The Booming U.S. Economy Forces The Fed To Hit The Hawkish Gas
Sunshine Profits | Aug 09, 2022 01:20AM ET
While investors erroneously assumed that the Fed could ease monetary policy with 9%+ inflation, the crowd bought into the notion that the post-GFC playbook still holds. However, with unanchored inflation forcing the Fed to raise interest rates during recessions in the 1970s and 1980s, I warned on Aug. 5 that the consensus misses the forest through the trees. I wrote:
To explain, the red line above tracks the FFR during the 1970s/1980s, and the vertical gray bars represent recessions. For one, unanchored inflation forced the Fed to raise interest rates during (not just before) all three recessions. In addition, the ~1974 and ~1982 recessions show how after the Fed cut rates to support economic growth, the central bank had to reverse course and raise the FFR once again. As such, the consensus underestimates how difficult it is to slay inflation once it gets going.
Likewise, while the prospect of a dovish pivot was a fallacy to begin with, another dose of reality hit the wire on Aug. 5. For example, U.S. nonfarm payrolls (the red box) came in at 528,000 versus 250,000 expected, which highlights the continued resiliency of the U.S. labor market. Moreover, employment strength only adds fuel to the hawkish fire.
Please see below:
Source: Investing.com
Furthermore, if you analyze the purple box above, you can see that average hourly earnings also outperformed economists’ consensus estimates. Therefore, while I’ve been sounding the alarm on wage inflation for many months, the data continues to come in hot.
More importantly, the blue box above shows how the labor force participation rate declined from 62.2% in June to 62.1% in July. This is profoundly inflationary. With the demand for workers still apparent and the supply shrinking each month, wages will remain elevated as companies compete for potential candidates. As such, the data should keep the Fed’s foot on the hawkish accelerator, and the prospect is bearish for gold, silver, and mining stocks.
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To that point, Fed Governor Michelle Bowman said on Aug. 6:
“One aspect of the job market that has not recovered is labor force participation. Based on the pre-pandemic trend, there are nearly four million people who are still sitting out of a strong labor market (…). Yesterday's job report showed continued significant growth in hiring with the unemployment rate finally returning to the pre-pandemic level of 3.5%.”
She added:
“When considering the risks to the labor market, these risks must be viewed in the context of its current strength and with the understanding that our primary challenge is to get inflation under control. In fact, the larger threat to the strong labor market is excessive inflation, which if allowed to continue could lead to a further economic softening, risking a prolonged period of economic weakness coupled with high inflation, like we experienced in the 1970s.”
As a result:
Source: U.S. Fed
Thus, while Fed officials have intensified their efforts to unwind the dovish damage done during Chairman Jerome Powell’s press conference on Jul. 27, the bond market took note of the fundamental developments.
Please see below:
To explain, the green and black lines above track the one-week performance of the U.S. 2-year, 5-year, and 10-year Treasury yields. As you can see, interest rates rose sharply last week, with the bulk of the move occurring after the payroll print on Aug. 5. Furthermore, with the U.S. 10-Year breakeven inflation rate declining to 2.46%, the U.S. 10-Year real yield closed at 0.37% on Aug. 5.
Therefore, while the S&P 500’s intraday comeback helped gold, silver, and mining stocks close off their lows, the fundamentals continue to support lower prices over the medium term. Moreover, I’ve long warned that the Fed needs higher real yields to curb inflation; and with Powell nodding in agreement during his June press conference, more downside should confront the PMs as the Fed’s inflation fight intensifies.
Source: U.S. Fed
h2 Spend, Spend, Spend/h2While the consensus expects a smooth normalization from 9%+ to 2% annual inflation, I’ve warned that underestimating demand has been investors and the Fed’s undoing. I wrote on Dec. 23, 2021.
While the fiscal spending spree may end, U.S. households are flush with cash. U.S. households have nearly $3.54 trillion in their checking accounts. For context, this is 253% more than Q4 2019 (pre-COVID-19)(…).
While some investors expect a dovish 180 from the Fed, they shouldn’t hold their breath. With U.S. economic growth still resilient and the U.S. consumer in much better shape than some portray, the Fed can raise interest rates without crashing the U.S. economy. As a result, Powell will likely stick to his hawkish script and forge ahead with rate hikes in 2022.
Therefore, while nine rate hikes (25 basis point increments) have commenced in 2022, higher interest rates have done little to derail the U.S. consumer. For example, Mastercard (NYSE:MA) released its SpendingPulse retail sales report on Aug. 4. An excerpt read:
“Spending increases in July outpaced monthly year-over-year (YoY) growth experienced thus far in 2022, with demand and higher prices both contributing factors (…). Apparel (+16.6%) and Jewelry (+18.6%) sales saw strong demand-driven YoY growth, well outpacing sector-specific inflation.”
In addition:
“Travel remains a priority, with Lodging up +29.6% YoY and Airline sales up +13.3% YoY.”
Furthermore:
“While in-store sales remain elevated, up +11.1% YoY/ +13.9% Yo3Y, e-commerce posted its first month of double-digit sales growth (+11.7% YoY) since December.”
Thus, while online spending surged during the pandemic and then decelerated as COVID-19 restrictions abated, in-store transactions remained robust, and e-commerce is now making a comeback. As such, the consensus doesn’t realize that the Fed’s war against inflation will be one of attrition.
Please see below:
h2 Too Loose/h2Another critical factor is how tighter financial conditions, higher real yields, and a stronger U.S. Dollar often go hand in hand. Therefore, while the latter two played their parts on Aug. 5, some metrics are still too loose for the Fed to materially reduce inflation.
Please see below:
To explain, the red line above tracks the high yield option-adjusted spread (OAS), while the green line above tracks the S&P 500. For context, the OAS is the interest rate above U.S. Treasury yields that investors require to own the riskiest U.S. debt.
If you analyze the right side of the chart, you can see that the metric has declined sharply over the last month. As a result, it’s cheaper for risky companies to obtain financing, and the development supports economic growth.
Furthermore, with the S&P 500 often moving in the opposite direction, you can see how a declining OAS helped embolden the equity bulls (as evidenced by the green line rising on the right side of the chart). However, if the Fed wants to curb inflation, it needs a higher OAS and a lower S&P 500, and a realization is bearish for the PMs.
h2 Hiding in Plain Sight/h2While the headline Consumer Price Index (CPI) may show a deceleration on Aug. 10 due to lower oil and gas prices, I’ve noted how corporate earnings calls have been riddled with mentions of inflation and price increases. Moreover, with Honeywell (NASDAQ:HON) – an industrial conglomerate with a nearly $130 billion market cap – releasing its second-quarter earnings on Jul. 28, the data remains troublesome.
For example, when asked about the recent decline in commodity prices, CFO Greg Lewis said:
“There are some commodities that are seeing some of that deflation. But overall, for our total portfolio of direct materials, that's sort of cherry picking. And overall, we still see a net increase.”
As such, Honeywell is now pricing its products ahead of the guidance management gave in Q1.
Please see below:
Source: Honeywell/The Motley Fool
Likewise, Procter & Gamble (NYSE:PG) released its fourth-quarter earnings on Jul. 29. For context, it’s one of the largest consumer products companies in the world with a nearly $350 billion market cap. CFO Andre Schulten said during the Q2 earnings call:
“The combined YoY profit headwinds from foreign exchange rates, freight costs, materials, fuel, energy and wage inflation are an even greater challenge in fiscal '23 than they were in fiscal '22. Based on current spot prices and supply contracts, we estimate commodities, raw materials and packaging material costs to be a $2.1 billion after-tax headwind in fiscal 2023.”
He added:
“Moving to the April-June quarter, organic sales grew 7%. Pricing contributed eight points to organic sales growth as additional price increases reached the market.”
Thus, while P&G raised its prices by 8% in Q4, more hikes are coming. As a result, the realities on the ground are nowhere near the Fed’s 2% goal.
Please see below:
Source: P&G/Seeking Alpha
h2 The Bottom Line/h2While reality returned to the financial markets on Aug. 5, asset prices are far from reflecting their fundamental values. With the Fed hawked up and a material reduction in demand the only way to normalize inflation, the medium-term ramifications are nowhere near priced in. Therefore, gold, silver, and mining stocks should suffer mightily as the hawkish realities hover over the financial markets in the months ahead.
In conclusion, the PMs declined on Aug. 5, as strong payrolls elicited fears of a more hawkish Fed. However, with the ‘buy the dip crowd’ hitting the bid in the afternoon, their faith in a “soft landing” was on full display. However, with nearly 70 years of data suggesting otherwise, harsh lessons should be learned over the medium term.
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