As the market widely expected, the Federal Reserve decided to raise the target rates by 25- basis-point to 2.5%. The Fed also announced that they are targeting to raise interest rates two more times in 2019, against three times indicted previously. However, the stance that the Fed has taken will continue market tightening by selling off bonds, viewed by the market as hawkish (or not as dovish as the market would have anticipated). The market immediately responded by selling off equities, the dollar index hovering around 97, and spot gold fell by over $15/oz from its high of $1,262.2/oz.
By Samson Li
The Fed has also revised down the United States’s economic outlook in 2019, down from 2.5% to 2.3%. While the Fed Chair Jerome Powell acknowledged that the risk and uncertainties have been increasing, investors have been largely disappointed that the Fed has not done (or planned enough) to prepare if market sentiment continues to sour and the risk of a U.S. recession increases in 2019/2020.
The Fed may need to consider more than just the domestic economy, and the risk of the U.S. recession is real as the stock market is turning bearish
President Trump has been criticising the Federal Reserve in public recently on their decisions to hike rates in 2018. We tend to agree with the stance of the President on this subject, that the United States do not have much room to raise interest rates in reality (more on that below). Indeed, we have stressed several times before that the Federal Reserve should have halted the rates during the September meeting, given the emerging markets were tanking at the time as the strength in the dollar sucked global capital into America causing liquidity issues in the non-U.S. regions. As the leader of the world, the Federal Reserve should not just consider the economic fundamentals of the United States itself, but from a global perspective and monitoring the situation in a bigger picture. Given the way today’s economic system has been shaped up, it is hard to imagine that if an economic crisis hit other countries the United States could be immune from any negative spillover effects. One of President Trump’s tweets read ‘…the dollar is strong already, but the outside world blowing up, Paris is burning and China way down, and the Fed is even considering yet another hike…..’ is really bang on.
If we look at the performance of the U.S. equities markets in 2018, the Fed will probably consider the recent correction has been a healthy one:
YTD (up till 18th December 2018)
Dow Jones Industrial: -4.2%
Nasdaq Composite: -1.7%
S&P 500: -4.8%
However, approximately half of the U.S. equities are now trading 20% lower from the historical high earlier this year. Technically, it could be argued that half of the U.S. equities markets are now in a bear market. A region’s stock market performance is usually a precursor of its domestic real economy, usually with a lead time of 6-9 months.
The tightening is the correct move by the Fed, but it could possibly backfire
In addition, let us demonstrate why the United States does not have too much room to increase interest rates. First of all, while the economy of the United States looks strong, and the 2008 Global Financial Crisis (GFC) has now become a tempest in a teapot, we can also argue that several of the problems that caused the 2008 GFC are yet to be solved:
1) After the 2008 GFC, the government(s) have transferred corporate debts to become public debts
2) However, total debt today is at even higher levels when compared to the end of 2007.
3) The growth in government revenues is lagging behind the increase in debts and money supply
We understand that the Fed’s insistence on raising interest rates is to contain the debt bubble before it becomes too big and that they are correct by continuing to tighten the market. However, it is very difficult to determine what interest rates are the most appropriate levels, a level that can prevent the credit market from becoming overheated, but also not to kill the economy. We do know that the higher the interest rate is, the faster the debt bubble will be popped once again.
Therefore, the so-called interest rate normalisation is just a slogan – the globe’s economic growth is built on cheap debt and the ever increasing money supplies, and the world’s interest rates will never be going back to historical average levels, because rates at inappropriate levels (too high) will push the global economy into a depression. The low interest rate era is now with us forever, and there is no going back, unless central banks would allow a massive credit collapse to set the market off from another clean sheet.
In 2018, the gold price has mostly been a major by-product of both the strength of the dollar and the U.S. equities market. The gold price sank when both the dollar and the U.S. equities surged higher, notably after mid-June when the United States fired its first shot on China on the trade front, and market capital flowed into the United States and its equity market. So how will the dollar perform in 2019? We try to offer some rationales on both sides:
Why the dollar could be weakened in 2019:
How high is the historical average of the Fed Fund rates? Starting from 1980s, the historical average of the six-month Fed Fund rate is 4.1%. However, the historical average is being pulled higher due to the super high inflation period in the early 1980s.
We think the chance of the United States falling back to the high inflation period experienced in the 1980s is highly unlikely. Thus obmitting this period and starting from the 1990s, the historical average is only 2.88%. In another words, given today’s debt level, the chance that the Fed Fund rates will exceed the historical average is slim. Let’s just be generous enough and say it is very unlikely that the Fed Fund rates would exceed 3.25%. It becomes obvious on why this currrent interest rates cycle is close to the peak (and an end) for the United States.
Under normal circumstances, when the market believes the U.S. rates are about to peak, the dollar should peak before the actual event takes place. Therefore in theory, commodities should bottom by the time the dollar has peaked. According to the CME FedWatch Tool,the market now assigns a 24.4% chance that the Fed will hike the interest rates by another 25-basis-point in the March 2019 meeting, up from 17.0% recorded on the 18th December, but down from 36.2% a month ago.
Another potential catalyst that is bullish to the gold price is that China and the United States are expected to meet in January, hoping to hammer a formal agreement on trade deals in the first quarter. If a formal deal is put in place, this should be negative to the dollar, and positive to commodities in general.
Why the dollar could remain strong in 2019:
However, a downfall of the dollar in 2019 is not guaranteed.
On top of the possibility that China and the United States may fail to reach an official agreement in the first quarter of 2019 (that would boost the dollar strength), the market now begins to worry that a recession is on the cards for the United States (an investment bank has recently assigned a probability of 80% that the U.S. will fall into a recession within the next three years). If there is a market panic as well as massive selling in the equities market, the dollar can possibly surge higher as investors run for exits, meaning demand for cash (dollar) will increase.
Another concern that could possibly be providing strength to the dollar in 2019 is the weakness of the non-dollar currencies. The European Central Bank (ECB) has not just downgraded the region’s economic growth in 2019 recently, but the more troubling message they are sending is they are now forecasting the region will grow by just 1.5% in 2021 (compared to 1.7% in 2019), but higher inflation at 1.8% in the same year (compared to 1.6% in 2019). That is basically suggesting that the EU could possibly be falling back into real negative growth, or a stagflation is possibly on the cards. The chance of the ECB raising interest rates in 2019 becomes slimmer. On the other hand the Chinese economy has weakened notably lately as well, and how much of that is being impacted by the trade war is still uncertain at the moment. Assume all things remain the same, the momentum of the Chinese economy will continue heading south in 2019, and under normal market mechanisms, the yuan should continue to depreciate against the dollar in 2019 (unless the United States insist the Chinese try to appreciate the yuan valuation as one of the critical conditions reached in a trade truce).
Conclusion- trading opportunities
While the outlook of the dollar remains muddy in 2019, traditionally precious metals tend to do well in the first quarters supported by seasonal demand. Traders may consider short term trading opportunities by taking advantage of the seasonal patterns – for example longing gold as a hedge against a weaker dollar and the possibility of further meltdown of the U.S. equities markets; and longing silver anticipating that if a trade deal becomes formalisaed between China and the United States the white metal could catch up against its rich cousin. However, it is still too early to predict if the dollar has already peaked based on the arguments we have raised above.