Race To The Bottom On Interest Rates

by: Andrew Hecht

The ECB went first.

The Fed followed with a mixed message.

Other central banks follow.

The Fed will follow.

Lower rates will lead to higher gold.

Last year at this time, the US Fed was still on a path of increasing short-term interest rates and reducing its swollen balance sheet. The period of tightening began in December 2015 when the Fed Funds rate lifted off from zero percent. The Fed then rolled out a rote program to reduce the legacy of quantitative tightening. The US central bank allowed purchases of government debt securities to roll off its balance sheet at a rate of $50 billion per month. What was quantitative tightening pushed interest rates higher along the yield curve as the central bank lifted short term rates to a high at 2.25-2.50% by the end of 2018.

In hindsight, the US central bank went too far when it came to tightening credit. Even though US economic growth remained robust in the aftermath of increasing rates, the US stuck out like a sore thumb compared to other countries in the world when it comes to central bank monetary policy. European rates did not budge from negative territory as the Fed tightened credit, nor did rates in Japan move higher. The trade dispute with China caused the world's second-leading economy to slash interest rates as the US became the only credit hawk in the world.

In 2019, the US Fed has capitulated as it realized that it went too far the previous year. A position as the only hawk is not only lonely but dangerous for the economy. When the Fed made its pivot, the price of gold took off on the upside and broke out of a multiyear trading range. Gold mining shares typically outperform the price action in the yellow metal during bull markets. The junior gold mining shares tend to do even better. The VanEck Vectors Junior Gold Miners ETF product (GDXJ) has roared higher and outperformed the yellow metal over the past weeks. There seems to be a race to the bottom developing when it comes to global interest rates, which is supportive of more gains in the price of the yellow metal.

The ECB went first

In the days before the July 31 meeting of the US Federal Reserve, the world heard from the European Central Bank and its retiring President Mario Draghi. Super Mario will hand over the ECB to the former managing director of the International Monetary Fund, Christine Lagarde, in October.

President Draghi set the stage for another round of stimulus in September to combat the eurozone's continued economic slowdown. In his last move as President, Draghi will cement his legacy as a soaring monetary policy dove. He commented that "This outlook is getting worse and worse in manufacturing, especially, and it's getting worse and worse in those countries where manufacturing is very important." He went on to say, "On the inflation front, we don't like what we are seeing." Based on his latest thoughts, a short-term rate cut below negative forty basis points could be on the horizon in September, and quantitative easing is likely to make a return.

The Fed followed with a mixed message

The ECB's message made the US Fed action on July 31 look like it tightened credit. The US central bank cut rates for the first time in a decade by 25 basis points. The move disappointed many market participants and the US President who were looking for a more substantial statement in the form of a 50-basis point reduction in the Fed Funds rate. Meanwhile, the Fed accelerated the end of the balance sheet normalization program by one month. The end of quantitative tightening came on July 31.

The members of the FOMC found themselves in between a rock and a hard place when it decided to cut short-term rates. Two dissenters, Eric Rosengren of the Boston Fed and Esther George from Kansas City, argued that economic data in the US did not support a reduction in the Fed Funds rate. However, crosscurrents and uncertainty surrounding the European and Chinese economies together with the low level of inflationary pressures prompted eight members of the committee to vote for the rate reduction.

The mixed message from the Fed came during Chairman Powell's press conference when he said that the market should not view the move as the beginning of a prolonged easing cycle. While he did not rule out another rate cut by the end of 2019, he also said that robust economic data could just as easily push the Fed Funds rate higher in the future. A 25-basis point move and the comments that followed made the US Fed look hawkish compared to the ECB.

Meanwhile, the day after the Fed meeting, the trade dispute between the US and China escalated as President Trump slapped another 10% tariff on $300 billion in Chinese goods flowing into the US. The duties will take effect on September 1. In response, China canceled purchases of agricultural products and devalued its yuan. The US then designated China a currency manipulator as the dispute is not a full-fledged trade and currency war between the nations with the world's two leading GDPs.

Had the Fed known what was coming on the trade front, it is likely the central bank would have sung a far more dovish tune on July 31.

Other central banks follow

Last week, central banks in New Zealand, India, and Thailand all announced larger than expected interest rate cuts. New Zealand cut rates by 50 basis points with a 35-point reduction from the Reserve Bank of India. The Reserve Bank of Australia held rates at a record low following its move to cut rates in June and July. Central banks around the world are taking a stand and resorting to significant monetary policy moves to avoid an economic downturn.

The move last week triggered a significant rally in the US bond market that took the long-bond futures to a high at 163-31 on August 7, the highest level since November 2016.

Source: CQG

The chart highlights the incredible rally in the US bond market that has taken prices higher and yields lower. Since October 2018, the long bond has rallied from 136-16 to 163-31 and was at the 162-27 level on Tuesday, August 13.

The Fed will follow

The Fed's July 31 meeting came on the heels of another dovish message from the European Central Bank earlier in the month. Since President Mario Draghi has sounded like a broken record over the past months and years, the members of the FOMC did not pay much attention to his message.

Given the events that followed the Fed meeting, the central bank likely regrets its minimal move and less than dovish commentary, If the vote for a rate cut came today, both Rosengren and George would have joined the other members of the committee. The escalation of the trade dispute moves by other central banks, and a budding currency war are reasons for more accommodative central bank policy in the US. The market is now factoring a 100% chance of a 25-basis point reduction in the Fed Funds rate at the September meeting and another move by the end of 2019. Some market analysts are calling for three more rate reduction before the start of 2020. Moreover, we have begun to hear a growing debate over the chances for negative interest rates in the United States.

While Chairman Powell said that the move on July 31 was not the beginning of a prolonged period of monetary policy easing, the events that followed the meeting could make him eat those words.

Lower rates will lead to higher gold

Lower interest rates around the world are likely to keep the bull market in gold going. The price of the yellow metal has been appreciating in all currency terms since the early years of this century.

After the June FOMC meeting when the central bank told the markets that rate cuts were on the horizon, the price of gold broke out from a $331.30 trading range that had been in place since 2014 to the upside. In the aftermath of the July 31 meeting, the price of the yellow metal dipped to just above the $1400 level, and then exploded higher and traded above $1500 per ounce for the first time since 2013.

Source: CQG

The weekly chart highlights the move in the price of gold to its most recent peak at $1531.40. The yellow metal was sitting at the $1500 level on August 13. Lower interest rates around the world, the coming capitulation by the Fed, and a trade and currency war between the US and China have created a potent bullish cocktail for the gold market.

With a hard Brexit on the horizon, problems in Hong Kong and the Middle East, and missile tests from within North Korea these days, gold looks set to continue its ascent after its bullish technical price action that has created the next leg in a bull market that started around 2004. The price of gold has moved from a low at $1266 in late April to its most recent high at $1531.40 last week, a move of 20.96%. Over the same period, the GDX ETF that golds the leading gold mining shares appreciate from $20.14 to $30 per share on the most recent high, a move of 49%. Gold mining shares typically outperform the price of the yellow metal during bull market periods. However, junior gold mining share prices often do better than both gold and the GDX.

The top holdings of the VanEck Vectors Junior Gold Miners ETF product include:

Source: Yahoo Finance

GDXJ has net assets of $4.38 billion and trades an average of over 17 million shares each day. The ETF product charges an expense ratio of 0.54%. GDXJ is a highly liquid product.

Source: Yahoo Finance

The chart illustrates that since May, GDXJ has moved from a low at $27.80 to a high at $43.10 per share or over 55% higher. GDXJ outperformed both gold futures and the GDX ETF over the period. If gold is heading higher, the share prices of the junior gold mining companies are likely to continue to act like the yellow metal on steroids.

A race to the bottom when it comes to global interest rates will pour bullish fuel on the gold market, which is already trending higher. Central banks around the world, including the US Federal Reserve, are in a position where dovish monetary policy is back with a vengeance. The dovish environment is the perfect reason to buy gold and gold mining shares in the current environment.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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: The author always has positions in commodities markets in futures, options, ETF/ETN products, and commodity equities. These long and short positions tend to change on an intraday basis.

The author is long gold