I love tracking the assets that develop cult-like status. The kind where the narratives are powerful and the emotions run high, where our behavioral biases become most transparent. It’s why it impossible to take your eyes off of bitcoin these days.
For the past few sessions we are seeing a new vibe creep into markets, driven by bonds.
The Federal Reserve currently holds about $2.5 trillion in Treasury securities and about $1.8 trillion in mortgage-backed securities. These securities were purchased in the aftermath of the GFC to help the Fed achieve its policy objectives once the Federal Funds rate ran into the ZLB.
In October, the unwind began.
We live in an increasingly complex world moving at an increasingly fast pace. The way it comes at us, it feels like we’re at the receiving end of a firehose. It demands quick reactions and baits us into quick conclusions. Compound this by our ever-shorter attention span, and the age-old challenge of battling conformation bias is today a lot tougher.
One of the strongest beliefs in currency markets is if a central bank is hiking policy rates its currency will strengthen. Nowhere is this a more powerful thought than in the US, whose reserve currency is dominant and whose policy rates set the tone for global cycles.
I know none of this is terribly new or groundbreaking, and I’ve oversimplified for the sake of parsimony, but here’s the null hypothesis:
The US yield curve reflects a global equilibrium rate for ‘risk free’ financial assets much more than it does any kind of capital formation equilibrium rate. In other words, it equilibrates financial activity, and economic activity is somewhat of a price taker.
Not only is the yield curve much more driven by financial balances these days, but, within financial balances, the share of price-insensitive demand for risk-free assets has grown sharply. And at the same time the supply for these assets has contracted.
Here are a few reasons why:
- Rating agencies were chastened by the GFC and aren’t slap happy with AAAs anymore
- Derivative structurers are, let’s say, more modest in their issuance ambitions
- Insurance companies and pension funds have endless structural demand
- Banks have higher liquidity requirements to meet
- Central bank QEs
This isn’t to say yields don’t react to economic info or don’t say anything about the state of the economy. Of course they do. But the dominance of financial drivers after 30 years of global financial deepening has made attempts to extract economic information from the level and shape of the US yield curve unhelpful–or worse, vulnerable to false positives.
Everyone is starting to take a look at oil names, and with good reason this time.
Back at the end of July I posted a quick thought on oil, arguing that we were starting to price in the oil industry’s secular headwinds. We had seen a sharp rise in the price of crude starting in mid-July, yet neither big oil or oil servicer names were following. At the same time, market analysis/chatter was that EVs were inevitable and would be on the market sooner than we thought.
Since then the performance gap between crude oil and oil stocks have continued their divergence.
The blue line is WTI, the burnt orange line is XLE, and the white line is OIH.
The upshot is that we have priced in a lot of secular headwind in a short period of time, investors, desperate not to lag the indices in a super bullish year marked by aggressive sector rotation, are likely to turn to the oil sector, as a laggard, to make up ground into year end.
And the charts are constructive.
Here is OIH, from one and 5 year perspectives:
Now, here is XLE, from the same perspectives:
It probably doesn’t matter for now that valuations are not attractive (i.e. oil names are pricing in a big earnings rebound) and that the secular headwinds haven’t gone away. And it probably doesn’t matter that late last week people already started recommending the sector.
What will likely matter most—unless crude oil ‘closes the divergence’ by itself taking a dive—is that people need performance, oil names have lagged crude sharply, and their chart patterns just turned up nicely.
So much for fundamentals and the efficient market hypothesis.
I go on way too much about gold. It’s starting to annoy even me.
So, I’m just going to lay out the cyclical and secular arguments against gold one last time. After that, you do you. If you want more on the cyclical framework, go here.
Cyclical weighs heavy
- Higher real interest rates. Except for extreme moments, the correlation between gold and real interest rates plots pretty high. And real rates are going higher. You don’t have to believe they are going a lot higher, but you do kind of have to believe the sign is positive. Europe and Japan are next, even if it’s early days and they’re likely to proceed slowly.
- Unwind of residual disaster myopia. Risk aversion from the GFC and fear of disruptive QE inflation fed a big run in gold 2009-2011. It was a bubble created by investors looking for safe haven from bubbles. The bubble popped in 2012, and is still slowly leaking today. Yeah, inflation is more likely to pick up than not, but we’re not talking about the kind of rampant, de-stabilizing inflation that was almost consensus back in 2009-10. And, sure, some people still fear systemic risk too. But synchronized global growth & better banking regulation/capitalization have been reducing this fear, not increasing it.
Bottom line: If you think the global economy is in synchronized upswing, and also you think major global CBs are going to be reducing exceptional accommodation over the next few years, it’s pretty hard to make the case that the cyclical pressures on precious metals are for higher prices and not lower.
Insidious secular forces
- Gold is losing monetary relevance. It’s moving further from the center of the global monetary system with every passing day. Nixon closed the gold window on August 15th, 1971. That was the day gold’s utility started to die. No one is going back to the gold standard. Each new generation sees less utility in it than the one before. Much in the way science progresses one funeral at a time, gold’s perceived utility fades one funeral at a time.
- Digital technology is accelerating this process. The rapid evolution of digital payments and assets is further reducing gold’s utility, and now, thanks to the visibility of bitcoin, at an accelerated rate. Technology is taking us further and further from the gold standard. Even central banks are starting to rethink payment and settlement systems. And this would still be true if bitcoin were officially banned tomorrow.
Where does it end? It’s always made sense to me that gold should revert to pre-bubble levels and maybe overshoot, but really I don’t know. What I do know is that as long as I believe gold’s perceived utility is declining, both cyclically and secularly, I want to be structurally bearish.
Yes, if gold falls to 500 I’m sure I won’t be able to resist coming out and taking victory laps. But, other than that, consider gold-posting done.
Jay Powell, the all-but-assured incoming Fed Chairman, had his Senate confirmation hearing yesterday. And the whole drive to extract a hawkish/dovish angle from the proceedings missed the point, in two important ways.
One, we should have learned by now that whether someone is hawkish or dovish at a point in time is far less telling than whether they show ability to evolve over time. Powell showed balanced pragmatism, both on monetary and regulatory issues. This is also consistent with his reputation.
Two, Boris Yeltsin might have been a larger-than-life hero in the Russian constitutional crisis of 1993, but he was an abysmal administrator. Bernanke and Yellen were wartime Chairs, technically deep but pragmatic, with a courage of conviction that only comes from a lifetime immersed in the subject matter. But both were shy on political skills. Hard to forget Bernanke’s quivering lip in his first dozen or so Congressional testimonies.
Powell may not have the technical expertise or the courage of conviction Bernanke showed in the depths of the GFC, but the Fed is not longer at war. The path to normalization is all but set. Financial intermediaries have been defused. The next recession is much more likely to be garden variety than apocalyptic—irrespective of what our lizard brains keep telling us.
The challenges now are political. The Fed now needs someone who can stave off the growing efforts of Congress to politicize the Fed and ‘usurp upon its domain’. It needs someone who can keep Elizabeth Warren and GOP troglodytes at arm’s length while the tweak and streamline the post crisis regulatory framework.
Yesterday, Powell showed great promise that he can be that guy.