A Passive Aggressive Market
From the June 30, 2017 HRA Journal: Issue 271
I really hate sounding like the “boy who cried wolf” when it comes to major markets. Nonetheless, I’m shocked at how little impact central bankers have had as they all started talking, planning or threatening tightening. Traders on Wall St in particular seem completely unconcerned by these comments. Clearly, traders don’t believe central bank words will be followed by actions. I’m afraid they may be wrong about that this time and we may see some wild swings when that sinks in.
I don’t see any immediate catalysts for a crash but a correction looks much more likely than it did to me even a couple of weeks ago. We continue to see huge flows of money into passive strategies, shorting volatility and cryptocurrencies. None of those things are alarming in themselves but all represent the sorts of activity we see when markets are close to rolling over. The general lack of cash balances in all those strategies increases the odds of something nasty if the traders placing those bets get spooked. Not sure who they will be selling to when the time comes.
“Risk On” virtually everywhere means weakened precious metals, even with the USD coming off. The one piece of good news is that gold sentiment has gone from mildly bearish to just about 100% negative. That’s not fun to experience but it does mean things are more likely to improve now. Watch for more frequent issues as we move into the main exploration reporting season.
We’re now past the GDXJ rebalancing. It would have been easier if it didn’t happen close to a US Fed meeting that had large impacts on the gold price, not to mention “fat finger” gold sells.
I think it’s now apparent that GDXJ and gold are displaying the high positive correlation you would expect, again. The charts at the bottom of page two make that clear.
Even though there were massive trading volumes in companies that had big shifts in their GDXJ allocations, a lot of that came as “at the close” trades on June 16th. The front running is done for now. For what its worth, the EFT has been a little stronger than the bullion price itself since the rebalancing. That is normally a good sign for future gold prices.
Whether that “good sign” is any help near term will depend on a positive sentiment shift, never an easy thing moving into July. Gold sentiment is terrible right now, notwithstanding a couple of things that should be working in its favor. If you look at the US Dollar chart on the top of page 3, its clear we can’t blame currency effects for gold price weakness. If you showed that chart to your average gold trader they would assume gold has been climbing almost daily for the past couple of weeks. Not so much.
What’s going on here? It seems to be a combination of movements in real interest rates (which, interestingly, haven’t helped the USD) and wildly risk on sentiment. You can see short term trading against the SPX for gold and anything else “risk off” lately. It may take some weakness in major NY indices to bring traders back to the bullion market.
The other “big” event since the last issue was the Fed meeting where, as expected, US interest rates rose by another 25 basis points. I noted a while back that it was optimistic to expect the same reaction from gold prices that we saw after the December and March Fed meetings. In both of those cases there was a large and fairly immediate bounce in gold prices. Not this time.
I think the reaction to the latest rate hike is two-fold. The main reaction came from short-term traders who front ran the meeting and were long GLD. They probably panicked when the expected bounce didn’t materialize immediately and sold.
The longer-term reaction relates to the FOMC not, as many expected, lowering their forward interest rate guidance, at least not meaningfully. There have been several public speeches by FOMC members since the meeting. Those have reiterated the member’s resolve to stay on a tightening path.
There is a lot of debate about this subject and its important to the overall health (if that’s the word) of the markets. Both the S&P 500 and NASDAQ indices made new all-time highs recently. I think a lot of that is just money flow (I’ll go into that below) but traders assuming a benign Fed is a big part of it too.
Look at the updated TNX 10-year Treasury Yield) chart below. Yields have declined since the last Fed meeting, except for the day before this issue, even though the Fed raised its benchmark rate 25 basis points. The move in the TNX isn’t huge but its significant under the circumstances. The bond market is giving the Fed the proverbial finger.
Traders do not believe the third rate increase in 2017 and three further increases in 2018 predicted in the Fed’s dot plots will happen. Should they? Gold bugs certainly side with bond traders, predicting an immanent return of QE and a reversal of rate increases.
If the only factors at play were forward inflation projections and economic growth rates I would agree with the bond market. There is no evidence that CPI inflation is rising and that’s before we factor in the recent trend in oil prices. Even so, I think we need to accept that the Fed may have an agenda that goes deeper than its public pronouncements.
As I predicted, the boost in prices from the last OPEC agreement was short lived and oil prices are again close to 52 week lows. It takes time for changes in oils prices to feed through to the rest of the economy but they are guiding some of the bearish interest rate bets. Between oil prices and growth rates bond traders are calling the Fed’s bluff. I’m not sure bond traders will be right though, for reasons discussed below.
The oil price may help explain why we haven’t seen a higher bottom for this gold price pull back. I think the main reason for the post-Fed pullback is positioning and gold traders being less skeptical about the Fed than bond traders. The assumption that further drops in inflation are coming may be part of it too, though.
Inflation declines work against declines in nominal bond yields when calculating “real” yields. If nominal yields keep declining we may see upward pressure on gold prices. Oil WILL have an impact though. If oil prices stay in the low $40s it could lower US CPI by as much as 0.5% over the next few months.
June tends to be a low point for gold prices and we’ve got “sell in May” to contend with already. It may require some cooing of general risk on sentiment to improve gold prices. The Fed may be planning to help with that.
Is The FED Trying to Manage the Equities Market?
And what of the Fed? Bond traders remain skeptical but FOMC members continue to strongly assert they won’t change their rate outlook. Everyone loves to dump on FOMC members but I’m pretty sure they can do the math where the effect of oil prices is concerned. So far, their fallback position is all about fear of wage gains starting an inflation spiral.
The chart at the bottom of the next page shows the US U3 unemployment rate since 1960. I’m including it because it forms the crux of the Fed’s argument for raising rates. The current unemployment rate in the US is near the bottom of the range. It doesn’t show the current rate is “historically low” as US financial media keeps claiming. Indeed, there are three periods on the chart when it was lower even than today.
Supposedly, the Fed is worried about low unemployment leading to wage growth acceleration leading to a surge in inflation. That is the spiel we’ve heard from one FOMC member after another for the past three months.
The example cited for this phenomenon is the lowest dip on the unemployment chart, the late 1960’s. Inflation started picking in in the late 1960s and really kicked in during the early 1970s. The accepted wisdom is that low unemployment drove wage gains which led to inflation. Personally, I think the inflation spike related to Vietnam War deficits followed by the original OPEC oil shocks.
Whatever the case, fear of another episode like that is what has the Fed worried, at least officially.
I remain highly skeptical about that argument. Take a look at upper chart. It’s a long-term plot of changes in core (PCE) inflation against changes in average hourly earnings, brought forward six months. Basically, if wages are driving inflation, you should see a correlation in the two measures.
From 1965 to 1994 you DO see a correlation. If you drew a trendline through the pre-1995 readings, the dark blue dots, you would get an upsloping trendline indicating correlation between wage gains and later inflation increases.
Something changed after 1995 though. After that you get a series of dots that have a flat trendline. This implies NO correlation in the past 20 years between wage gains and later inflation or at least very weak correlation.
Low unemployment, so far, is not driving wage gains and it doesn’t appear that wage gains drive inflation lately anyway. It may be that the conspiracy theorists are right about the real unemployment rate being far higher than the real one.
I think there’s truth to that in the US. So many politically driven adjustments have been added (like the birth-death model) that I agree we should distrust current unemployment numbers. I’m not as cynical as some but I do think its understated. And the current US unemployment rate is still above levels that triggered wage gains in the 1960’s.
So if the FOMC, and other central banks don’t really believe their own story on inflation, what’s driving their tightening cycle? Maybe they really believe the economic models that don’t seem to be working. I think there is an alternative explanation though.
I think the real worry that underlies the Fed’s actions is rampant asset markets, including equity markets in New York. Janet Yellen’s two predecessors were
reviled for presiding over financial crashes. Two major crashes in less than ten years that permanently scarred millennials when if comes to equity investing. Yellen does not want to preside over crash number three.
I think tightening financial conditions is not about inflation. It’s about cooling the markets. As markets continue to levitate, central bankers get increasingly concerned about the potential for a crash. Yellen has made recent comments about market overvaluation. Most of us can recall her predecessors making similar comments. They usually fall on deaf ears. Its action, not words, by central bankers that will matter.
In the past week, the Bank of Canada, Bank of England and even the ECB have indicated the likely path is tightening financial conditions. The fact most major central bank heads are talking about this—not just the Fed-explains why the USD has weakened as much as it has. Interest rate spreads between the US and other currency blocks have narrowed in the face of across the board hawkish comments.
Other than Britain which had an inflation uptick there is little sign of rising prices. I firmly believe inflation has nothing to do with central bank hawkishness. The markets are scaring the crap out of them and they are trying to jawbone a correction. That is a dangerous tightrope to walk. If it doesn’t work—and it never has in the past—we have to assume CBs will tighten conditions further.
The table below shows relative money flows into active and passive equity funds to the end of 2015. The trend you see there—investors abandoning active management—has accelerated recently. ETFs and passive funds generally carry small cash balances. If markets reverse enough to scare retail traders these funds will have to sell simultaneously. Things could get nasty very fast if that happens.
I’m not saying it will happen tomorrow, but if central bankers are determined to cool frothy markets we should keep a close eye on things. Market history is full of examples of central bankers taking one tightening step too many, creating bear markets they didn’t intend.
In the near term, this is negative for gold. If central banks are determined to tighten even without higher inflation readings, real rates will go up. That’s why a a lower USD hasn’t helped, though it may if it keeps dropping.
The trend hasn’t hurt either general equities or base metals, which have had a good month. It would be unusual to see a bear market start in the depths of summer. I don’t really expect it, but the level of “dumb money” flows into things like passive funds, shorting volatility and cryptocurrencies few understand concerns anyone with enough market history.
We’ve seen this movie before, where retail money chases the bubble du jour. It doesn’t always end immediately but it always ends badly. I’m not expecting an imminent crash but can’t discount the possibility either. Keep your guard up if you’re playing those markets.
The update section includes names that didn’t get the response hoped for because of underlying sentiment. And more we’re still waiting for results from. Lots of room for good news still.
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