The Fed is Painted into a Corner

This week was without a doubt a “risk off” week. Or was it?

One might expect Treasuries to decline (rates to rise) if the economy is so strong. As James Rickards tweeted at the end of the second quarter, “On March 31, 2021, the yield-to-maturity on the 10-Year Treasury note 1.75%. Today the yield is 1.460%. That’s a disinflationary signal from a market that almost always gets things right. (The stock market is the last to know.) The inflationists are marching off a cliff.”

I recall one time asking guest Pat Gorman (now deceased) on my radio show whether he was more worried about inflation or deflation. His answer was “Yes!” 

Pat wasn’t trying to be a wise guy; his point was that both inflation and deflation dynamics are always taking place simultaneously. It could very well be that Jim Rickards is right in suggesting that the bond market is telegraphing the next stock market decline, which could bring with it some deflationary forces. But if you apply the Austrian economic school of inflation, then I am nearly 100% sure that we are heading for some very serious inflation in the not-too-distant future. I say that because the Fed is truly painted itself into a corner that it has no way out of. To fund the Treasury without printing money, the Fed has to stop purchasing Treasuries and let interest rates rise to the level where the market would start investing in U.S. Government paper rather than in stocks. But the Fed can’t implement that rightful policy without causing the biggest stock market decline ever. If the Fed were to do what Paul Volcker did in 1980 then I would, with 100% certainty, bet on a horrific deflationary depression. But I think it’s safe to assume the Fed will not pull a Paul Volcker because there truly would be blood in the streets and it would likely be the blood of the Fed Chairman and other elites. 

Gold and Treasuries both rose last week. They are “safe haven” so they should both retreat when stocks go up. I believe there must be some smart money that is hedging their bets by trading some of their equity holdings for gold and Treasuries. Michael Oliver has been short term bullish on the T-bond for that very reason. And he believes gold investors should focus mostly on the equity markets for the next major run higher.

But even if we look at current prices, there is no sign that inflation is transitory.  Here are some comments along those lines from Peter Boockvar, chief investment officer of Bleakley Advisory Group in Fairfield New Jersey: “For all the talk about the pullback in lumber and copper prices and the comfort some in the ‘transitory’ camp are taking in that, the CRB raw industrials index has rallied back to within .3% of its 10 yr high. As said before, many materials within this index don’t trade on a futures exchange and thus better reflect actual supply and demand and not the behavior of speculators. And, it doesn’t include energy prices where WTI is nearing its highest level in 3 years.

“The housing price bubble in the U.S., with different characteristics than the last one, is not just a U.S. thing. Today, the Nationwide House Price index in the U.K. for June saw prices rising by 13.4% y/o/y. Easy money is definitely the main factor but there is also a rush before a purchase tax holiday expires. Housing bubbles are also seen in Canada, Australia, New Zealand, and other parts of Europe. As for the U.S., today’s S&P CoreLogic home price index is expected to show a y/o/y price increase of 14.7%. So much for the Fed’s all-inclusive monetary policy where lower income people now can’t afford housing.”  

Gold, and Basel III’s Trillion-Dollar Question is an article that provides a link to an excellent summary of the impact of Basel III’s new regulations on gold, silver, and other commodities. The link to this article is on the home page of Basel III requires banks to ante up capital for unallocated gold, silver, and other commodities, whereas previously it did not need to do so. As the article pointed out, the banks are flush with excess capital so there is no urgent need to sell down those positions immediately, but they will no doubt do so over time. Banks backing away from this business are likely to lead to less liquidity in those markets and it may become more expensive to buy those metals. But the article suggested it is likely to be bullish in the longer run and also provide more honest price discovery, which should benefit those who own physical gold as well as the mining companies. So if you were hoping that June 24, the day that the new regulations kicked in for European banks, and July 1 for U.S. banks would suddenly result in a major rise in the price of gold, you may have been disappointed. But don’t despair. As the article pointed out, you need to do what the bankers are doing, not what they are saying. In fact, bankers are buying more physical gold (as opposed to phantom paper gold) than they are U.S. Treasuries, as the chart on your left shows.

About Jay Taylor

Jay Taylor is editor of J Taylor's Gold, Energy & Tech Stocks newsletter. His interest in the role gold has played in U.S. monetary history led him to research gold and into analyzing and investing in junior gold shares. Currently he also hosts his own one-hour weekly radio show Turning Hard Times Into Good Times,” which features high profile guests who discuss leading economic issues of our day. The show also discusses investment opportunities primarily in the precious metals mining sector. He has been a guest on CNBC, Fox, Bloomberg and BNN and many mining conferences.