Why It’s Time to Trade in Irrational Exuberance for Gold

We currently view long gold and miners as perhaps the strongest near term trade(s) if you believe the “Trump trade” is unwinding for the time being.

The American Health Care Act is dead in the water and it is very murky water indeed. Is volatility going to rebound? Is tax reform going to have a tough go at crossing the finishing line before the August Congressional recess? How about infrastructure spending to “rebuild America?”

Quick question: are massive deficits cool again? Or, is there a secret plan to make a trillion dollars of waste, fraud, and abuse disappear without anybody noticing in order to fund Reagan-esque tax cuts and new infrastructure? Probably neither.

It seems increasingly unlikely that after the AHCA deficit reduction savings were buried at least three feet under ground (though maybe not quite six) on Friday evening, that we now pivot to rapid enactment of $54 billion more in military pork, corporate tax cuts, deregulation, and a heap of new infrastructure investment.

Where exactly is this money coming from? House Speaker Ryan’s Border Adjusted Tax (BAT) could cover only half of the proposed deficit increases–and that is in an ideal world. Since the BAT is looking as likely to pass as AHCA, given ardent internal opposition from more than one key Republican bloc as well as the entire retail corporate sector, it would then appear to be trending toward offsetting none of the proposed deficit increases at all.

The numbers simply don’t add up for quick passage of the Trump growth agenda. Failure to pass AHCA makes the deficit math even more difficult. My base case is a delayed, scaled down version of the Trump agenda. As is typically the case, politicians love making heroic hatchet swings to the federal budget when it counts the least or when someone else is in charge. The Republicans were handed a beautiful, shiny hatchet glorious enough to make Paul Bunyan blush. The first thing they did with it was point it at immigrants and then drop it on their own foot.

Until such a time when the Trump agenda finds its second wind, it is best to trade-in the irrational exuberance for investment grade precious metals, primarily gold. When I highlighted a tradable top in bond yields on a risk/reward basis, there was plenty of low hanging fruit to be picked by buying Treasuries and closing dollar longs. The risk/reward is now more favorable for buying gold as bond yields fall, dollar declines are steepening, and oil can’t catch a bid, which means inflation expectations and growth won’t be screaming for faster Fed hikes for the time being.

The Fed was previously behind the curve as it allowed inflation to spike from low levels without wages doing the same, which as I’ve pointed out is what happens in an aging demographics world where consumer price inflation is never good for this type of economy. It only reduces real growth and wages, harming future growth. Now we have the aftermath of reduced real wages, political dysfunction, a deteriorating outlook for deficit reduction, and accelerating shale energy production into falling oil prices. Gold will shine brightly in this theme. Maybe very brightly.

The Oil Chart Changing Minds

Pinning down accurate energy production numbers has historically proven to be more challenging than gauging the trend of energy inventories.

In the past couple of weeks, there were several miscommunications about whether and why Saudi Arabia oil production moved back above 10 million barrels per day in February. Although the Saudis are still bearing the brunt of production cuts from the OPEC deal, they seem to be sending a message that they won’t do it alone.

The reason given by officials for why the slight Saudi production increase in February was supposedly not significant was that it went into domestic storage rather than immediately dumped on the international market for sale. This is clearly an underwhelming response lacking in legitimacy. Production is production. Just because it isn’t sold immediately doesn’t mean it escapes the laws of supply and demand on a longer term basis. Markets are all too aware of that when it comes to pricing a commodity such as crude oil.

Although combined production cuts resulting from the OPEC deal are said to be greater than combined production increases from the US and others, meaning inventories should be moving into balance, global inventories keep rising–particularly in the US. Something isn’t adding up. Until we have a better explanation for why inventories are not moving toward balance as expected and why that will change, oil will trade heavy. The initial OPEC-inspired bump is over and selling crude rallies right now has a more favorable outlook than buying dips.

us oil inventories 031617

Top 3 Takeaways From March FOMC Meeting

1.) Dovish hike of 25bp – As expected, the FOMC hiked the benchmark target rate by 25 bps to a range of 3/4 percent to 1 percent. The hike was paired with cautious and dovish commentary by Fed Chair Yellen, as she is known to do. The balance of risks is neutral. There was no “reassessment” in the economic outlook but things are progressing in line with the Committee’s expectations for meeting the dual mandate soon. I actually believe the mandate was effectively achieved last year if measured more realistically. There were no notable hawkish surprises. Gold roared higher, bond yields were clobbered, the dollar was slammed, equities surged–with each asset class moving by more than 1% on the day (for a change).

2.) Is the Fed all of a sudden paying attention to asset bubbles again? – The dovish Fed Chair did reiterate during the question and answer session that higher financial asset prices, particularly equities, impact the Fed’s monetary policy expectations. This is a soft admission to keeping an eye on the asset bubbles the Fed’s policies have likely already inflated. In other words, further stock melt ups similar to those experienced in the past few months could cause the pace of tightening to increase in order to put a lid on even larger asset bubbles. One could be forgiven for being skeptical of this materializing given the Fed’s recent history of ignoring asset bubbles until it is too late. But this suggests it is perhaps on the radar more than it has been. Beware of single direction stock moves northward precipitating increased expectations for tightening, thus muting the magnitude of said moves.

3.) 10y Treasury Note had a blow torch lit underneath the bid –  The 10y yield plummeted below 2.5% from above 2.62%. Per my post yesterday, long TLT and BLV cranked out impressive reversals higher from the recent base lows. The move happened so rapidly that I’m keen on taking profit and reassessing. This is a short term bull move in bond prices within what I view to be a longer term bond bear market on tap.

10y plummet 031417

Change in Oil Market Outlook to Relieve Pressure on Fed Rate Hike Pace

Energy trader positioning has been heavily long oil and that trade seems to be unwinding. I am guilty of not weighing enough importance on market positioning in initiating a $60 WTI price target back in December. While initially thrusting higher per expectations on satisfactory OPEC compliance during the first two months of 2017, there were not enough new buyers in the market to push WTI to the full $60 target before the fundamental theme deteriorated somewhat.

Record US crude inventories, as well as increased production in countries excluded from the OPEC deals, such as Iran and Libya, nearly filled the 1.2MM  bpd supply gap left by those who participated in the deal. While the core theme of Saudi Arabia doing whatever it takes to avoid another oil market crash still stands, upside is now more limited. The new WTI range is likely to be $43-51 per barrel, with an outside chance of reaching the downside technical support level just below $40. I now have a 2017 Q2 price target of $46 WTI.

A moderated crude oil outlook has implications for the Fed’s monetary policy as it will allow inflation to plateau without the wheels coming off from a continued interest rate spike. Global central banks are being partially saved by shale oil producers in rural America. I expect a 25 bp hike tomorrow with no more than 1 or 2 more hikes this year. I also see the Fed beginning to reduce the size of its balance sheet in Q4, which along side energy price moderation, could even take a third hike for the year off the table.

The secular bond bull market may be behind us, but bond prices have fallen too far, too fast. Expect a short to medium term pause in bonds, especially if the 10y Treasury reaches 2.75% in the near term. A non-consensus, cautious long position in TLT or BLV is much more attractive now than it has been in months, but this is not a long term call by any means.

Finally, I expect some near term moderation in USD gains to turn into a mild pullback in the greenback after the Fed likely hikes the target rate tomorrow. The risk/reward for fresh long dollar positions is poor against nearly any cross, particularly NZD, JPY, and EUR. Wait for a more favorable dealing rate if you are chomping at the bit to get long USD.

Euro Set to Rise on Reversal of Deeply Negative Bond Yields

Real interest rates are deeply negative in much of the Eurozone due to the combination of interest rate repression by the ECB’s bond buying program plus above-target inflation.

Take a look at the real 10y German bund yield below.

bund - cpi feb 2017

As I have pointed out, the further behind the curve a central bank gets, the harsher the snap back toward normalization is once the process to normalize is anticipated by market participants. No central bank is further behind the curve right now than the ECB.

Investors are pricing in two or three 25 basis point Fed rate hikes this year. No such expectations exist in the Eurozone due to Mario Draghi’s persistent, stubborn denials of even discussing normalization with the Governing Council—yet. We may be at a turning point in market expectations for the euro as the severity of political risk subsides.

The 2yr yield spread divergence in US-German government debt is at extreme levels of 221 basis points. You could cruise a row of mega tanker ocean liners through that spread. This suggests a higher EUR/USD if and when the spread narrows to historically normal levels, but most likely long before then. The 10y Bund real interest rate yield is so deeply negative during a period of increasing economic activity and inflation that probabilities suggest a brisk reversal higher in yields the moment markets start pricing in a post-QE Europe.

The exact timing of when the yield spread will close is not as critical as knowing what will happen when it does. Once the sea tide resides back from the beach, it will be apparent holders of European government debt were swimming without bathing suits. They will likely be standing along side short sellers of the euro who will also be… exposed.

In summary, now is probably as good of a time as any to make sure you aren’t holding long European bonds that look and sound an awful lot like time bombs. The same could be said for short euro positions. Long EUR/USD and EUR/GBP entries on political fear-based dips will provide favorable asymmetric risk/reward opportunities.

Squeeze on Real Incomes Are a Headwind for the Pound

Pound sterling seemingly can’t get up off the floor after its EU referendum-inspired knock out and it’s about to get kicked while it’s down. Real wages are falling across the UK. Q3/Q4 2016 surprised many analysts with a stubborn resilience in UK economic output and consumer confidence. This period was likely due to a false surge of front-loaded consumer purchases in anticipation of price hikes on goods and services that won’t be matched by wages. Going forward, household spending will be strained by the squeeze on real incomes that had already begun in the UK before the referendum. Just when the exports sector is needed to plug the gap left from crimped consumer spending, political challenges will limit the scope of future trade deal negotiations. Negotiation uncertainty will plague the pound at least throughout 2017 and much of 2018.

Short GBP/USD positions are attractive as the Fed hiking cycle is in its infancy and UK data will disappoint on a relative basis. The strongest short GBP play will be against JPY if political risk-aversion sets in over the US failing to enact the Trump Administration’s highly anticipated pro-growth policies to the full extent hoped. It is becoming increasingly apparent the growth policies promised can not be enacted without blowing a truck-sized hole through the US budget or offsetting them with vicious negative side effects (as the BAT would). GBP/JPY is currently the FX pair most likely to sustain trauma when investors flee risk assets.

Take a look at the “unaffordability index” for private rents in London below. The gap between incomes and the rents index is reaching new highs while consumer prices are set to leap in price as well. Something has to give, and it will be reflected in an even weaker GBP.

london rents 030717