The Big Conversation
Episode 74: Will the fed initiate a taper tantrum?
This week we look at the latest surge in inflation data, the opportunity this presents for precious metals such as silver and gold, and the likely response from policymakers. Gold and silver are breaking out of their short-term consolidation patterns and this could be a great opportunity to look at the high-octane mining names. In this week’s Chatter, Robin Marshall, Director of Fixed Income Research at FTSE Russell outlines the criteria that need to be fulfilled for the Fed to taper its bond purchases.
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Last week's US CPI figures have supercharged the inflation debate that's been raging for weeks now. The headline figure hit 4.2%, well ahead of the 3.6% that was forecast. But that still remains well short of the levels experienced just before the Great Financial Crash of 2008. At the same time, the less volatile core CPI series hit its highest level since the 1990s. And many people have derided the comments from the US Federal Reserve that the current inflation will be transient. Base effects and ongoing bottlenecks should continue to put upward pressure on short-term inflation data, which in turn will benefit the precious metals sector. But is it now time to taper and what would happen if they did? In this week's Big Conversation, we look at how gold and silver are once again on the move and whether the market should fear a taper tantrum like we saw in 2013.
Although gold and silver often move in lockstep, silver should be the better reflation trade because of its many industrial uses. For gold, one of the key drivers is of course, the direction of real yields, which is why the outlook for inflation and bond yields is absolutely key. When real yields are falling gold is usually rising and vice versa. Earlier this year, the weakness in gold was on the back of higher real yields after a move higher in nominal yields from under 100 basis points to close to 175 basis points on the US 10 year. And you can see the relationship between real yields, nominal yields and inflation expectations. When nominal yields rise, but inflation expectations are relatively static, then real yields will also rise. Real yields fall when inflation expectations rise, but nominal yields flatline. And recently we've seen real yields make new lows, fueling the recovery in gold because of the recent strength in industrial commodities and the increase in many measures of actual inflation, which have again seen inflation expectations move higher. The US 5-year measure of inflation expectations is at its highest level in 15 years. At the same time, US nominal yields have only ground back towards their recent highs, despite all the concerns about inflation. Fears of a surge in yields have so far been sidelined. This is partly because the decline in holdings by foreign governments has been offset by significant demand for U.S. fixed income securities from foreign official institutions. They've been buying into the corporate bond market and taking advantage of the healthy spread that has opened up between yields on government bonds in the US versus other regions such as Germany. The US German spread for the 10-year government bond has narrowed, but it suggests that there is a natural brake on U.S. yields rising too quickly relative to other international peers, because each time it widens out too far, it encourages capital to chase those U.S. yields. For gold the backdrop of loose fiscal policy and higher inflation look even more exciting when we look at the US 10-year yield minus CPI or the Fed funds minus CPI. Fed funds minus CPI is at its lowest level in over 40 years, indicating that the supportive policy mix is coming from both monetary and fiscal. And so the recent backdrop of lower real yields has been advantageous for spot gold prices, which have been breaking out of a short-term channel consolidation and could now head back to the 2000 dollar highs. The options market is not currently playing for a break above that 2000 dollar level, suggesting that momentum players would have to chase the prices if it broke those levels. For those who would like a higher octane play on the gold theme, the miners have also been breaking out of a consolidation pattern. Many of these companies have strong operational leverage to a gold price in excess of 1400 dollars, so any price rises in gold will provide a boost to free cash flow. If we also think that this reflationary period has more legs, especially over the next couple of months where inflation numbers are expected to come out at the higher end of expectations, thae silver should have even more upside. Silver is also close to breaking higher. It looks similar to the bullish pattern that's starting to play out on gold. Furthermore, when we compare silver to gold in recent months, silver has performed better than gold. Silver is more of a reflation play, so this should be expected. If we compare silver to copper, then it would appear that there's still some way to go. We've discussed before that copper is probably in a megatrend of its own and can break away from the broader commodity complex. But nonetheless, if we are to have a couple more months of solid inflation data and a reflation narrative as the driving force for markets, then silver should start to outperform copper. And of course, in the same way that gold miners are high octane way of playing gold, so too are silver miners a high octane way of playing the underlying commodity. And silver miners look like they have also begun the process of breaking out. So gold and silver are once again looking like a good play on the inflationary outlook in an environment where bond yields are relatively subdued, considering the growing consensus that inflation is here to stay. A weaker US dollar would also be beneficial to all commodity prices, and the DXY is getting close to testing recent lows. But perhaps the most important questions are what does the Fed think about inflation? Are they behind the curve? And what would it make for them to do a policy U-turn? And can today's markets withstand a taper without a tantrum? There's many moving parts ranging from the nature of reflation to the tolerance of both the market and of policymakers to those higher yields. I spoke with Robin Marshall, Director of Fixed Income Research at FTSE Russell, about the inflation we're seeing, the expected policy response and whether it's now time for the Fed to taper.
Roger: At the center of the inflation debate is whether the inflation we're seeing is transitory in nature? Are these one-off rises or are they the beginning of a series of increases? Are they due to bottlenecks and supply chain disruptions, or will inflation become stickier in measures such as wages and housing? Robin Marshall runs through a number of different inflation angles.
Robin: Well, when you look at the CPI Roger, it's notable that we've had big jumps in items which appear to be linked to sort of semiconductor prices and the sort of shortfall of global sort of semiconductor supply. So if you look at the US CPI breakdown, you'll see used car prices suddenly surged sort of 10% in April, and that followed a 0.5% Increase in March. And the reason for that was, of course, there are less new cars being made, so demand got reallocated to used cars. Hence we have this huge kind of one-off price surge in March, April. I mean, that's the biggest since they started compiling the index in the 50s, that surge in April. And then if you look elsewhere, you'll see energy prices are up sort of 25% year-on-year in the index. So those those kind of looked like very much kind of transitory inflation impacts. And you've got that, alongside that you have these big base effects. Remember that in the February to May period of 2020 when Covid hit, the CPI dropped about 1%, so even if prices had stayed unchanged, for example, in April, we would still have had a big surge sort of point 8 year on year. So there are these, those base effects are working very much to drive inflation up at the moment as well. When you look at what might be more persistent inflation gains or price gains, you could argue, I think that house prices are showing some signs of a more genuine uptick, and that's reflected to lower inventory in housing and the housing crisis frankly, that never was, because if you remember, during the early stages of Covid people were reading off the GFC playbook and saying, "oh, we're going to get another housing crash" well, of course, it was very different, the housing market now than it was then. We have a shortfall of housing supply. So you could get a little bit of pressure there, and that creeps through into the rented sector as well, where you've got this big owner equivalent rent sort of housing component in the CPI. But overall, I think there are reasons for thinking that the bulk of these moves are transitory. And as we go into the summer months, get beyond those big base effects, which should be later on in the third quarter, you're going to see the CPI stabilize, particularly if energy prices also stabilize.
Roger: Currently, the Fed thinks that this inflation will be transitory, but the Fed have been reactive rather than proactive over the years. So therefore investors will understandably be wary that policymakers could do another U-turn if the inflation data stays persistently strong.
Robin: In terms of the signaling we've had from the Fed Roger, it looks as though we're going to need probably, I would say, two or three things. But principally they've talked about a sustained improvement in the economy and indeed a sustained increase in inflation and inflation expectations. And one or two months data just isn't enough, a sustained improvement in the economy is a big part of this and indeed sustained increase in inflation. And remember, of course, they've moved already as of last summer to an average inflation target of two percent. They're prepared to accept what they deem to be temporary inflation overshoots. We don't have any time period, incidentally, on how long is temporary. The related variable I think, the other key variable to look at is the labor market, and how far that the tightening of capacity in the labor market starts to affect wage settlements. And again I'd signal there that the current unemployment rates, you know we're not far away from twice the sort of three and a half percent unemployment rate that we saw pre-covid. So we're still miles above sort of full capacity in the labour market, maybe you look at other measures like U-6, underemployment, we're still a long way away from full capacity. So there isn't any sign yet, I think, of any type of genuine cost push inflation coming from the labour market. And I counsel a little bit of caution too, in terms of average wage settlements, because there's been a bit of a statistical effect pushing up average hourly earnings with some of the poorest paid industries, the ones that were hit hardest in covid with those job losses, that distorted average wages upwards in sectors like retail, hospitality, leisure, and so on where those wage settlements tend to be lower. And so overall, I think those are the two, probably the two key areas to look at. How long this persists, this inflation overshoot and economic growth recovery and again, the tightening, how far there is genuine tightening in the labor market. Are we approaching some notion of full employment? And we've seen some distance from that at the moment.
Roger: Many investors remember the taper tantrum of 2013 when the Fed started to rein in their QE programs and found themselves repeatedly having to dial back their intentions because of an adverse market reaction. Investors are again concerned that the Fed may be wrong foot the market, although the market set up today may be very different from eight years ago.
Robin: Very much so. This is a different setup. I mean, and the lessons you might argue, some lessons have been learned from 2013. There are people doing a kind of Kahneman system one jumping to the conclusion that a genuine inflation process is now developing. I think that's not based on anything genuinely fundamental. We don't see evidence of capacity or labour market constraints, the type of factors that drove big inflation numbers in the 70s, 80s, 90s and so on. So the bond market so far, although yields have been backed up, of course, from the sort of covid, post-covid lows in the sort of 50 basis point region in the 10-year. And we're now well above one and a half. The market, I think, took the Bank of Canada taper of in a pretty mature fashion when that was announced in mid-April, hardly reacted, and I think there's a realization the market's already priced in a decent growth recovery now and these higher inflation numbers. So actually, I don't think the taper reaction will be as marked and as extreme as the one we saw in 2013, because the markets also realize that if you look at QE and Fed purchases, although it's clearly an important variable, there have been periods since QE was started in 2008 09 when yields have fallen. The yields fell when the Fed wasn't doing QE and similarly yields increased when the Fed was doing a lot of QE, as we've seen the last six months. So for that reason, it's not the dominant variable in driving yields, and I think the market realizes the growth inflation outlook is the key, as it's always been. And we've already priced in a significant V shaped recovery and indeed quite high inflation rates. If you look at break-evens now above two and a half percent in some areas. The break-even curve, incidentally, is a little bit inverted, which suggests the highest inflation break-evens are in the shortest maturities, which suggests that market fears are more about short-term inflation pressures and expect those to ease over time,
Roger: Although these are very unusual times for both the economy and financial markets, it could be that much of the drama for bond yields is actually now behind us.
Robin: It's a good point that in that regard, Roger, as to whether or not we've seen that the bulk of the increase in yields and indeed curve steepening, that's gone with it since the middle of last year, the sort of bear steepening of the curve that we've seen. I think you could make a case to say that fiscal policy and the scale of the Biden stimulus programs are a factor that could lead to a bit more curve steepening in the in the next sort of three, six months. However, when you look at what's already been priced in on growth and inflation, you've still got the issue of those numbers being delivered. And what we know pre-Covid is that the US economy and indeed the global economy was not that strong. And there are forces of secular stagnation still in play. So I find it hard to see how yields can be can re-enter a kind of the old old regime, if you like, the sort of pre-GFC regime that some people are even talking about on the back of these policy stimulus, because that has to deliver stronger growth. And we've seen since the GFC over 10 years of QE on and off from the Fed, and that's never really succeeded in delivering the kind of growth inflation numbers that people seem to be scared of still. So for that reason, the worst of the drama may already have played out in terms of how far yields back up.
Roger: So it's clear that the inflation debate will rage on. The view that inflation remains higher for longer is based on the ongoing fiscal stimulus colliding with supply chains that have so far been unable to adjust meaningfully. The less dramatic view on inflation is that the bottlenecks and base effects will pass and that it will take a long time for jobs to fully recover and put upward pressure on wages. The market fears a taper tantrum, and expects that yield curve control will be implemented by central banks. But it may be that the best of the growth surprises are coming out right now and will have passed us by the second half of this year.