A few days ago on the Ace Talking Stocks Forum on December 10th, I put forth a hypothesis that we could witness a reversal in gold’s fortunes ( or more precisely its misfortunes) once the US Federal Reserve (“the Fed”) likely raises interest rates on December 16th. I realized at that time that such a view was definitely not mainstream. Then, this weekend, I read in Barron’s Streetwise column by Ben Levisohn that he believes there is the chance that the US dollar will have peaked once the Fed begins hiking rates. In other words, a dollar reversal may have already begun.
I am sure that many would consider such a reaction to be illogical, but perhaps not really when one considers that dollar and gold traders have been selling the rumor of a rate hike the past few weeks…so why wouldn’t these same traders buy the news of a rate hike once that is confirmed?
From a fundamentals point of view, the dollar bears and gold bulls might find a bid once traders see that the equity markets and the economy may not be able to sustain themselves in the wake of even one Fed rate hike. Of course, as many traders realize, the pundits and the financial news media keep talking about how they believe the Fed will hike rates 2 or 3 times in 2016….they come up with these assumptions based on the Fed’s dot plot chart which forecasts rising rates for the next few years. In past rate hiking cycles, it was not uncommon to see a cycle of rate increases happen over a few years time.
But what if that one tiny rate hike next week is all it takes to put the economy and equity markets into a downward spiral? My contention is that REAL interest rates are at zero or below and raising rates will choke off an already fragile economy. Then toss in the growing panic in the junk bond market (which I have successfully traded several shorts on the I-shares I-Boxx Corporate Bond High Yield Fund ETF/ NYSE: HYG) in recent months, and this situation puts pressure on both bond and equities markets as we witnessed in the past week.
If these pressures are greater than the Fed perceives, then this blows holes into the Fed’s dot plot dreams! This in turn, would put more pressure on the dollar and give gold and silver a huge boost because some investors and economists would be pushing for the Fed to reverse the rate hike and maybe even bring back some more Quantitative Easing (“QE”) to save the economy.
The more I think about it, the more I sense that a Fed hike could cause a dollar reversal, and hence, gold could take off higher once the reality sinks in that there will be no more rate hikes to come after next week’s hike. Barron’s columnist Ben Levisohn points out that of the last 11 initial Fed rate hikes over the last few decades, 5 of them led to a weaker dollar within days or weeks of the Fed’s hike.
He also points out that 5 major economies (Europe. China, Japan, Australia and the UK) have all attempted to raise interest rates since the 2008 financial panic, and in all 5 cases, those central banks had to take back their rate increases and some are now into new QE programs. So, what makes the US Fed think that this time it might be different?
The Fed says a rate hike is justified under its “dual mandate” from Congress that it should raise rates when 1) prices are stable or rising and 2) employment is rising. The pressure has been on the Fed to raise rates because many seers perceive that both legs of the dual mandate are being met. Additionally, many of these observers believe that recent strong jobs growth should generate greater wage inflation and pump more money into the economy.
However, this observer believes that the Fed is attempting to raise rates to relieve political pressure from the financial news media and the many Wall Street titans who believe the Fed must end emergency measures. They point to the dual mandate as satisfying that requirement. However, it seems to this observer that the Fed has forgotten the first tenet of a modern central bank, and that its real mandate is to control inflation and keep the economy afloat with liquidity when financial markets are shaky. Right now, both of these unanswered “natural mandates ” are telling us that the Fed would be wise not to raise interest rates–at least not at this time.
The Fed looks mostly at the core inflation rate and gives less emphasis to the full inflation rate. For many years, the Fed’s economists have insisted that the core inflation rate is a better arbiter of inflation in the economy because food and energy (which are excluded components of the core rate) are cyclical and volatile and can unduly influence the true path of inflation. Before the 2008 Financial Crisis, there was some evidence that following the core rate made sense, since for many years, inflation was exerting a strong pressure on the cyclical elements of the American economy. By excluding volatile food and energy prices, the Fed could be more patient and methodical in raising or lowering rates by looking at the more stable influence of the core inflation rate.
The Fed tends to use a rate published as the “PCE deflator” to measure the core rate of inflation. A year ago, this rate was at 1.6% inflation. Since the Fed has repeatedly said that it will work to keep inflation at 2% or below, this 1.6% reading was getting close to the high side of its range. Moreover, the perception among many mainstream economists is that a 2% inflation rate is a most natural rate that allows an economy to grow without over-heating.
Now, even the PCE deflator has slowed dramatically to a recent 0.3% annual rate. That is hardly any measure of inflation, even by the Fed’s own definition. Past Fed chairs would have felt no pressure to raise rates with such an anemic rate, but somehow, Janet Yellen seems to believe she must act. Looking at the official US inflation rate of the last 12 months (through October 2015), we see that the rate is a very low 0.2%. That’s the official rate, which is measured by a series of rules and tests set up by the Bureau of Labor Statistics (BLS). Right now, both measures of inflation tell us that inflation is almost non-existent.
More importantly, the low 0.25% annual rate of inflation (using an average of the two official rates) is a full 1-and- 3/4% below the so-called natural rate of inflation in a healthy economy. In other words, the Fed would be wise to consider a rate hike if the rate of inflation was near or greater than the natural rate of inflation. But the current situation reflects an actual disinflation rate in the economy. To hike interest rates in such an environment is the equivalent of putting brakes on an already slow moving economy.
As I pointed out, the Fed is focused (perhaps mistakenly to some extent) on increasing jobs, but let’s consider that most of the new jobs are lower wage ones and the workers in these jobs are just trying to pay the rent and don’t have much disposable income. These new jobs do not suffer from wage inflation simply because they are paid out at lower wages.
In this observer’s opinion, the Fed should be more focused on the real inflation in the economy–of which there is very little. To raise rates in such an environment–when the dollar is already strong and choking off exports– reminds me that the Fed may be ready to commit the same sin that it did in 1937 when it choked off the struggling economy with a rate hike. At any rate, the free markets will soon be telling us if the Fed is on the right track or not. To see how the markets react, keep an eye on the US dollar and Gold charts.
Hint: as I look at the daily Gold chart, I see rising a Chaikin Money Flow (CMF) and Accumulation indicators which are a sign that some (“smart money”) investors are taking positions of late in the precious metal. We will soon find out how smart they really are.