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Eternal Hope & The Barbarous Relic

FRI 18 FEB 2022

One of the extraordinary features of the current inflation/rates episode is that the markets appear to be focused on the end of the tightening cycle before it has even begun. As Cam Crise has noted this week, it’s almost like investors think they have a fast-forward button on their portfolios and can skip ahead to the part where the FOMC starts easing again. Stated differently, eternal hope in the Fed “put” is not dead yet.

As we noted last week, 90% of Fed rate cycles over the past 100 years have ended in recession and that is despite the asymmetry in the policy reaction function since Greenspan. While financial markets are clearly forward looking, the real damage from higher rates tends to occur much later in the cycle when tighter policy flattens/inverts the curve. However, in order take policy to a restrictive level, the funds rate would likely need to increase above 2.25% over the next 12 months. That is approximately consistent with consensus beliefs, but it is still modest in the context of current inflation pressure. Moreover, as we have noted recently, there has not been any material shift in the prevailing bias on terminal/neutral rate or medium term inflation expectations.

Clearly the yield curve is flattening rather fast in the current episode. The 5/30 yield curve is already close to recession levels or not far above outright inversion (chart 1). From our perch, the message from the curve is probably too pessimistic on the stage of the macro cycle. For example, note the strength in US January retail spending. To be fair, some forward looking indicators of final demand such as consumer expectations and the performance of some sectors sensitive to the macro cycle are consistent with the signal from the yield curve. However, odds are that reopening ought to sustain growth momentum in the second half. Although, clearly many pandemic beneficiaries have seen a sharp fall in earnings after the pull-forward of demand during the current cycle.

The other episode that is vexing risk perceptions at the moment is Ukraine and Russia. As we noted earlier in the week (see “Armchair Generals”) we have no edge on how the episode will be resolved. However, what we do know is that similar episodes in history have often contributed to emotional indiscriminate selling (de-leveraging) that can create opportunities to purchase distressed assets. While the potential threat is very serious, the contagion into broader risk assets (European equities and credit) has still been relatively modest. Put another way, the episode has been largely idiosyncratic to Russian related assets. From our perch, the more significant challenge to financial conditions and volatility is still the risk that persistent inflation will force central banks to hike rates and withdraw liquidity faster than markets would like.

A recent beneficiary of the episode in Ukraine has been Gold (the barbarous relic). Spot gold has generally trended down over the past year as consensus beliefs on short-term interest rate expectations and QE shifted last year. Recall, that gold is a negative yielding safe haven currency where the competing asset is the real interest rate. Gold has a negative yield because it has a cost of carry (storage). While the real interest rate has been deeply negative, especially based on actual inflation, real interest rate expectations have started to move higher again which has likely contributed to the pressure on gold (chart 2). On the positive side, once markets pivot back to future Fed easing that would likely be bullish for gold. However, our sense is that expectation is probably premature. As we noted above, investors are probably too pessimistic on macro conditions, the stage of the cycle and rate expectations.

The trend weakness in spot gold has also contributed to the trend under performance (even revulsion) in mining equity. While we are not convinced that the challenging phase for gold miners is over, the sector trades at a 40% discount to global equities and generates material free cash flow. To be fair, gold miners are facing similar cost escalation (wages and fuel) experienced by corporations more broadly. On the positive side, the divergence between spot gold and miners is interesting. The gap is particularly interesting for Australian producers where costs are in local currency and revenue is in US dollars (spot gold has appreciated even more in AUD terms -chart 3).


In conclusion, our sense is that markets are probably too pessimistic on macro conditions and therefore short-term rate expectations beyond 2022. Our sense is that it is too early to consider Fed easing when the tightening cycle has not even begun. It is also our sense that the greater challenge for markets is persistent inflation and rates, rather than geopolitical risk in Ukraine. However, if more rate hikes in 2022 equal less later and the (recession) signal from the yield curve is correct, the gold and miners are an inexpensive diversifier for portfolios.


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