from: HRA Special Delivery 645 18 SEPTEMBER 2016
Spot the rate hike?
It was a strange and roller coaster week on the markets. Not a lot of change in most indices but no shortage of volatility. We didn’t get as much HRA list news as I hoped for last week. Several companies assured me things were simply a bit slower than expected with the labs and they should get news out next week. Personally, I suspect more than a few of them are really waiting for the outcome of the next Fed meeting which takes place on Wednesday the 21st.
Traders seem totally fixated on the next meeting, even though the bond market continues to price in only a 20% chance of a rate increase this month. Odds of one in December are pegged at 50% plus now, an indication bond traders buy into the FOMC’s conviction, if not the underlying data on the economy. I place the odds of a rate hike this week higher than 20% but not still high enough that a rate increase is the most likely outcome.
All the recent FOMC jawboning hasn’t been without impact though. The yield curve has shifted higher with the two year yield up about 20 basis points from it’s low before Jackson Hole. I could see FOMC hawks arguing that the bond market is out in front so they may as well get it over with. Perhaps, but the Fed has shown little backbone when it comes to shocking equity markets. Equity traders haven’t fully priced in a move though last week’s drop got markets part of the way there.
All this speculation has traders of gold and gold miners particularly anxious. Gold is off 3% this month and most gold equity indices have given back their post Jackson Hole bounce. Gold traders seem the most concerned the Fed will move this month which inevitably means a soaring US Dollar and falling gold prices.
Doesn’t it?
Take a good look at the charts on the first page of this alert. Can you see where the Fed last raised rates? I’ll give you a hint. If you’re looking at the lows in the Dollar chart and highs in the Gold chart to spot it, you’re looking in the wrong place. The first rate increase was announced December 15th. The USD did trend slightly higher, roughly half a percent, during the two weeks after that meeting. It then flat lined for a few weeks before continuing the downtrend. It’s bounced some recently but is still over three percent below the level it was at when the first rate hike was instituted. Weird, eh? Well…no, its not. This is virtually identical to the behavior of the USD during the last three tightening cycles. These cycles get telegraphed endlessly and traders position themselves well in advance of a move. Buy the fear, sell the news.
The gold chart is more unequivocal. It’s had its zigs and zags like other markets but the bottom was basically in when the first rate hike was announced. It too went sideways for a couple of weeks but really hasn’t looked back since. As I’ve noted many times in the past, gold has a history of doing well during periods of tightening rates. Traders seem to forget that every cycle so, yes, there’s a good chance we see knee jerk selling if there is a rate increase.
At the end of the day, its about whether the Fed is ahead of or behind the inflation curve. It’s certainly behind at the moment. How much behind depends on which of several inflation measures you choose to follow. Based on CPI ex food and energy, which is what moved (slightly) higher on Friday and spooked traders, the Fed is currently 1.8% “behind the curve”. Using the more widely watched full CPI measure the Fed funds rate is only 0.6% below inflation but the key point is that it’s below it and still behind the curve. Whatever the Fed may do, I don’t see it moving aggressively enough to catch up and move short terms rates to a level that implies a significant positive interest rate after inflation is deducted. No one in the market expects that scale of move near term. Markets would crash if the Fed attempted it. There’s no one on the FOMC, hawk or dove, that doesn’t realize that.
As long as I’m on the topic of the US Dollar let’s remember currencies never trade in a vacuum. Strength or weakness of the main currencies the USD trades against, the Euro and Yen, will help determine the trend going forward. As it happens, the next Bank of Japan meeting is a few hours ahead of the FOMC announcement on Wednesday. The Yen’s been moving sideways this month. Traders don’t expect much from the next BoJ meeting so we might not see much movement after it. Barring the BoJ doing something dramatic overnight on Tuesday I expect a bit of Yen strengthening after the meeting. Not much, but enough to put a bit of pressure on the USD ahead of the Fed meeting.
The ECB doesn’t meet again for a few weeks. Many hope for more dramatic moves by the ECB, perhaps a broadening of the asset purchase program. The general shift upward in the yield curve makes that less likely. As the yield curves shifts upward more bonds are priced at yields above the ECB reference rate, where they must be to be legally purchased under the ECB QE program. The ECB has more breathing room now. Unless rates plummet again I don’t think the ECB will do anything dramatic. Like the BoJ, the lack of new initiatives by the ECB should strengthen the Euro a bit, adding more pressure on the USD.
So where does all this meandering leave us? The most probable outcome on Wednesday is the Fed standing pat. That should generate a move up in gold prices and move down in the USD. The current pullback would represent the forth successful defence of the $1300 level in that case. With absolutely no one believing the Fed would move before December the way would be cleared for a sizable rally in gold price and an even larger one for gold stocks.
The less likely (but still possible in my opinion) outcome is the Fed raising rates on Wednesday. If they do, we’d see some knee jerk selling in gold and I don’t think the SPX will react happily either. In this scenario I think the SPX would ultimately fare worse, since “lower for longer” is the major underpinning for Wall St. Its possible we’d see a replay of early Q1 in fact, with equity markets throwing a tantrum and gold, after an initial selloff moving higher against equities and perhaps against the USD. I think traders would downgrade their opinion of US growth if the Fed moves, which won’t do the Dollar any favors in the medium term.
In other words, I think we’ll see a gold rally before year end, and perhaps from more or less here until year end. The only question in my mind is whether there is a final leg down first. That question should be answered just a little after 11AM Pacific time on Wednesday. If you have firm conviction the Fed won’t move the first half of the week should be a buying opportunity across the board for producers and developers. If you don’t want to “bet the Fed” wait until the announcement, then look to bid on the down stroke if the Fed moves. I think a down move would be short lived even if it does and, arguably, present and even better buying opportunity. Pick your poison. Whatever the Fed does, several HRA companies should report this week. So the next SD won’t be long in coming, either way.
Regards for now
Eric Coffin
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