Federal Reserve (Literally) Stuck Between A Rock And A Hard Place

by: Nairu Capital

The U.S. FOMC refuses to give the market a clear directional signal.

If the Fed cuts rates, precious rocks will likely continue to skyrocket, and equity and bond investors may be in for a dollar-driven shock.

If the Fed becomes hawkish, the U.S. dollar will likely break resistance and put the trade war and emerging economies in a very hard place.

The Federal Reserve has become increasingly dovish over the past six months despite the extremely rapid return of equity market steam paired with a considerable decline in interest rates. In modern economic thought, it is customary to believe that recessions are necessarily deflationary. Indeed, the four recessions since 1980 all saw inflation decline or, as in 2008, dip into negative territory. The reason is simple: a fall in aggregate demand pushes prices lower.

The jury is still out on whether or not a recession is imminent. A reasonable argument could be given for either, but it seems clear that the next recession will be far different from those in the past. Most notably, it will likely see a rise in inflation due to monetary instability. The U.S. Federal Reserve as well as global central banks seem to be missing the point. They are stuck in "aggregate demand analysis" mode and have too little concern for growing potential for monetary instability. In short, rocks (specifically gold) will do well if rates are cut, and if not, the U.S. dollar will push the world into a very hard place.

A Challenging Type of Inflation

As you may remember during the first months of President Trump's election, many analysts and investors were touting "reflation" as an excellent trade. Since then, commodities and CPI both saw a spike that culminated with crude oil reaching $75 last October but have reversed course to roughly the same levels as January 2017. This has been particularly true for hard commodities with industrial uses, such as oil (USO) and gas (UGA). Soft commodities such as corn (CORN) and wheat (WEAT), as well as precious metals like gold (GLD) and silver (SLV), have just begun to break considerably above their 2016-2017 lows. Most notably, palladium (PALL) is by far the best performer with a 40% gain since January 2017, driven by Russian sanction concerns and demand from automakers (and perhaps over-speculation).

To illustrate these commodity trends here are a series of charts on our three categories of commodities since just before the last recession. Please note these are commodity ETFs and are subject to futures roll and expense ratio drag, so they are all lower than the commodities themselves, particularly for DBA.

Energy via Oil:

Food via Agricultural Prices (DBA):

Precious Metals via Gold (GLD):

(Data source for charts: Yahoo Finance)

As you can see, the most bearish is agricultural commodities and the most bullish is gold, while oil is somewhere in between. This is because current inflationary concerns are not based on demand pull inflation but on monetary risks.

Following the last recession, great concerns regarding QE causing this monetary-driven inflation caused precious metals to double (or more) in value. Those concerns did not pan out, but today, with precious metals skyrocketing in value, it seems they are beginning to.

Rising Signals of Monetary Instability

To illustrate this best, let us take a look at the rolling daily correlation between a few assets to gather insight into the developing market regime.

Here is a chart of the gold-to-short term government bonds (SHY) rolling daily correlation measured over a 60-day time frame:

(Source: Portfolio Visualizer)

As you can see, the correlation bottomed out at -0.10 at the end of last summer and has since risen to nearly 0.70. It appears to have no intention of slowing. This may seem obscure, but it is absolutely critical, because it has an implication that equity and sovereign bond investors are missing. That is, if the U.S. Federal Reserve cuts interest rates (which is an event investors have come to expect), it will cause currency instability that will eventually result in high inflation (i.e., devaluation of dollar to precious metals). In fact, we are seeing that narrative play out as we speak as gold makes new highs.

The Federal Reserve Cannot Safely Lower Interest Rates

Equity and bond investors have been betting heavily on future Fed dovishness. Indeed, Jerome Powell may cut rates in meetings to come. But as we see in the correlation chart, doing so will cause a potentially extreme rise in the price of precious metals and hard commodities. Not because of a rise in demand, but because of a devaluation of the dollar.

This is not at all a new narrative. It was the driving factor for precious metals from 2008 to 2012, but as seen above in the low correlation of GLD and SHY, the short-term rate side of the picture had yet to come into play.

This is not necessarily to say that now is the time to buy precious metals. If recession fears continue to subside, then the Fed will become hawkish and precious metals will likely fall back to their lows as the dollar breaks above its long-term resistance level. With that said, if you believe there will be a recession soon, precious metals appear to be a much stronger investment than long-term bonds (TLT).

This is reflected well in the rolling 12-month gold-to-S&P 500 (SPY) correlation chart compared to that of gold and long-term treasuries:

The correlation of gold to both assets is falling. It is very negative for equities and slowly falling for bonds. This implies that the typical 60/40 bond-stock portfolio may not be as safe a bet as it was in the past. Further, it is a signal that the market regime is turning toward concerns over dollar devaluation.

The Dollar Has the Last Word

Let us take a quick look at the technical setup for the dollar ETF (UUP):

(Data source: Yahoo Finance)

The dollar is absolutely critical at its current level. If the Fed continues to go down the dovish path, the dollar will decline and global investors who moved their money into U.S. stocks and bonds to avoid economic risks at home will have reason to sell those investments. This is highly probable because the dollar has been held up by its large interest rate differential with foreign currencies in developed nations. While a decline in the dollar may be good for U.S. exports (i.e., trade war), it will be very harmful for financial asset investors.

To put this scenario in summary, the expectation that the Fed will lower rates has been good for equity and bond investors but has yet to affect the U.S. dollar. That said, it has begun to cause a surge in precious metals, and the potential for a continued reversal of U.S. interest rate differentials will eventually bleed into the U.S. exchange rate and cause it to fall at least 10% and potentially more. This will likely end the U.S. foreign equity and bond investment flows, and cause everything but precious metals and possibly all commodities to rise.

On the other hand, if the Fed returns to its hawkish stance, the story still does not look pretty. The dollar would most likely rise above the channel resistance that has been in place since 2015 with the potential to blow upward in a blow-off top that would cause widespread risk in emerging market economies with dollar-backed debt. In the short run, U.S. stocks and bonds will likely rise due to foreign investment flows, but the U.S. trade deficit will become extremely large and the rest of the world would become unstable as the value of external debt increases by, say, 20%. This would certainly be a hard place for the global economy. After the dollar's significant rise, the prior story would still likely take shape, but with much greater volatility.

These scenarios are not necessarily new, and many macro analysts have tried to time each of them in the recent past. But with the dollar at its current level, the FOMC reversing its stance daily, and gold making six-year highs, now seems like the time to keep your eyes wide open. Today it seems it will either be the dovish rock or the hawkish hard place. Of course, the course of events may be delayed by Jerome's current state of indeterminism, but the longer the world waits, the more of a shock we may be in for.

Disclosure: I am/we are long SLV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Long: USO, SLV, GLD. Short: TLT. May short SPY in next 72 hours.