.

How does that compare with our current tightening cycle? If my estimate of neutral being zero before the pandemic still holds (and this is uncertain), then we have accomplished a similar tightening to what was achieved in the 1994 tightening cycle. However, as I stated earlier, the underlying inflationary dynamics are quite different today than in 1994, so simply repeating the 1994 tightening might not be enough and the neutral rate may well have moved up relative to before the pandemic.

Given these developments, what is my current outlook?

I see us facing two primary scenarios going forward:

Soft landing: After potentially one more 25-basis-point federal funds rate increase later this year, the FOMC holds policy at this level long enough to bring inflation back to target in a reasonable period of time. Substantial progress has already been made in reducing inflation while a healthy labor market has been maintained. In this scenario, the policy tightening we would soon achieve would prove enough to finish the job. Given the resilient economic activity we have observed, this looks increasingly like the proverbial soft landing that we are hoping to achieve. Because of the actual progress we have made against inflation and the actual labor market performance, today I put a 60 percent probability on this outcome.

High-pressure equilibrium: Underlying inflation proves more entrenched than expected, and the policy path described in the first scenario softly lands the economy to something like 3 percent inflation rather than our 2 percent goal. In an essay in March 2022, I observed that robust consumer spending appeared to be funded by current income rather than the spending down of pandemic savings, suggesting that the economy might have entered a high-pressure equilibrium that was inconsistent with our 2 percent target. In such an equilibrium, households feel more confident about their economic futures and spend more than prior to the pandemic, keeping consumer demand strong and the economic flywheel spinning.

In this scenario, the FOMC would then have to raise rates further, potentially going significantly higher to push inflation back down to our target. The case supporting this scenario is that most of the disinflationary gains we have observed to date have been due to supply-side factors, such as workers reentering the labor force and supply chains resolving, rather than monetary policy restraining demand. Indeed, consumer spending and economic activity both continue to exceed our expectations.

In addition, the sectors of the economy that are typically most sensitive to interest rates, housing, and automobiles, have proven surprisingly resilient and, by some measures, have bottomed and are now showing signs of beginning to recover. These dynamics raise the question, how tight is policy right now? If policy were truly tight, would we observe such robust activity?

Services inflation has also been quite sticky and remains elevated relative to pre-pandemic levels. Once supply factors have fully recovered, is policy tight enough to complete the job of bringing services inflation back to target? It might not be, in which case we would have to push the federal funds rate higher, potentially meaningfully higher. Today I put a 40 percent probability on this scenario.

I would have more confidence in the soft landing scenario if I were more certain that policy is truly tight relative to neutral today. The good news is that we don’t need to make this determination right now. We can observe the actual progress in bringing inflation down over the next several months to determine which scenario is the dominant one.

Of course, policymakers must always consider the risk that new shocks could hit the economy. Some of those shocks potentially could include a government shutdown, escalation of the war in Ukraine, extended domestic auto sector disruption, and spillovers from the slowing Chinese economy. The FOMC remains absolutely committed to achieving our dual mandate goals, and I am confident we will do what we need to do to achieve them.”

Overall, Kashkari indicated another +25 bps rate hike on 1st November for a terminal repo rate of +5.75% and then a final pause for 2023. Fed may continue to hold rates at +5.75% till at least till Feb’24 and if core inflation falls well below +4.00% sustainably, Fed will continue to hold rates at +5.75% till at least June’24 and then begin to indicate/discuss potential rate cuts in Sep’24 (Q3) and Dec’24 (Q4) for a cumulative -50 bps. On the other side if U.S. core inflation fails to sustain well below 4.00% by Feb’24, then Fed may be forced to go for another +25 bps hike in May’24.

In addition to Fed’s Kashkari, Wall Street was also spooked by JM CEO Dimon, who predicted a doomsday for the U.S. economy and Wall Street (and then QE-4/5-as JPM is the biggest beneficiary of QE). Dimon said in an interview with TOI (India) that the Fed may have to hike up to +7.00%, which will cause an outright stagflation/recession:

Conclusion:

The Fed is now preparing the market for another hike in November and then a possible end of the tightening cycle by Dec’23. Overall, the U.S. labor market and core inflation trajectory are still hot enough for another Fed hike. Fed never surprised the market with its rate action and by mid-October (after core inflation and labor/wage data for September), it will be clear whether the Fed will go for another +25 bps hike in Nov’23 before going for a final pause in Dec’23.

As per Taylor’s rule, for the US:

Recommended policy repo rate (I) = A+B+(C+D)*(E-B) =0.00+2.00+ (0+0)*(5.50.00-2.00) =0+2+3.50=5.50%

Here:

A=desired real interest rate=0.00; B= inflation target =2.00; C= permissible factor from deviation of inflation target=0; D= permissible factor from deviation of output target from potential=0.00; E= average core inflation (CPI+PCE) =5.50% (for 2022); H1CY23 average core inflation around +5.40% (~5.50%)

As there is no significant easing of core inflation, especially core service inflation, the Fed may go for another +25 bps hike in Nov’23 and possibly the end of a tightening cycle. But, if core CPI inflation indeed eased further to below +4.0% by Oct’23, then the Fed may refrain from any further rate hike in 2023 and may also indicate some rate cuts in Q2CY24 in the Dec’23 SEP (ahead of the US Presidential Election in Nov’24) to keep real repo rate around +1.00% levels (restrictive zone).

Looking ahead, oil prices may stay elevated in the coming months between $75-95 instead of the earlier $65-75 despite US efforts to bring more supply from, Mexico, Brazil, Iran, Iraq, and Venezuela. OPEC/Saudi Arabia will not ‘cooperate’ with the U.S. for ‘breach of trust’ in refilling SPR (as agreed ‘verbally’). Elevated oil prices around $90 will continue to boost energy/transportation/logistics costs and core inflation. Saudi Arabia/most OPEC producers and even Russia are now seeking $85 oil prices on a sustainable basis to fund budget deficits, EV transition, and also the cost of the Ukraine war. China may also deploy more targeted stimulus to bring out the economy from the deflationary spiral in the coming days, which may also support elevated oil prices.

The U.S., as a producer, is also benefitting from elevated oil prices. The U.S. is also a beneficiary of the Russia-Ukraine war and other geo-political tensions involving North Korea, China, and Iran. The U.S. defense/military industry is now booming. Also, the lingering Cold War mentality with China is resulting in supply chain disruptions and elevated inflations. The global economy continues to face the daunting challenges of macro-headwinds- elevated inflation, high levels of debt, tight and volatile financial conditions, continuing geopolitical tensions, fragmentations, and extreme weather conditions.

Going by the present trend/run rate, the U.S. core CPI may fall to +3.8% by Dec’23 and +3.4% by Feb’24, which may keep the Fed to hold on rates at +5.7% till at least Aug’24 before going for any rate cuts -25 bps or even -50 bps each in Sep’24 and Dec’24. Fed would like to boost Wall Street as well as Main Street before Nov’24 U.S. Presidential election. Fed has to ensure a soft landing; i.e. price stability along with financial/Wall Street stability and Main Street stability.

Looking ahead, the Fed may try to balance the financial/Wall Street stability and price stability by expressing intentions to cut from June’24 (H2CY24) to ensure a soft landing while bringing down inflation. Also, the Fed has to ensure lower borrowing costs for the U.S. Government (Treasury) endless deficit spending and mammoth public debt of almost $32T. The U.S. is now paying around 9.5% of its revenue as interest on public debt against China/EU’s 5.5%. This is a red flag, and thus Fed has to operate in a balancing way while going for calibrated hiking to bring inflation down to target, avoiding an all-out recession; i.e. to ensure both price stability and soft-landing.

Overall, it seems that the White House would be quite happy if the Fed could bring back core inflation towards 2% on a durable basis, while keeping the unemployment rate below 4% ahead of Nov’24, the U.S. Presidential election. The Fed is itself eager to cut its losses by cutting rates. The U.S. 2Y bond yield is now hovering around +5.13% and may soon scale 5.25-5.50% in hopes of another +25 bps Fed rate hike for a terminal repo rate of +5.75%.

Market wrap:

On Wednesday, Dow Future further slid to a fresh multi-month low around 33544, but recovered almost +300 points from the Fed panic low and closed around 33842, almost flat for the day, boosted by energy and techs amid higher oil (lower Russian export of petrol and diesel) and renewed AI/Meta optimism.

Meta announced its new mixed-reality mobile handset:

“The Meta Quest 3 mixed reality headset is available for pre-order now and will be released on October 10, 2023. The Quest 3 is the world's first mass-market mixed-reality headset. It starts at $499.99 for the 128GB version and $649.99 for the 512GB version. The Quest 3 has a new camera setup that allows for more immediate interaction with the world beyond the headset. It also has a higher-resolution display and pancake optics, which should make for a more immersive experience. The Quest 3 is powered by the Qualcomm Snapdragon XR2 Gen 2 chipset, which offers twice the graphical performance of the Quest 2.”

On Wednesday, Wall Street/tech-savvy Nasdaq was also boosted after U.S. President Biden stressed the promise of AI in a meeting with advisers. The promise of executive action on AI in the fall helped the Nasdaq 100 ended the day up 0.2%, with AI favorite Nvidia driving the tech-heavy index higher. After falling as much as 0.8%, the S&P 500 was little changed. Palantir jumped after the tech company inked a $250 million contract for AI services with the US Army.

On Wednesday, Wall Street was boosted by energy, industrials, communication services, techs, and materials (hopes of further Chinese stimulus), while dragged by utilities, real estate, consumer staples, healthcare, consumer discretionary and financials. Dow Jones was boosted by Intel, Chevron, Caterpillar, JPM, Microsoft and Salesforce, while dragged by Verizon, McDonald’s, Merck, P&G, J&J, Coca-Cola, Apple, Nike and GS; Meta hits a 4-week low. Also hotter than expected U.S. durable goods order data for August dragged Wall Street and Gold as it would keep Fed on a hawkish path going forward.

Bottom line:

Technical trading levels: DJ-30, NQ-100 Future and Gold

Whatever may be the narrative, technically Dow Future (33825) now has to sustain above 33900 levels for any recovery to 34300/34555-34600/34825-35070/200-415/850 levels; otherwise, sustaining below 33850, may again fall to 33475/450 and further 33240/200 levels in the coming days.

Similarly, NQ-100 Future (14750) now has to sustain over 14600-550 levels for any recovery to 14925/15150-15325/15500 and 15750/900-16000/655 in the coming days; otherwise, sustaining below 14500 may further fall to 14300/175-100/13890 and 13650-13125 levels.

Gold (XAU/USD: 1876) now has to sustain above 1872-70 for any recovery to 1885/1900 and 1910/1920-1926/1937 and 1952/1970 levels; otherwise, sustaining below 1865, may further fall to 1855/1820-1798/1700 level in the coming days.