Negative Interest Rates

Remember when negative interest rates were unthinkable? In Europe they are increasingly normal, even in nominal terms. Subtract inflation to get a real yield and yields are even deeper underwater. For instance, here’s a chart showing the recent real yield for 10-year German government bonds.

Of course, this real yield presumes inflation will stay where it is for another 10 years, which is unlikely. The real point here is to highlight the particularly toxic combination now afflicting the developed world: zero or below-zero nominal rates combined with inflation that’s historically mild, but still the highest in recent memory. The scary part is how central banks and governments are trapped. Raising rates would aggravate their massive debt payments, but cutting rates would make them even more negative and might spark more inflation. Where this leads is hard to say but it probably won’t be good.

Gold and Interest Rates

Gold analysts have long “known” that the real interest rates have an effect on gold prices. By “real” interest rates, I am referring to the inflation-adjusted interest rates which are represented by the 3-month T-Bill yield minus the CPI Inflation rate. The current T-Bill yield is +0.05 (hey, at least it’s a positive number), and the latest CPI data show prices up 5.37% from a year ago. So the difference between those two is -5.32%.

Gold was first traded freely in the U.S. beginning in 1975 and, since then, it has been demonstrably well correlated (negatively) with the real T-Bill interest rate. There was even a brief moment of negative real rates back in 1970-71 that put enough pressure on the dollar to kick the U.S. off the gold standard. Since then, episodes of negative real rates have been fairly well correlated, but with a twist.

Rates that are a little bit negative are stimulative to gold prices going higher. But, if the spread gets too big, that tends to stifle further progress. It is almost like it is too much of a good thing. The -3% threshold seems to be the boundary line for this effect. Excursions below -3% tend to mark important tops for gold prices, or at least that has been the case for the past 37 years. Maybe this time will be different.

So why would this matter? A big negative real yield is a sign of a huge imbalance in the banking system and horribly misguided Fed policy. It says that the Fed is WAAYYYY behind the power curve and has let inflation get away from them.

When that happens, the natural reaction is for the FOMC to start raising short term rates, trying to get the genie back into the bottle. It is the hiking of the short term Fed-controlled rates that does the work of discouraging people from owning gold. Higher interest rates mean that a gold investor misses out on that much more money which he could have earned in a bank account or CD, instead of in gold. It is also the anticipation of those rate hikes that gets gold traders moving the price down in advance of the actual Fed action.

The very real question (and that does not mean an inflation-adjusted question) right now is about whether the current Fed is not going to do its job, and respond as it would have in the past to a ridiculous spread between the inflation rate and its short term interest rate targets. We arguably have a Fed whose honchos are to not only think that 2% is their goal (statutorily, it is 0%), but who also think that 5%+ is just “transitory” and so they don’t need to do anything about it.

If a big negative real yield is an indicator of what the Fed is about to do that will hurt gold prices, but if we now have a Fed which cavalierly ignores market conditions, then does this indication really still work as an indicator for gold?

US Economy

• The July payrolls report topped market expectations, posting another strong month of job gains.
• The surprise came from state & local hiring. Some of this is noise related to seasonal adjustments (teacher hiring didn’t follow the usual pattern last year). The total jobs figure, therefore, was distorted to the upside.
• It’s worth noting that without seasonal adjustments, payrolls declined in July.
• It will be a while before employment returns to 2019 levels, let alone the pre-COVID trend.

• Prime-age labor force participation is rebounding, but the total participation rate has stalled.
• Labor force participation among Americans aged 55 and older remains depressed.
• Here are the leaders and laggards.

• Job openings hit another record in June, with the May figures revised higher. The demand for labor in the US is unprecedented.
• Layoffs are near the lows, and voluntary resignations (quits) are near the highs.
• The ratio of unemployed to job openings is back below one.
• Consumer credit jumped by most on record in June as Americans tapped their credit cards (revolving credit).
• Banks have been increasingly accommodative (easing underwriting standards) as demand for credit card borrowing picks up.
• Student debt growth continues to slow.
• Households’ liquid assets as a percentage of disposable personal income are at record highs.
• The overall household credit rose sharply in the second quarter, driven by mortgages.
• Banks have been easing lending standards on jumbo mortgages amid strong demand.
• Mortgage financing remains dominated by top-credit-score borrowers.
• Consumer financial distress is at record lows.
• What happens when Government support ends?

• The NFIB small business sentiment index was weaker than expected last month.
• Small firms continue to struggle with labor shortages. Companies increasingly report challenges attracting qualified workers.
• The rebound in small business hiring has stalled.
• Companies are boosting wages to keep/attract workers
• The percentage of firms raising prices appears to have peaked but remains near the highs.
• A record percentage of companies view current inventory levels as “too low” amid persistent supply-chain challenges.
• CapEx expectations have been trending lower.
• US productivity gains were lower than expected in Q2.
• Output growth was driven more by hours worked than productivity increases.
• But manufacturing saw substantial improvements.
• The overall productivity growth remains above the pre-COVID trend.
• Nomura expects to see lower core CPI gains in July.
• Consensus forecasts for inflation continue to revise upward.
• The slowing oil price rate of change points to a decline in core PCE inflation.
• A Fed rate hike next year is once again fully priced into the market.
• The Delta Variant

• Consumer price gains remained elevated last month, but the pace of growth slowed (roughly in line with expectations).
• Homes, new autos, and hotels drove much of the CPI increase in July.
• On a year-over-year basis, the core CPI is expected to stay elevated, even as the base effects dissipate.
• The median CPI rose sharply in July, indicating that price gains have been broad.
• Mortgage refi activity remains elevated.
• Approximately 7.3 million homeowners have been in a forbearance plan at some point over the past 15 months. That’s more than 14% of all mortgage properties, according to Black Knight.

• Home price gains have surpassed the prior housing bubble peak.

• The supply of available lots for home construction continues to dwindle.

• Rental vacancies are trending lower.

Here is the breakdown by sector.

COVID-sensitive items continue to drive the core CPI gains.

Restaurants have been boosting prices

Retailers haven’t had this much pricing power in years (perhaps decades).

Ride-share prices have risen sharply due to driver shortages (and increased demand in some areas).

What is the current difference between the CPI and PCE inflation indices?

• Social Security payments will increase more than usual next year due to the spike in inflation.

• It’s hard to grow the labor force when the prime-age population remains flat for over a decade. This trend will continue to be a drag on GDP growth.

• The recent surge in household net worth has been unprecedented as stocks and housing prices have soared.

Market Data

• High-growth stocks have been correlated to Treasury prices.
• Higher Treasury yields tend to benefit banks.
• Roughly 50% of S&P 500 stocks have dividend yields greater than the 10-year Treasury yield.
• Share buybacks are about to break a new record.
• VIX is entering a seasonally strong period, which can lead to a sideways/choppy market over the next two months. VIX higher means markets lower.

• A record number of firms are beating earnings estimates.
• But outlook has become less optimistic.
• Valuation measures continue to indicate poor returns over longer periods.
• Market cap to gross value added ratio:

• Forward PE ratio:

• High-yield bonds (HYG) have diverged from stocks (SPY).

• The decline in bank liquidity points to lower stock prices.

• Markets breathed a sigh of relief on signs that inflation appears to be peaking.
• “Reopening” stocks continue to outperform.
• Retail bullish sentiment has declined from extreme levels.
• Merrill Lynch private clients’ equity allocations remain near record highs.

• China’s influence on the US stock market continues to moderate.
• The global policy stimulus impulse is deeply negative, which means economic growth could normalize to lower levels.

• Global excess liquidity growth continues to roll over.

Thought of the Week

AT&T fired President John Walter after nine months, saying he lacked intellectual leadership. He received a $26 million severance package. Perhaps it’s not Walter who’s lacking the intelligence.

Pictures of the Week

All content is the opinion of Brian J. Decker