Wake up, Gold Market! Otherwise, inflation will tread on you

The Fed’s aggressive warnings sound like a voice in the desert for investors. However, a carefree attitude can backfire on them, in just a few months.

An epic battle is unfolding in the financial markets as the Federal Reserve warns investors of its impending rate hike cycle with the latter ignoring the ramifications. However, with perpetually higher asset prices only exacerbating the Fed’s inflation conundrum, a profound shift in sentiment is likely in the coming months.

To explain, I highlighted in recent days how the Fed has raised the hawkish dial to 100. Additionally, I wrote on March 22 that it is remarkable how much the PMs’ domestic fundamental outlook has deteriorated in recent weeks. However, prices remain elevated, investors remain optimistic, and bullish bands continue to play out.

However, with the rise continuing and the Fed finishing up its game, the next few months should set off plenty of fireworks. For example, with another deputy sounding the aggressive alarm, San Francisco Fed President Mary Daly said on March 22:

“Inflation has been going on for so long that people are starting to wonder how long it’s going to go on. I’m already focused on making sure this doesn’t fester and we’re seeing those long-term inflation expectations rise.”

As a result, Daly wants to make sure the “top risk” to the US economy doesn’t end up triggering a recession. Likewise, St. Louis Fed President James Bullard reiterated his position on March 22, telling Bloomberg that “faster is better” and that:

“The 1994 tightening cycle or removal of the accommodation cycle is probably the best analogy here.”

falling on deaf ears

At that point, while investors seem to think the Fed can tighten monetary policy massively without upsetting the health of the US economy, a big surprise could be on the horizon. For example, him The futures market has now priced in almost 10 rate hikes by the Federal Reserve in 2022. As a result, should we expect aggressive developments to run smoothly?

Please see below:

To explain, the light blue, dark blue, and pink lines above track the number of rate hikes expected by the Fed, BoE, and ECB. If you look at the right side of the chart, you can see that the light blue line has risen sharply over the last few days and months. For your reference, If you focus your attention on the material underperformance of the pink line, you can see why I have been so bearish on the pink line. for a long time.

Also worth noting, take a look at the US minus 2y German bund yield spread. If you look at the rapid rise on the right side of the chart below, you can see how much US short-term yields have outperformed their European counterparts in 2021/2022.

Source: Bloomberg/Lisa Abramowicz

However, what is more important, with recent rhetoric from Fed officials encouraging a more aggressive price revision rather than lowering expectations (like the ECB), they want investors to cut their advance. However, investors are now battling the Fed, and the epic battle is likely to lead to deep disappointment in the medium term.

Case in point: When Fed officials ramp up aggressive rhetoric, their “message” is supposed to change investor expectations. As such, threatening to raise interest rates often has the same impact as doing so. However, when investors don’t listen, the Fed has to further increase the hardline dial. If history is any indication, a calamity will eventually unfold.

Please see below:

To explain, the blue line above tracks the US fed funds rate, while the various circles and notations above track global crises that erupted during Fed rate hike cycles. As a result, standard adjustment periods often result in immense volatility.

However, with investors who refuse to give up asset prices fall, are forcing the Fed to speed up its rate hikes to achieve the desired result (calm inflation). As such, the next few months could be a rate hike cycle on steroids.

At the time, with Fed Chairman Jerome Powell swinging the aggressive hammer on March 21, I took note of his response to a question about inflation calming in the second half of 2022. I wrote on March 22:

“That history has already unraveled. To the extent that it continues to unravel, my colleagues and I may well conclude that we will have to move faster, and if we do, we will.”

At that point, Powell said that:

“There is excess demand” and that “the economy is very strong and well positioned to handle tighter monetary policy.”

As a result, while investors seem to think that Powell’s hoax, enlightenment will likely materialize in the coming months.

Furthermore, with Goldman Sachs (NYSE:) economists noting the change in tone from “steadily” in January to “rapidly” on March 21, they also raised their hawkish expectations. They wrote:

“We now forecast 50 bps hikes at the May and June meetings (vs. 25 bps at each previous meeting). The funds rate level would still be low at 0.75-1% after a 50bp hike in May, and if the FOMC is open to moving in bigger steps, then we think it would see a second 50bp hike in June. as appropriate under our forecasted inflation path.

After the two 50bp moves, we expect the FOMC to return to 25 sc rate hikes at the remaining four meetings in the second half of 2022, and then slow the pace further next year by delivering three quarterly increases in 2023Q1-Q3. We have left our terminal rate forecast unchanged at 3-3.25%, as shown in Exhibit 1.”

Please see below:

Also, this does not take into account the Fed’s willingness to sell assets on its balance sheet. For context, Powell said on March 16 that the quantitative tightening (QT) should occur sometime in the summer and that the balance sheet reduction “could be the equivalent of another rate hike.” As a result, Investors’ unpreparedness for what should happen in the coming months has been something to behold. However, the reality check will likely spark a major shift in sentiment.

Instead, the bond market heard Powell’s message loud and clear.and with the US hitting another 2022 high of ~2.38% on March 22, the everything is paying attention.

Please see below:

US Treasury yields

Source: Investing.com

Finally, the Richmond Federal Reserve released its Fifth District Manufacturing Activity Survey on March 22. With the overall index rising from February 1 to March 13, the report cited “increases in all three component indices: shipments, volume of new orders, and number of employees.”

Additionally, the Prices Received Index increased month-over-month (MoM) in March (the red chart below), while the six-month forward expectations for prices paid and received also increased (the blue chart below). As a result, inflation trends are not moving in the direction desired by the Fed.

Please see below:

price trends

Source: Richmond Federal Reserve

Similarly, the Richmond Fed also released its Fifth District Service Sector Activity Survey on March 22, and although the headline index declined from 13 in February to -3 in March, current inflationary pressures/expectations and Six-month futures increased month-on-month.

price trends

Source: Richmond Federal Reserve

The bottom line? As the Fed yells at financial markets to ease it to help quell inflation, investors aren’t listening. With higher prices resulting in more aggressive rhetoric and policy, the Fed should continue to amplify its message until investors finally take notice. Otherwise, inflation will continue to rise until demand destruction sets in and the United States falls into a recession. As such, if investors assume that several rate hikes will kick off in the coming months with little to no volatility in between, they are likely in for a big surprise.

In conclusion, PMs declined on March 22 as sentiment continued to swing. However, as I noted, it is remarkable how much the domestic fundamental outlook for PMs has deteriorated in recent weeks. So while the conflict between Russia and Ukraine is keeping them buoyant, for now, the Fed’s inflation problem is nowhere near an acceptable level. As a result, when investors finally realize that they will be facing a much tougher macroeconomic environment in the coming months, the change in sentiment is likely to culminate in sharp declines.

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