What's Love Got To Do With It?

I don't love this market. I understand it, but that doesn't mean I have to love it. But when it comes to money, what's love got to do with it? Tina had it right all along - it's a second-hand emotion.

In a perfect world, an investor's motivation to risk his/her capital is up to them. If they are so inclined, a bet on the future is often made without coercion or influence of others. There are no outside forces dictating their behaviour. With our eyes wide open, we willingly risk capital, without knowing what the future holds.

We now find ourselves in a world in which those notions have been tossed into the waste bin. The rules of the game have changed. By persistently suppressing real yields, monetary authorities are distorting the normal motivations of the suppliers of capital. Savers are now implicitly financing spenders, in a real-time experiment in social engineering. Central Bankers have now joined politicians as architects of social policy. By their explicit subordination of the inflation part of their dual mandate, the Fed has pivoted dramatically. Employment levels, and by extension income inequality, are now frequently cited as the primary policy imperative of the Fed governors.

And risk-averse savers are paying a price for that policy. Clearly, the Fed is saying that they are willing to transfer wealth from the owners of capital to those they believe are underserved by current fiscal and social policies. The wealth tax is already here! By suppressing the yield curve well below normal inflation-adjusted levels, they have created a distortion that still dominates investment decisions throughout the globe.

But be careful what you wish for. By reordering their priorities, the Fed has headed down a dangerous path strewn with unintended consequences. As I see it, the current inflation policy is not what is best for the underserved classes. What good is a job that doesn't pay enough for someone to pay the rent, fill the tank or keep food on the table? And as the prices of all three continue to rise, the price wage spiral is now in full swing. The timid pace of the Fed's removal of excess accommodation that is currently driving investor behavior is also driving risk asset prices higher. At the same time, low-risk asset prices are languishing and failing to generate an adequate real rate of return.

This construct of proactive easy money is extending the so-called 'TINA/FOMO' rally that was born in the Covid-induced depths of 2020. Markets are higher than almost all forecasts and we are left scrambling to explain it. But what can you expect when company earnings continue to surprise to the upside while discount rates remain surprisingly subdued? This market is hard to love but even harder to short.

Why are bond yields refusing to reflect the inflation risks that are now more persistent than promised by the Fed? At first, bond investors seemed to be buying into the 'transitory' narrative espoused by Jerome Powell. But now, what explains yields at record negative 'real' levels?

In the short run, there is still the massive direct QE support from central banks, which has yet to be completely reversed. Then there is the technical bid that comes from asset mix policies (like 60/40) that continue to force-feed investment demand for prudential risk-adjusted wealth management. And there is a growing global savings glut derived from demographic deceleration that continues to underpin demand for financial assets. Safe assets are still in high demand.

But the stock market is partly to blame as well. If I had a nickel for every person that asked me when is the market going to reverse course, I could buy a share of Tesla, even at last week's prices. People are scared of this market.

It seems that the highly touted 'Fear of Missing Out' has actually been replaced by the 'Fear of Flaming Out'. As the chart below shows, there hasn't really been a FOMO market. It's more a case of fear of being in an asset that is so inflated. Where is the euphoria? When the taper talk started in September many investors again raised cash in anticipation of a repeat of the 2013 blow-up. That cash ended up in a banking system already flush with cash and thus the 'bid' to risk-free assets strengthened, causing the current undershoot of bond yields to the growing inflation scare. Today's 10yr auction looks like another blow-out.

Inflation-protected assets have been slow to receive investors' full attention. Although Bitcoin has replaced gold in many portfolios, its credibility as an inflation-resistant asset remains untested. It seems more like a high beta growth strategy to me. The chart below is the critical one to watch now. The hesitancy being shown by investors to fully embrace a scenario of higher for longer inflation is demonstrated by the consolidation pattern in the Tips vs Tilt markets. The desire to hedge the possibility of persistent inflation could see this consolidation pattern breakout to the upside. Given the lagged effects of recent strong employment trends on company cost structures, and their predilection to raise prices, there may be just such a break just ahead.

If the market starts to bet on the sustainability of inflation and the TIPs market begins to outperform their nominal alternatives, watch the chart below. Real rates are currently lower than expected for reasons that are mostly technical in nature. But unlike in the past, gold hasn't benefitted. It seems like a good time to hedge against a growing complacency that has formed in the financial markets. We now have a stretched equity market with narrow leadership and weak breadth. Pockets of speculation are rampant in EV and other meme stocks (re-read last week's blog for that). Risks to the system from China's property market meltdown have been widely dismissed. All while yields remain artificially depressed.

When the Fed is so willing to stay behind the curve and a multitude of systemic risks, there is every good reason to buy gold now. Right here, right now.

Risk Model: 2/5 - Risk Off

With prices overbought, and a sharp drop in the Copper/Gold ratio last week, the model has flashed caution. As I warned last week, copper has been artificially elevated by a sharp backwardation reflecting a temporary supply squeeze at the LME. Conversely gold is showing signs of life in response to sharply lower real yields. This morning we are seeing a sharp rise in volatility measures. A small move higher in $VXV would cause a confirmation of the sell signal and a full-on correction could quickly unfold. On Tuesday at 11 no less - imagine that!