Keeping An Eye On Europe

It's More Than Just Japan

Jerome Powell in a speech this week effectively announced that rate cuts weren’t coming anytime soon. He said Tuesday that the economy showed a lack of progress on inflation and that it would take more time for restrictive policies to work. In addition, he said that the Fed can maintain high rates for as long as needed. Those who have been following the trends know that this was probably where things were always headed, but now we’ve got confirmation from the guy himself. It’s very unlikely that we’re going to see a major change in conditions in the next few months. If we also assume that the Fed doesn’t want to do anything in the lead-up to the November election, that targets the December meeting as the first real chance that the Fed could cut rates. Given that the inflation data is heading in the wrong direction and the GDP & unemployment numbers don’t support rate cuts either, it’s entirely possible, maybe even likely, that rate cuts are off the table until 2025. In fact, I think that’s becoming my base case assumption.

I do believe that all of this dovishness that has been built up in this market, first by Powell and then by investors who immediately priced in 6-7 rate cuts this year, will eventually be undone, maybe in a way that spikes volatility in the process. The Fed clearly had a big hand in the stock market rally that started in Q4 and continued throughout most of Q1 and helped flame this inflationary pulse by making consumers feel wealthy because their brokerage statements showed big gains. Now we’ve got the inflationary effect and higher interest rates that are a result of it and investors are starting to get concerned (although with the VIX having yet to touch even the 20 level I don’t think we can say that investors are panicking). Once the concern turns into a sense of panic and/or something begins to break either in Japan or because of the war in Israel, that’s when the flight to safety returns and Treasury yields start moving lower. Obviously, there are a lot of moving parts in this scenario, but this is how I think things could ultimately play out.

I’ve heard some people looking at the rally in gold and say things like because most of the buying demand is coming from Asia and not from retail investors that somehow it’s not really a risk-off signal. Here’s my take on it. There’s a reason why someone, whoever it is, is buying gold here (and a lot of it at that). If it’s retail investors, then there’s probably a major sentiment shift in progress. If it’s governments or central banks, they probably already know that something is broken or breaking and are preparing themselves now for it. I don’t really care who’s buying it. Someone is making a big risk-off bet and the trajectory of the gold price chart shows that it’s a big one. I don’t think any reasonable person can see a 20% increase in the price of gold over a two-month period and simply dismiss it out of hand because it doesn’t line up with their personal narrative. Something is happening here. The fact that lumber is dropping precipitously at the exact same time that gold is taking off should be a flashing red warning.

The biggest thing happening in the global markets right now is still Japan. With the yen/dollar rate crossing the 154.5 level, the odds increase every minute of the Bank of Japan stepping in to save its currency. I’ve said before that the most likely outcome here is that the BoJ intervenes yet this week and begins selling off its stockpile of U.S. Treasuries in order to fund its yen purchases. In that scenario, the yen strengthens, the dollar weakens and long-term Treasury yields move higher. I just don’t see a reasonable way around this right now. The Bank of Japan is dealing with inflation for the first time in decades and it seems more likely than not that they will fumble it (the plummeting yen would strongly suggest that this is already in progress). It’s amazing to think how one little 0.10% rate hike, which was supposed to finally usher in this new regime of normalized monetary conditions and global economic confidence, has instead turned into the trigger point of a yen collapse that the BoJ will likely need to swoop in to save.