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Markets have been beset by jitters recently.
No trade deal in sight. Signs of manufacturing slowing across the globe. Bond yields sliding.
The S&P 500 down by – oh, at least a handful of percentage points – from its most recent high.
So of course, it’s time for the Federal Reserve to break out the doves.
Investors are demanding that “the Powell put” come into play
Investors are desperate for the Federal Reserve, America’s central bank, to cut interest rates and prove that it has their back.
And Fed boss Jerome Powell appears keen to soothe their fears. Earlier this week, markets rebounded strongly as Powell sounded a lot more open to cutting rates if needs be.
And the pressure is piling on for him to deliver. Investors apparently now believe that there’s a 72% chance of a cut at the next Fed meeting at the end of July.
Indeed, markets are now firmly in “bad news is good news” mode. The worse the economy looks, the more likely the Fed is deemed to cut.
Yesterday, the ADP measure of private payrolls suggested that job creation in the US has stalled. It came in at just 27,000 for May, versus expectations for 185,000, which of course, is terrible. By contrast, the April figure was 271,000 – although that was unusually high.
Now, most of the time, no one really cares about the ADP numbers. As Capital Economics points out, the survey doesn’t have a great record. The number that people usually pay attention to is the official non-farm payrolls figure, which is out tomorrow.
But desperate markets are willing to cling to any scrap of proof that deliverance will come from on high any minute now. You can see why people get irritated with Wall Street – three cheers for rising unemployment, because it means rate cuts, which means a higher S&P.
I suppose, for investors, there are now two questions here: will the Fed cut? And what happens if it does?
The answer to the first is that it’s pretty clear that if the market doesn’t get cuts at some point, then it will throw a wobbly. So I suspect a cut is going to happen sooner or later.
The Fed might be reluctant to cut come July – that would be a big turnaround from earlier this year. But an easier way to signal its intentions without losing too much face would be to suspend quantitative tightening (QT).
The answer to the second question is: it depends. As David Rosenberg of Gluskin Sheff puts it, the time to buy is typically not on the first rate cut, but the last. In other words, by the time the Fed starts cutting, the party is all over. The time around the financial crisis is a good example of this.
However, in the past, there have been a few occasions where the Fed has cut early, and simply added more fuel to the fire. 1998 is a good example. And my gut feeling is that the Fed is much more sensitive these days. It’s far more likely to err in the direction of being too early.
So what’s the most likely outcome?
What drives the gold price
Well, we might not get either of these. We might get a loose Fed and a plain old ropey economy, rather than the downright 2008-style relapse that lots of people still seem to expect. Let’s turn to my favourite yellow metal to think this through.
Gold surged yesterday for a reason. People talk about gold being driven by “safe-haven” demand, or geopolitical uncertainty, or general “inflation”. There’s an element of truth in all of those, but they’re also not very helpful.
The thing that primarily drives gold is the direction of “real” interest rates – in other words, interest rates after you take account of inflation. If real rates are rising, gold hates it. If real rates are falling, gold loves it.
So the following scenarios (falling real rates) are good for gold:
1. Falling interest rates and rising or static inflation.
2. Rates rising, but inflation rising faster.
3. Falling inflation, but with rates being cut even faster.
And the opposite scenarios (rising real rates) are bad for gold:
1. Rising interest rates and falling or static inflation.
2. Rates rising more rapidly than inflation.
3. Rates falling but inflation falling faster.
In other words, as long as the Fed is “behind the curve” in terms of tackling inflation, that’s good for gold. At the moment, it looks as though markets are starting to bet that we might see option one (falling rates and rising inflation) or option three (falling inflation but collapsing rates).
In all, that makes sense to me – trade wars drive up costs. The whole point of globalisation is that it drives down costs by bringing a much greater supply of everything – from labour to resources to finished goods – into the global market. If you reverse that, then you lose the savings too.
This is not necessarily all catastrophic, by the way. As Merryn discussed in an interview with Allianz’s Walter Price last week’s issue of MoneyWeek magazine, a shortage of cheap labour may encourage innovation and investment, which in turn could help to turn around our current problems with low productivity.
But in the short term at least, this doesn’t point to a deflationary bust. Instead it smacks to me of stagflation, 1970s style. You end up with a Fed that’s paralysed because the economy is fragile, even although you have inflationary pressures building.
We’ll see what happens. This isn’t the 1970s, and I like to think we won’t head back there. But this is why we all should own a bit of gold in our portfolios – just in case.