The Adjustment Bureau

From the HRA Journal: Issue 308

Trade wars and geopolitics, along with signs of decelerating economies around the globe, continue to support bullion prices. The new gold bull market is very much official now. Even if we get some near-term pullback-and we should hope for one-I think the die is cast.

Equities have been fairly calm, given all the craziness at a political level. Falling bond yields have cushioned the stock market, though you can see traders-final--starting to ask themselves WHY yields are so weak everywhere. Expect volatility to be high for an extended period.

A few HRA list companies reported good drill results and got some credit for them. We're just seeing companies start to deploy the funds they were only recently able to raise. The back half of the year should feature lots of news and hopefully a new discovery or two.

It will be at least 2-3 months before we see the impact of the broadened China-US trade war on the real economy. In the meantime, expect to get whipsawed often by presidential tweets and news out of Beijing. So, more of the same, basically.

Eric Coffin
August 12, 2019

The Adjustment Bureau

(Note: I started this editorial a few days ago and have had to edit it and update charts several times along the way. Things are moving fast, and the days of low volatility are over, perhaps for an extended period. That's great for gold but do not lose sight that we've entered a dangerous market phase overall. Don't underestimate the potential for a slow-motion crash in the next few months. That risk is increasingly real.)

Sometimes, in this "bad news is good news" market we're living in, it seems like US Federal Reserve meetings end up as poster children for "the law of unintended consequences". The July 31st meeting was a great example.

I noted before the meeting that I expected a 25-basis point cut but was worried we'd see a 50-point cut that might send the "wrong" message. Wrong in the sense it would have traders wondering why the FOMC had decided it needed to use up so much ammo in its first fusillade.

As it turned out, Fed Chair Powell managed to cut by only 25 points and spook the market anyway. President Trump finished the job of scaring Wall St with his own input the next day. Those guys have skills.

Just to keep us resource stock types happy, I'm leading off with an updated gold chart below, as I did last issue. A month of "sideways" kept the gold market from getting overbought even while it managed to maintain strength relative to all currencies including the USD (positive gold/US correlation, bottom-right on the chart).

Gold initially reacted badly to the rate cut, though I was pleased to see it stay above $1400. I think it would have made its way higher even without Trump's tariff announcement the following day. We'll never know, however, as Trump threatened 10% tariffs the next day and freaked out markets far and wide.

Make no mistake, the trade war escalation is a serious issue that could have very negative market consequences. We'll get to that below, but let's start with the Fed decision and its effects.

What upset the markets about the latest Fed rate decision wasn't its size. It looked like traders had largely priced in and expected 25 basis points. Market volatility was average for a "Fed day". Then Powell decided to answer questions.

As soon as he described his 25-basis point cut as a "mid-cycle adjustment" that might, or might not, be followed by more cuts the selling started in earnest. That was not what traders wanted to hear. Wall St expects the Fed to do its bidding and stops bidding when it doesn't.

I think Powell is concerned about using too much ammo right away, and also concerned that cutting 50 points would, ultimately, spook most traders. The last two major rate cutting cycles marked equity market tops, after all. Powell may have been right to be cautious but tossing in the "mid-cycle" quote was a mistake. Ten years into an expansion, you just sound silly using that phrase. And, the way the bond market its reacting, that ship has sailed, and traders just don't believe it.

Traders paying attention were also unhappy to see two dissenting votes on the FOMC. Not only did the Fed cut just 25 basis points, two FOMC members didn't even want to do that. If you're moderately bullish about the US economy, that signal would tell you that the 1%+ in rate cuts by year-end you're hoping for probably isn't going to happen. That's the implication of the "mid-cycle" phrasing-that the rate cut was a minor tweak, not the start of a series of cuts.

That was how things looked immediately post-Fed, but it quickly changed. The day after the Fed meeting, President Trump announced he would levy 10% tariffs on the $300 billion in Chinese imports not currently subject to them on September 1 if he wasn't seeing a trade deal taking shape.

Markets were not happy about that tweet storm. The 10-year yield chart above shows you the impact of the tariff tweets and China's "response" to it.

Rates didn't move much on the Fed rate cut announcement, indicating the FOMC had read the market right and the move was priced in. Rates moved down, a lot, after Trump's tariff tweet as traders sold equities and bought safe havens, like US Treasuries-and gold. Hard.

The move accelerated after China responded by leaking the story that Chinese government departments had been ordered to stop buying US agricultural products.

More alarming still was that China fixed the exchange rate for the offshore Yuan below 7 to 1$US for the first time in several years. Predictably, Trump freaked out after this move and the US Commerce department swiftly labeled China as a "currency manipulator".

A rapid escalation in trade tensions has traders on edge, as can plainly be seen in the 10-year yield chart. That move down to 1.6%, amazing in itself, is not a reaction to the Fed Rate cut. Its traders seeking safe haven, just as the recent move in gold is. The last time the 10-year yield was at 1.6% it was bottoming out in 2016 as the Fed was starting its rate hike cycle. Last week, it was at that level with Fed Funds Rate at 2.00-2.25%. That's a complete reversal. Part of the broader yield curve inversion we've been seeing since earlier this year. This isn't a reaction to rate cuts, it's the bond market saying there is bad stuff on the way. The bond market is pushing the Fed, not the other way around.

The escalation of the China-US trade war, piled on top of an already decelerating world economy, makes for a dangerous paradigm. Traders calmed in the last few sessions as the Chinese Yuan stabilized around the 7CNY/1USD level. Hopefully, that holds as it doesn't seem many traders can handle much more stress.

China had plenty of issues before the trade war started, with huge debt loads and capital flight causing headaches. The real irony is that, if China was manipulating its currency earlier this year-and it seemed it was-it was doing precisely the opposite of what Trump and his advisors think. There is pretty good evidence the Bank of China was a large-scale buyer, not seller, in the Yuan market earlier in the year. They didn't want to anger the US but were more concerned about capital flight.

Beijing has been trying to stop the outflow for a couple of years (ask any Vancouver real estate agent) with only partial success. A falling Yuan just makes the situation worse for them. A cheaper currency helps the trade situation some but Beijing is more worried about investors selling its bonds and shadow banks not being able to recapitalize.

And Hong Kong. Beijing is more worried about Hong Kong and how markets will react to a harsh crackdown that seems all but inevitable now. I'm cheering for the protesters and concerned for family members there but no realist expects the situation in Hong Kong to end well or at least without a severe crackdown.

I don't know how the end game there will affect Hong Kong's position as an important gateway for investment into China. But its hard to see it ending well. I think markets (outside of Asia) are still ignoring it but the impact could be large. Hong Kong is one of the world's premier financial centres and a lot of money flows through it.

My point is that Beijing has plenty to distract it. And if comments from Chinese media with known connections to the Party are anything to go by, Trumps latest gambit backfired badly.

China's leaders aren't cowed, they're angry. The chart above shows the trade war, among other things, is having an impact. The growth rate in US imports from China started falling at the start of 2018. The growth rate turned negative and imports from China have been shrinking since the start of this year.

For Washington, that means they're "winning" but it also means the US is becoming less important to China's export sector. It's still huge, but if Beijing thinks the damage is done it will be that much less likely to compromise. I don't think the trade war will end soon and I think its impact will grow over time.

We're already seeing regional impacts, with SE Asian central banks cutting rates, along with New Zealand, Australia and India. And ongoing trade frictions, among other things, has led to a deceleration in Germany, particularly in the manufacturing sector. It's leading a slowdown across the Eurozone that has the ECB talking about new stimulus starting as early as next month.

That brings me to the current version of the US yield curve, which I've highlighted before. It appears b. You won't be surprised by the latest shift, given 10-year yield chart shown earlier.

The US yield curve is now fully inverted from spot out to beyond 10 years. If you accept inverted yield curves-whatever the reason for it- are an historically accurate recession predictor, which I do, this isn't a good development.

Not much of this risk is reflected in US equities yet, though I think it's fair to say that it's starting to be. Lots of traders expect the bond market, and President Trump, to force the Fed's hand. The shape of the yield curve makes it clear the bond market expects at least a couple more rate cuts this year. The stock market is taking solace from that.

Even so, there is some heightened risk aversion. Not very long ago, a 50 point down move in the 10-year yield would have been considered "bullish" news. Probably enough to lift the SPX all by itself. Not this time. Trade worries and an increasing sense that maybe the bond market is telling us something has kept the S&P below the level it reached right before the Fed meeting. It's not much of a pullback, all things considered, but I do sense increasing levels of unease.

The bond market is looking at trouble overseas, but also at a different sort of "adjustment", later revisions to major economic indicators. The two charts below show a recent history of revision to US GDP readings and non-farm payroll readings, respectively.

Many traders ignore these and focus on the initial headline numbers, which are often inaccurate. Payrolls and GDP readings are a lagging indicator, so why would we care about revisions?

Revisions are far from perfect as an indicator, and they don't give great timing signals, admittedly. What they do give is a good indication of where the economy is in its growth/recession cycle. Based on recent revisions to both GDP growth and payrolls, both negative and getting more negative each reading, we're getting very close to the end of the growth cycle.

We've already seen corporate investment give way with all the trade uncertainty. The consumer is the main source of strength in the US economy. But consumers depend heavily on perceived strength of the job markets and stock markets for confidence. So far, there's been nothing to worry about. We should stay vigilant though. Even though jobs and consumer confidence are lagging indicators, they can still give us clues about future spending. It's the consumer that's keeping growth positive in the US, and several other regions. If they falter, we've got trouble.

Where does that leave us? For the gold market at least, in great shape. Many people, me included, have called for the end of the bull market in bonds. There is still no sign of it, even with over $16 trillion in sovereign debt carrying negative yields. All the moves in rates lately have been to the downside, with little sign of a bottom.

I really find this mind-boggling. Yields so low, everywhere, combined with a lot of bond issuance by numerous governments, speaks to massive demand for bonds. You just can't get yield curves across the developed nations like we have now without a lot of buying.

That, in turn, speaks to increased risk aversion, and probably deflationary fears as well. No one (who isn't crazy) buys a negative coupon bond unless they expect some form of outright deflation. Somebody, a lot of somebodies in fact, expect something bad to happen, and fairly soon.

I hope they're wrong. I've been relieved to see the US Dollar stable, even though US rates are "relatively" high. I'm not worried about it diving. I'm worried about it running higher and magnifying all the imbalances that already exist across credit and currency markets. For that reason alone, it would be good to see the Fed cut rates further, even if I don't like the underlying message that might send.

All those negative rates are good news for gold at least. The 10-year chart of gold in a bunch of major currencies show it hitting all-time highs in several of them already, and most of the rest won't be far behind. Gold has also hit all-time highs in a couple score minor currencies.

US real interest rates are still positive, but not by much. And it's one of the few economies where that is still the case. If the bond market gets its way, they will go negative in the US too. A worldwide negative real rate environment is THE best possible scenario for the gold price. It's run hard and may consolidate a bit now. That would be healthy. But, medium term, I think gold is going higher. If even US rates go negative on a real basis, it's going a lot higher. The gold sector's day in the sun has arrived.

I wish I was as positive about base metals and other commodities, but my own recession concerns, and the way they are trading, doesn't look positive. A negative real rate environment should be good for all commodities, but most are trading terribly. Traders are reacting to slowing economic readings, and fears for China especially. I hope I'm wrong about that too, but I can't see much good news in the base metal or bulk material space. I'm assuming many of them will go lower before they go higher.

We're in a new gold/silver bull market. Let's not fight the tape. Be vigilant about problems on the big boards but stay positioned for profit in our corner of the market.

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