Ferguson’s Law states that any great power that spends more on debt service (interest payments on the national debt) than on defense will not stay great for very long. True of Hapsburg Spain, true of ancien régime France, true of the Ottoman Empire, true of the British Empire, this law is about to be put to the test by the US beginning this very year, when (according to the CBO) net interest outlays will be 3.1% of GDP, defense spending 3.0%.
Niall Ferguson: China, Russia, Iran axis is bad news for Trump and GOP isolationists – Bloomberg, 4/21/24
End of Dollar dominance | Michael Pettis
Because a world in which the US dollar and the US economy continues to play its current roles in accommodating deep structural imbalances is unsustainable, a major shift is inevitable and we can’t simply call on Washington to prevent any change.
The issue should be whether Washington directs this shift unilaterally, directs it in concert with major allies, or waits until unsustainable pressures force a much more disruptive adjustment.
It’s not whether things will change but how they change.
Gold, Crude, Copper and the Elephant
Gold, crude and copper is where the action is, while stocks and Treasuries take a back seat for the present.
Markets are signalling a reluctance to take on risk, while long-term Treasury yields threaten to trend higher.
We also revisit rising Treasury debt — the elephant in the room — and examine the CBO’s budget projections in more detail.
Crude Oil
Brent crude respected resistance at $84 per barrel, signaling a decline to below $80.
Nymex light crude breach of support at $78 per barrel would confirm the reversal. A decline in crude oil is likely and would ease inflationary pressures, with the expected fall in long-term yields bullish for stocks, bonds and precious metals.
Crude oil production remains steady at a massive 13.1 million barrels per day according to the EIA report for the week to May 3.
Inventories (including SPR) recovered to above 1.6 trillion barrels, while market concerns eased over Iran-Israel tensions.
Copper
Copper is testing short-term resistance at $10K per metric ton. Breakout is likely and would test major resistance (green) at $10.5K.
The rise, however, is caused by a production halt at Cobre Panama. Production could be resumed if the mine-owner First Quantum can reach agreement with the new president-elect Jose Raul Mulino. From Reuters:
Mulino, a 64-year-old former security minister, won Panama’s election on Sunday [May 5] with 34% of the vote and said his government would be pro-investment and pro-business, adding that the Central American country would honor its debts, while he vowed to not forget the poor. He won with the help of popular former President Ricardo Martinelli who was barred from running due to a money laundering conviction. Mulino, who served as security minister during Martinelli’s administration from 2009 to 2014, had been Martinelli’s vice presidential candidate and took his place.
Gold & the Dollar
The Dollar Index continues to test support at 105. Respect remains likely, with Trend Index troughs above zero signaling buying pressure, unless Janet Yellen at Treasury intervenes to weaken the Dollar in support of the UST market.
Gold broke resistance at $2350 per ounce, signaling another advance. But first expect retracement to test the new support level. Respect would confirm a target of $2500 per ounce.
Shanghai Gold Exchange domestic contract Au99.99 is trading at 553 RMB/gram, equivalent to a USD price of $2380 per ounce at the current USDCNY exchange rate of 7.2268.
Stocks
The S&P closed above 5200 on Friday but a doji candlestick and lower Trend Index peaks indicate a lack of enthusiasm from buyers.
The Russell 2000 small caps ETF (IWM) reflects the lack of broad market support for the rally, with Trend Index peaks below zero warning of selling pressure. Another test of support at 200 is likely.
Financial Markets
Ten-year Treasury yields continue to test the band of support between 4.4% and 4.5%. Recovery above 4.5% would signal another test of 4.7%.
Bitcoin is testing support at $61K. Follow-trough below say $60K would confirm the decline — initially signaled by breach of support at $64K — and warn that financial markets are moving to a risk-off position.
Commercial bank reserve balances at the Fed, however, grew by $78 billion in the week to May 8, indicating that financial market liquidity is improving.
Consumers
Consumer sentiment retreated to 67.4 in the University of Michigan survey for May 2024, but the up-trend continues.
Five-year inflation expectations jumped to 3.1% but the three-month moving average, ranging between 2.9% and 3.0%, signals little change in the long-term outlook.
The Elephant in the Room
Last week we published a note suggesting that investors were distracted by short-term noise and ignoring the elephant in the room — the precarious level of US federal debt. The bipartisan Congressional Budget Office (CBO) projects that Treasury debt will grow to a clearly unsustainable 172% of GDP by 2034.
The US fiscal deficit is projected to grow from $1.6 trillion in 2024 to $2.6 trillion by 2034. Remember: all projections are wrong, but some are useful.
Often the most useful part of a projection is the underlying assumptions.
Real GDP growth below is a modest 1.5% in 2024, reaching 2.2% by 2026 — nothing controversial there. But the inflation projection is Pollyannaish, assuming a steady CPI decline from 3.2% in 2023 to 2.2% by 2034 — totally unrealistic if the budget deficit is to remain at close to 6.0% of GDP.
Assumed inflation (above) also impacts on projected nominal interest rates, with the projected fed funds rate declining to 2.9% by 2027 and 10-year Treasury yields to a low 3.8%. Every 1.0% overshoot in inflation would be likely to cause a similar increase in both long- and short-term interest rates.
The budget projection below is equally unrealistic. Defense spending, the CBO would have us believe, declines to 2.5% of GDP by 2034. Given rising geopolitical tensions with Russia-China-Iran, defense spending is likely to exceed the long-term average of 4.2%.
Net interest is budgeted to grow from 2.4% of GDP to 3.9% of GDP by 2034 but is based on unrealistic interest rate projections.
Treasury debt is likely to grow a lot faster than projections — because of the likely understatement of both defense spending and interest costs. That means that debt held by the “public” will have to grow a lot higher than the $48.3 trillion projected by 2034. If real interest rates are too low, any shortfall in take up by the public will have to be absorbed directly or indirectly by the Fed.
Conclusion
Rising inventory and easing Middle East tensions have weakened crude oil prices. A long-term decline in crude would be likely to relieve inflationary pressures and allow the Fed to cut interest rates.
Copper is rising steeply due to supply shortages, but prices could fall just as rapidly if the Cobre Panama mine is reopened by the new president-elect.
Gold broke resistance at $2350 per ounce, signaling another advance. Retracement that confirms the new support level at $2350 would offer a target of $2500.
Long-term Treasury yields are testing support. Respect of support is likely and would confirm the recent up-trend.
Perceptions of market risk are rising, with Bitcoin testing support at $61K and the Russell 2000 small caps ETF (IWM) warning of selling pressure.
Financial market liquidity, however, recovered slightly in the last week.
Consumer sentiment continues to trend higher, while long-term inflation expectations remain steady at close to 3.0%.
The elephant in the room remains Treasury debt, with CBO projections understating likely deficits due to unrealistic assumptions for inflation, interest rates and defense spending. Debt issuance by Treasury is expected to exceed demand from foreign investors and the general public, leaving the shortfall to be absorbed by the Fed or commercial banks.
The result is likely to be higher long-term inflation, boosting real asset prices while eroding the value of financial assets.
We are long-term bullish on Gold, Defensive stocks, the Heavy Electrical sector, and Critical Materials (Lithium and Copper). The last two stand to benefit from the energy transition. We are also overweight short-term financial assets with duration of 2 years or less: Mortgages, Term Deposits and Money Market Funds.
We remain underweight Growth stocks — which we consider overpriced — and long-duration financial assets.
Acknowledgements
- EIA: Petroleum & Crude Inventory
- EIA: Weekly U.S. Field Production of Crude Oil
- University of Michigan: Surveys of Consumers
- CBO: The Budget and Economic Outlook, 2024 to 2034
- Shanghai Gold Exchange: Delayed Quotes
- CoinDesk: Bitcoin Prices
- Reuters: Exclusive-Panama’s president-elect vows to help fix canal water problems, build major train line
- Adam Taggart’s Thoughtful Money: Interview with Michael Pento
The elephant in the room
A weak seasonally-adjusted increase of 175K in non-farm payrolls had a surprisingly bullish effect on stocks. The increased prospect of rate cuts from the Fed excited investors. The opposite of what one would expect from a sign that the economy is slowing.
Markets are focused on the immediate impact of shifts in data and policy but ignoring the elephant in the room — the long term consequences of current monetary and fiscal policy.
Labor market
Job growth slowed to 175K jobs in April, the lowest since October 2023.
Average hourly earnings growth remained low at 0.20% in April (2.4% annualized), signaling that inflationary pressures are easing.
The unemployment rate is still low at 3.9%. The Sahm Recession Indicator is at 0.37. Devised by former Fed economist Claudia Sahm, the indicator signals the start of a recession when the red line below rise to 0.50%.
The Sahm Rule signals the start of a recession when the three-month moving average of the national unemployment rate (U3) rises by 0.50 percentage points or more relative to the minimum of the three-month averages from the previous 12 months.
The rule has proved a reliable recession indicator in the past but we need to remember that: (a) it is not a leading indicator and normally only crosses above 0.5% after the start of a recession; and (b) this is a far from normal labor market.
Non-residential construction jobs are way above previous highs as the industry benefits from fiscal spending on infrastructure and the drive to on-shore key industries such as semiconductors.
Average hourly earnings growth (green below) slowed to 4.0% for the 12 months to April (for production and non-supervisory employees) indicating that inflationary pressures are easing. In the past, average hourly earnings growth above the unemployment rate (blue) has caused high inflation as in the 1970s (red circle).
Economic Activity
Aggregate weekly hours worked are growing at an annual rate of 1.8%. This is below the rate of real GDP growth, suggesting either that (a) productivity gains from AI and other new technologies are having an effect; or (b) real GDP growth is likely to slow.
The GDPNow model from the Atlanta Fed forecasts an optimistic 3.3% annualized real growth rate in Q2.
But the Lewis-Mertens-Stock Weekly Economic Index is far more cautious at an annualized rate of 1.7% for Q2 (so far).
ISM Services PMI declined to 49.4% for April, indicating a contraction in the large services sector. Earlier, the ISM Manufacturing PMI was slightly weaker, at 49.2%.
The Services New Orders sub-index remains above zero, suggesting some improvement ahead.
The Employment sub-index, however, shows a sharp contraction, falling to 45.9%. The services sector is the major employer in the economy and the negative outlook warns that overall jobs growth could slow rapidly.
The Prices sub-index, on the other hand, warns of persistent inflation, rebounding to a strong 59.2%.
Financial Markets
Bitcoin rallied strongly to again test resistance at $64K. Respect of resistance, signaled by a fall below $61K, would confirm the down-trend and warn of contracting liquidity in financial markets.
The Chicago Fed Financial Conditions Index recovered slightly to -0.47, also warning that easy monetary conditions are receding.
Ten-year Treasury yields declined on news of the weak labor report, testing support at 4.5%. Breach would indicate a decline to 4.2%.
The S&P 500 jumped above resistance at 5100, suggesting another test of resistance at 5250. But we first expect retracement to test support.
Gold & the Dollar
The Dollar weakened in line with falling Treasury yields, with the Dollar Index testing support at 105. Breach would signal a correction, with follow-through below 104 signaling end of the up-trend.
Gold continues to test support at $2300 per ounce. If support holds, with recovery above $2350, the shallow correction would be a bull signal, suggesting another strong advance. Otherwise, a test of $2200 is likely.
Crude Oil
Brent crude broke support at $84 per barrel as tensions in the Middle East ease. Follow-through below support at $82 would warn that the up-trend has weakened and is likely to reverse.
Conclusion
Financial markets, like Pavlov’s dog, are conditioned to react bullishly to rate cuts. Long-term Treasury yields declined and stocks jumped in response to a weak labor report. However, weak jobs growth is not a bull signal, suggesting that the economy is likely to slow. This is borne out by a weak ISM Services PMI for April, warning of a contraction.
The unemployment rate remains low but average hourly earnings growth is declining, indicating that inflationary pressures are easing. ISM Prices sub indices for both Manufacturing and Services, however, warn of strong producer price pressures.
Brent crude broke its rising trendline and follow-through below the next support level at $82 per barrel would warn of reversal to test primary support at $75. Declining energy prices would help to ease inflationary pressures.
The Fed is likely to hold off cutting rates until the outlook for inflation is clearer.
Gold could weaken to $2200 per ounce in the short- to medium-term — if it can break stubborn support at $2300. But we remain long-term bullish on Gold. The elephant in the room is Government debt which is growing at a rate of more than $1 trillion a year, with little prospect of a bipartisan agreement in Congress to address the shortfall. The chart below shows the bipartisan CBO’s projection of federal debt as a percentage of GDP from 2024 to 2054.
The only practical way to solve this is to increase GDP at a faster rate than the debt, through inflation. That would erode the real value of the debt but is likely to send Gold and other real assets soaring.
Acknowledgements
- Institute for Supply Management: Services PMI
- CoinDesk: Bitcoin Prices
- Congressional Budget Office: Budget and Economic Outlook – 2024 to 2034
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Markets move to Risk-Off
Bitcoin broke support at $64K, warning that financial markets are moving to risk-off . Traders and investors reduce their exposure to risk and focus on protecting their capital. Follow-through below $62K would confirm, warning of a sharp fall (in BTC) and a stock market correction.
The 10-Year Treasury yield has climbed to 4.67%, confirming our target of 5.0%.
The Japanese Yen fell to 154 against the Dollar, increasing pressure on the Bank of Japan to loosen the cap on long-term JGB yields — to protect the Yen. The result of such a move would be an outflow of Japanese investors from the US Treasury market, increasing upward pressure on UST yields and downward pressure on the Dollar.
Fed Monetary Policy
From CNN:
The US economy’s enduring strength and a “lack of progress” on inflation means the central bank likely won’t cut interest rates at its upcoming policy meeting just two weeks away, Federal Reserve Chair Jerome Powell said Tuesday.
“The recent data have clearly not given us greater confidence” that inflation is headed toward the central bank’s 2% goal, Powell said during a moderated discussion hosted by the Wilson Center. Instead, he said, there are indications “that it is likely to take longer than expected to achieve that confidence.”
Stocks
The S&P 500 broke support at 5100, warning of a correction. Lower Trend Index peaks reflect selling pressure. Our target is 4950.
The Equal-Weighted Index ($IQX) continued its downward path after breaking support at 6650, presenting a target of 6250.
US Consumers
Real retail sales ticked up in March to remain on trend.
Light vehicle sales also remain reasonably strong, at 15.5 million units (annualized) in March.
Gold & the Dollar
The Dollar Index climbed above 106, strengthened by safe haven demand and the appeal of higher long-term yields. Our target is the October 2023 high at 107.
Gold is again testing resistance at our target of $2400 per ounce, currently at $2383. The Shanghai Gold Exchange continues to display a premium on its international gold contract (iAu99.99) at 558.3 Yuan which translates to $2399 per Troy ounce (31.10348 grams). The domestic contract trades at an even higher price of 569 per gram but is subject to capital controls. The price premium should ensure a constant inflow of physical gold from other exchanges to China for as long it is maintained.
Silver retraced from resistance at $29 per ounce and is testing support at $28. The lower Trend Index peak warns of selling pressure. Breach of $28 would warn of a correction to $26. Breakout above $29 is less likely in the short-term but would signal a fresh advance, with a medium-term target of $34.
Crude & Commodities
Brent crude is in a narrow consolidation (pennant) at $90 per barrel. Continuation is likely and would test resistance at $96 per barrel.
Nymex crude has retraced to test short-term support at $85 per barrel. Respect is likely and would indicate an advance to our target at $90.
Conclusion
Geopolitical risk dominates, with an Israeli retaliatory attack on Iran expected before the end of the month.
Rising crude oil prices are likely to increase inflationary pressure and the yield on long-term Treasuries, with the 10-year yield expected to test 5.0%.
Safe haven demand from investors is concentrated on Gold, with bond prices falling and stocks warning of a correction. We expect a short retracement to test support levels but respect is likely and would signal another advance.
Bitcoin is diverging from Gold as investors grow more risk averse. Breach of support at $62K would confirm a correction, with support expected at $52K.
Acknowledgements
- Federal Reserve Bank of St. Louis: Advance Real Retail and Food Services Sales
- Shanghai Gold Exchange: Delayed Quotes
- CoinDesk: Bitcoin Prices
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Iran attacks Israel
Markets are overshadowed by news that Iran directly attacked Israel in retaliation for the bombing of its embassy in Damascus which killed two high-ranking Iranian generals.
This is a significant escalation in Iran’s on-going proxy war against Israel.
Russia and its allies are emboldened by the US failure to support Ukraine and are stepping up their attacks on Western allies.
Mick Ryan (retired Australian Maj. General) writes:
…What is Iran’s ultimate goal here and its strategy to achieve it? This is a major shift in the way the Iranians have attacked Israel for years. Proxy forces are normally Iran’s preference in order to keep it at arm’s length from a potential Israeli response. Why has it decided on such a drastic course change in its strategy to confront Israel?
He lays out four options for retaliation — ranging from no direct response to a massive hammer blow to deter a repeat — and concludes:
All of these are possible in the hours and days ahead. All have advantages, as well as considerable disadvantages, for the Israelis. But one thing is certain, the concept of ‘re-establishing deterrence’ against Iran will be an important guiding idea.
And, it is uncertain whether the Iranians are really prepared for what they may have unleashed against their country and the wider region.
Flight to Safety
Given the high level of uncertainty, we can expect a significant flight to safe haven assets. Stocks are expected to weaken, with the S&P 500 breaching support at 5100 to signal a secondary correction.
The S&P 500 Equal-Weighted Index ($IQX) has already warned of a market move to risk-off after breaching support at 6650. A test of support at 6400 is likely.
The Russelll 2000 Small Caps ETF (IWM) has similarly breached support at 200, warning of a correction to 190.
Brent crude is expected to test resistance at $96 per barrel.
10-Year Treasury yields are already retracing and headed for a test of new support at 4.35%. Respect is likely, however, and would confirm an advance to test resistance at 5.0%.
The Dollar Index may not follow 10-year Treasury yields, with safe haven demand fueling a test of 107.
Gold saw significant profit-taking on Friday after reaching our target of $2400 per ounce earlier in the day. Retracement is likely to respect support at $2300, followed by a strong advance fueled by safe-haven demand.
The international contract on the Shanghai Gold Exchange (iAu99.99) is trading at 562 Yuan/gram. This equates to a USD price of $2415 per troy ounce — a sizable premium over Friday’s close at $2344.
Silver has retraced to test support at $28 per ounce. Respect is likely, signaling a test of resistance at $29 per ounce. Breakout above $29 would offer a long-term target of $36 per ounce.
Bitcoin is consolidating below resistance at $72K. Breakout is likely and would offer a target of $92K, while reversal below support at $64K would warn of a correction to test $52K.
Conclusion
Escalation in the Iran-Israel conflict is likely to drive crude oil prices to new highs as geopolitical risk rises. Inflationary pressures are expected to climb as a result, reducing the possibility of Fed rate cuts this year.
Other geopolitical factors could intervene, including the Saudis increasing production to hold crude oil prices below $100 per barrel. Above $100 is considered unsustainable by many producers and believed to lead to sharp falls in demand as the global economy contracts in response.
Financial markets, stocks and precious metals are likely to be dominated by safe-haven demand in the weeks ahead. A shift from small caps — and even the broad S&P 500 to the largest “magnificent seven” tech stocks — is expected as investors grow increasingly risk averse. Demand for Gold & Silver is expected to rise. The Dollar is likely to strengthen, along with short-/medium-term Treasuries. But long-term yields are unclear because of conflicting inflation/safe-haven pressures.
Acknowledgements
- Mick Ryan: Futura Doctrina – Iran Attacks Israel
- CoinDesk: Bitcoin Prices
Rising Crude and Gold warn of inflation
Brent crude continued its advance, closing at almost $89 per barrel on Tuesday. Our target is $94 per barrel would increase inflationary pressure in the months ahead and possibly delay Fed rate cuts.
Rising crude oil prices have forced cancellation of plans to restock the strategic petroleum reserve (Bloomberg). US crude and petroleum inventory (including SPR) is testing the lows from January 2023.
Treasury Market
10-Year Treasury yields broke resistance at 4.35% but is retracing to test the new support level. Respect would confirm an advance to test resistance at 5.0%. Failure of support is less likely but would warn of another test of 4.05%.
Federal debt at 120% of GDP, deficits of 6% of GDP, and a growing interest rate burden limit the available options.
The Fed can suppress long-term interest rates but the cost — in terms of inflation — is likely to be high.
The US is well along the path to fiscal dominance as explained in this 2023 paper from the San Francisco Fed:
Fiscal dominance refers to the possibility that the accumulation of government debt and continuing government deficits can produce increases in inflation that “dominate” central bank intentions to keep inflation low….If global real interest rates returned tomorrow to their historical average of roughly 2 percent, given the existing level of US government debt and large continuing projected deficits, the US would likely experience an immediate fiscal dominance problem. Even if interest rates remain substantially below their historical average, if projected deficits occur as predicted, there is a significant possibility of a fiscal dominance problem within the next decade.
The essence of fiscal dominance is the need for the government to fund its deficits on the margin with non-interest-bearing debts. The use of non-interest-bearing debt as a means of funding is also known as “inflation taxation.” Fiscal dominance leads governments to rely on inflation taxation by “printing money” (increasing the supply of non-interest-bearing government debt).
The rise in Gold — currently at $2270 per ounce — reflects bond market fears of an inflation rebound.
The same inflation fears are also driving demand for stocks.
US Economy
The US economy continues to display resilience, with job openings holding steady at 8.8 million in February, exceeding unemployment by a wide margin of 2.3 million.
Light vehicle sales remain robust at a seasonally-adjusted 15.8 million annual rate in February, reflecting consumer confidence.
However, heavy truck sales (41.6K in February) are trending lower — with the 6-month moving average crossing below the 12- month MA — reflecting declining business confidence.
Conclusion
The economy remains robust but fears of an inflation rebound are growing, fueled by rising crude oil prices and large fiscal deficits. The odds of Fed rate cuts in the second half of the year are shrinking but there are still two possible scenarios:
- A sharp decline in economic activity could still prompt the Fed to cut rates despite inflationary fears. That would be a strong bear signal for stocks.
- Fiscal dominance, with the deliberate use of inflation as a tax in order to restore the ratio of debt-to-GDP to more sustainable levels. This involves shrinking the public debt in real terms by expanding GDP through inflation. A strong bull signal for real assets such as Gold, Stocks and Commodities.
Acknowledgements
- EIA, Petroleum & other liquids: Weekly Stocks
- Lyn Alden: Geopolitical Shifts and your Portfolio
- SF Fed, Charles Calomiris: Fiscal Dominance and the Return of Zero-Interest Bank Reserve Requirements
Solid-state Lithium batteries: the next generation
Money is pouring into research into solid-state lithium batteries (SSBs) which promise to leapfrog existing lithium-ion battery technology.
A battery consists of three parts: a cathode, an anode, and the electrolyte. The cathode releases electrons which are then transported through the electrolyte and received by the anode. Current lithium-ion batteries use a graphite-silicon anode with a liquid electrolyte. Solid-state batteries replace the liquid with a solid electrolyte (SE), normally in a thin film — made from either an oxide, sulfide, a halide or a polymer.
Metal-halides are gaining more attention due to their excellent compatibility toward oxide cathode materials, acceptable ionic conductivity and wide electrochemical stability. (Science Direct)
SSB Advantages
Solid-state batteries promise greater energy density, better performance at low temperatures, greater safety, faster charging, longer range, and longer battery life.
Enhanced thermal performance is expected to improve operation at low temperatures — a key weakness in cold climates. Safety is also improved by the solid electrolyte which is unlikely to leak if the battery casing is punctured — for example in a car accident — reducing the risk of a fire.
Anodes
There are still problems that have to be solved. A key stumbling block is the anode.
Lithium-metal anodes show promise but development has been plagued by dendrites which accumulate on the anode and rapidly reduce its effectiveness. Dendrites are also likely to cause a fire if they grow to the point that they pierce the barrier between the anode and the cathode.
Other developers have opted for silicon anodes but these present a different problem. Silicon is highly conductive, making it suitable for use in battery construction, but the silicon expands and contracts with each charging cycle, causing deterioration over time.
State of Progress
Toyota, one of the leading developers, has pushed back the planned introduction date for their new SSBs until 2028.
Another developer, California-based QuantumScape (NYSE:QS), seems to be making progress:
In January, Volkswagen announced successful testing on a solid-state battery developed by QuantumScape achieved more than 1,000 charging cycles and maintained 95% of its capacity. (The Guardian)
Acknowledgements
- Energy Intelligence: Competition Heats Up in Solid-State Battery Race
- The Guardian: Solid-state batteries: inside the race to transform the science of electric vehicles
- Science Direct, Dengxu Wu, Liquan Chen et al: Solid-state lithium batteries-from fundamental research to industrial progress
- The Harvard Gazette: Battery breakthrough for electric cars
- Seeking Alpha, Nelson Alves: From Prototype To Production: QuantumScape’s Leap Forward
Strong liquidity and a weak Yuan boost stocks & Gold
The S&P 500 Equal-Weighted Index ($IQX) closed at a new record high above 6800. The advance signals that the current rally is finding broader support and is not as concentrated on the top 7 mega-cap technology stocks.
Retracement on the Russell 2000 Small Caps ETF (IWM) respected support at 200, signaling a fresh advance. Our target is the 2021 high at 240. The breakout again signals that investors are growing more comfortable with risk,
Financial Markets
Bitcoin retraced slightly. Respect of support at $68K is likely, however, and would confirm an advance to test $72K.
The Chicago Fed Financial Conditions Index eased to -0.556, indicating plenty of liquidity in financial markets.
The Corporate Bond Market Distress Index reflects healthy credit markets, with Investment Grade (brown below) slightly above the 25th percentile and the High Yield Index (ocher) near record lows, below the 5th percentile on the right-hand scale.
Gold & the Dollar
The Dollar Index continues to test resistance at 104.5. Follow-through above 105 would offer a target of 107.
Gold is strengthening despite a relatively strong Dollar, with demand from China driving up prices. Breakout above $2200 would confirm our target of $2400 per ounce.
Crude Oil
Crude is retracing, with Nymex Light Crude testing support at $80 per barrel. Respect is likely and would confirm our target of $90. High crude prices are caused by (a) the Red Sea threat to shipping, forcing tankers to take the longer route to Europe around the Cape of Africa; (b) Ukrainian drone attacks on Russian refineries; and (c) OPEC extension of production cuts through June.
Conclusion
Strong liquidity in financial markets maintains upward pressure on stocks, with advances widening to include the broad S&P 500 index and small cap stocks.
Gold continues to test resistance at $2200 per ounce, driven by demand from China in response to a weakening Yuan. Breakout is likely and would confirm our target of $2400 per ounce.
Crude is retracing to test support, but respect is likely and would confirm another advance. Rising crude prices would increase inflationary pressures in the months ahead, making it difficult for the Fed to cut rates. This would add upward pressure to long-term Treasury yields and erode demand for stocks.
Acknowledgements
- NY Fed: Corporate Bond Market Distress Index (CMDI)
- CoinDesk: Bitcoin (BTC) prices
Gold & Oil – a new paradigm
The expanding BRICS bloc is moving away from the PetroDollar, looking to settle oil imports in their domestic currencies. But that is unlikely to be achieved without the use of an alternative reserve asset that can be used to settle trade imbalances. The only likely candidate is Gold.
But first let’s start with a review of financial markets.
Financial Markets
The Chicago Fed Financial Conditions Index fell to -0.53, signaling further monetary easing.
Bitcoin found support above $60K and recovery above $68K would signal a re-test of resistance at $72K, indicating ample liquidity in financial markets.
10-Year Treasury yields respected resistance at 4.35%. Breach of support at 4.20% would signal another test of 4.05%.
Janet Yellen at Treasury is doing her best to keep a lid on long-term Treasury yields in order to ensure a smooth run-up to the November elections. This includes limiting the supply of long-term Treasuries by issuing short-term T-Bills in their place.
Keeping long-term yields low helps to support stock prices. High stock prices in turn boost tax revenues which reduce the deficit and new issuance of USTs.
The S&P 500 weekly chart shows how the index has been rising since late-2023. Shallow corrections, of less than 3%, indicate exceptional buying pressure. That and a strong rise in the Trend Index (above zero) suggest that stocks are getting overheated.
The magnificent 7 technology stocks have been leading the advance but now two — Apple (AAPL) and Tesla (TSLA) — are falling behind. A stumble in more key stocks would be cause for concern.
The Dollar
The Dollar Index, shown on the weekly chart below, is headed for a test of resistance at 105. Breakout would signal an advance to 107. The sharp rise on Friday is attributed to a surprise rate cut by the Swiss central bank.
The PBOC also relaxed its managed float, allowing the exchange rate to rise above 7.2 Yuan to the Dollar.
It is unusual to see the Dollar strengthening while long-term Treasury yields are falling. We need to monitor this closely.
Crude Oil
Brent crude is retracing to test support at $84 per barrel. But respect is likely and would confirm our target of $94 per barrel. If that occurs, we expect upward pressure on inflation in the months ahead.
Gold
Spot Gold in London is retracing to again test support at $2150 per ounce. Respect would signal another advance and follow-through above $2200 would confirm our target of $2400.
A New Paradigm
The global crude oil market dwarfs other commodities, with production of more than 100 million barrels per day (EIA). Gold production is only 5000 metric tonnes per year — a fraction of the crude market — but the two have close historic links.
High crude prices often coincided with high gold prices. It was believed that oil producers increased purchases of gold when they made excess profits but in the last decade, there has been greater divergence between Gold and Crude.
Another historic factor was the relationship between gold and real interest rates. The chart below shows how gold made large 12-month gains (orange) whenever the real 10-year Treasury yield (adjusted for CPI) fell below zero.
Negative real yields were the perfect signal to go long Gold, in expectation of rising inflation, funded by negative real interest rates. But that relationship too broke down, with negative real yields of -5.0% accompanied by falling Gold prices after August 2020.
Gold bulls have long accused the Fed/Treasury of manipulating the gold price. In the 1960s, it was done openly by the London Gold Pool, a consortium of 8 major central banks, led by the Fed, who collaborated to maintain a fixed gold price of $35 per ounce. The Gold Pool collapsed in 1968, allowing gold to appreciate above the fixed exchange rate. This led to Richard Nixon to end US Dollar convertibility to gold in 1971.
It makes sense for central banks to suppress the price of Gold — this would increase demand for US Treasuries and other sovereign debt as reserve assets.
We have also observed unusual activity on Comex futures, with heavy selling into rallies. Any rational seller would sell in smaller quantities and avoid off-peak times — when bids are thin — in order not to interrupt the trend and maximize prices achieved. Large sellers generally take pains to avoid alerting the market as to their intentions. The opposite of some of the “shock and awe” selling in futures markets that we suspect is intended to destroy momentum built up in preceding days.
Typical Gold Dump in Futures Market, February 2nd 12:36 PM to 12:45 PM
These are merely suspicions. We have no definitive proof. But those suspicions are now being put to the test.
BRICS+
China and Russia have been uncomfortable with US dominance of the global financial system and have long been making efforts to establish an independent reserve currency as an alternative to the Dollar. Their efforts failed to gain much traction until Russia’s full-scale invasion of Ukraine in 2022. US and European sanctions — blocking Russian assets held by European banks and removing Russian banks from the SWIFT payments system — alerted non-aligned countries to their vulnerability should they ever offend the US or its European allies.
The response has been an expansion of the BRICS bloc, with Iran, Saudi Arabia, the United Arab Emirates, Argentina, Egypt and Ethiopia invited to join in August 2023. Argentina has since declined the invitation — after the election of Javier Millei — and the Saudis are “still considering”. The shift is motivated by a desire to reduce dependence on the US Dollar for trade — and US Treasuries as a reserve asset.
Central bank (CB) gold purchases are growing.
Jan Nieuwenhuijs recently suggested that CB purchases may be far higher than official declarations (red below). He estimates that 80% of unreported purchases are made indirectly on behalf of CBs.
PBOC purchases account for a large percentage of unofficial buying.
Crude Oil Payments
Major oil importers like India and China have signed agreements to pay for oil in their own currencies but that is likely to leave exporters like Russia and the Saudis holding excess Rupees and Yuan that they do not need and are unlikely to want to hold as reserves.
Non-USD trade in oil would only be viable if net trade imbalances are settled by transfer of gold between trading partners, with surplus countries like the Saudis purchasing gold from the Chinese with Yuan that are surplus to their needs. Demand for gold is expected to rise exponentially as the BRICS bloc expands and oil trades are increasingly settled in domestic currencies. Major oil importers like India and China are likely to require larger gold holdings in order to settle trade imbalances with oil exporters like the Saudis and Russians. Oil exporters are expected to recycle gold to fund purchases of goods and services from non-BRICS trading partners but the total “float” of gold in the system is likely to increase.
We continue to see a growing pile of evidence that gold is re-becoming an oil currency, which by virtue of the oil market alone being some 12-15x the size of the global physical gold market annually, suggests a continued relentless bid for gold in coming quarters and years that will puzzle many on Wall Street. ~ Luke Gromen
Physical Gold Flows
Physical gold is flowing out of London and Zurich as Asian buyers bid up prices.
A recent Doomberg interview pointed out that Gold quoted on the Shanghai Gold Exchange is at a premium of between $20 and $40 per ounce above the London Gold price. Friday’s PM Benchmark of CNY 511.40 per gram converts to $2200 per troy ounce, compared to the London spot price of $2165 per ounce — a premium of $35.
Arbitrage will ensure a steady flow of physical gold out of London and Zurich for as long as that premium is maintained.
Gold in CNY/gram as quoted on Shanghai Gold Exchange
(red = AM, blue = PM benchmark price).
Conclusion
Stocks continue their bull run, supported by strong liquidity in financial markets and weakening long-term Treasury yields.
The Dollar has diverged, however, rising sharply against the Euro and China’s Yuan. Dollar Index breakout above 105 would warn of an up-trend with an immediate target of 107.
Gold is retracing to test support at $2150 per ounce. Respect would signal another advance. But we need to be careful of the rising Dollar. Breakout above 105 would be likely to weaken demand for Gold.
Brent crude is testing support at $84 per barrel. Respect is likely and would confirm our target of $94. High crude oil prices would be expected to increase inflationary pressures in the months ahead and force the Fed to delay rate cuts. The resultant rise in long-term Treasury yields would be bearish for stocks.
We expect a new paradigm to emerge, where the Gold price is no longer determined by Western buyers seeking an inflation hedge to protect against erosion of currency purchasing power and as a safe haven when risk is high. Marginal buyers are likely to be BRICS+ (the expanded BRICS bloc) central banks, seeking to use gold to settle trade imbalances from oil and gas imports paid for in non-USD currencies. The supply of Gold is inelastic, so the price is expected to rise steeply until a new equilibrium is reached.
Acknowledgements
- Luke Gromen, FFTT: March 22, 2024
- EIA: Short-Term Energy Outlook, March 2024
- World Gold Council: Historical demand and supply
- Shanghai Gold Exchange: Gold Data
- Jan Nieuwenhuijs: China Has Taken Over Gold Price Control from the West
- Resolve Asset Management: The Dangerous Game of Modern Economic Warfare with Doomberg
- Nominally Rich: Example of Gold Dump in Futures Market