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A More Optimistic Outlook for Gold? Or Not?

January 31, 2022 2 comments

Something interesting has been happening in gold over the last decade.

I know that sounds strange, but what has been happening is interesting in a very specific way: gold has been outperforming a priori expectations for returns, by a significant margin. So far, that’s still not very interesting since just about every asset class has been outperforming a priori expectations for returns for quite a while. That’s what excess liquidity provision will do (and is supposed to do), after all. But what’s interesting about gold is that for a very long time the relationship between the starting real price of gold and the subsequent real return has been very strong, and it still is – but the relationship seems to have shifted.

Naturally, the key to good long-term returns is buying at low prices and selling at high prices. But the question of what “high” and “low” prices are is the squishy part. In gold, though, it turns out that going back for quite a while the subsequent real return to gold has been strikingly regular. The chart below is snipped from Erb and Harvey’s “The Golden Dilemma,” an excellent paper published in 2013. It shows the subsequent 10-year annualized after-inflation return to gold, as a function of its starting real price (defined by E&H here as simply the gold price divided by the CPI Index).

The chart below shows this relationship as I’ve recreated it, but putting the prices relative to the current spot price (that is, adjusting past prices by the ratio of the current CPI price level index to the CPI Index at that time). This is for periods starting 1975-2000 and ending therefore 1985-2010. Unsurprisingly, it matches Erb & Harvey except for the different ending point, and the choice of how the x-axis is represented. I’ve also drawn a log regression line here. Obviously there should be a bit more curvature to the line but you get the idea. It’s a pretty decent fit: tell me the starting price in today’s dollars and I can give you a pretty accurate guess at the future real return. Lower prices lead to better subsequent real returns. The current price, though (where the vertical line is drawn), is not encouraging.

But here’s where the interesting part comes in. The next 10 years’ worth of starting points and ending points, after those plotted above, still fall on a very nice curve. But the curve is a lot higher.

This is much more encouraging! Whereas the original curve suggested that the expected real return to gold, starting from the current price, is presently about -8% per annum, the more recent curve suggests that the expectation should be roughly a 0% real return. That is, gold ought to approximately keep up with the price level. The curve in red is also more encouraging in that it suggests that while you can have great real returns by buying gold when it occasionally gets quite cheap, it shouldn’t drastically underperform inflation even when it gets kinda expensive. That’s great news for owners of gold, if we can believe it.

I have one mild concern, though – what caused this shift in curves? Clearly, gold has done wonderfully since 2001 partly because it started at a very low real price but also partly because the tremendous liquidity that has been a feature of the financial landscape for the last 13 years (at least) has raised all “real” boats. Because it turns out that gold – moreso than a lot of other commodities – also reacts fairly directly to real interest rates. In a study that we did as part of our work with Simplify Asset Management, we found that for one-year horizons gold has approximately 4 times as much duration with respect to real interest rates than it does to the price level, and the delta to the 10-year real interest rate is about 10x. That is, if real interest rates drop 1%, then that effect alone will influence gold to rise about 10%.

Thus, at least some of what is happening here is that the ‘new curve’ reflects the steady decline in 10-year real interest rates since the late 1990s, from a bit above 4% to the neighborhood of -1% now. Given the (current) starting real price of gold, our expectation for gold’s return over the next decade is that it should be roughly equal to the aggregate inflation over that time frame. The caveat, though, is significant. If real interest rates rise during that time, then gold will probably underperform inflation. Only if real interest rates fall appreciably further – which seems unlikely – can we concoct a scenario where we would think a priori that gold should beat inflation comfortably. And that means that even if you think the red dots in the plot above are a better basis for a forecast, the net message should still not be overly bullish for gold. The most optimistic guess would be that gold’s return equals the change in CPI, unless interest rates collapse further.

However, that circumstance is not damning to gold alone; just about every asset class is subject to the same law of liquidity/gravity. Take away liquidity, and real interest rates tend to rise. Take away liquidity, and prices of all sorts of assets decline – to some level where they’ll offer a better future return from a lower starting price.

Categories: Commodities, Gold

The Coming Peak in Inflation (and Why You Should Hold Off on the Party)

January 17, 2022 1 comment

Get ready for it: over the next month or two, the vast majority of stories on inflation – at least, in outlets that are friendly to bullish interests – will remark on the 40-year highs in inflation but append the following phrase:

“But economists expect inflation to moderate in the months ahead.”

This is meant to do two things, if you’re a PhD economist or a market observer with a BA in Art History (the difference in prognosticative ability between these two groups is remarkably slim). First, it is meant to be a soothing reminder that inflation is just a passing fad and nothing to worry about. Pay no attention to the man behind the curtain… Second, it is meant to demonstrate the powerful insights that the speaker commands. Look on my Works, ye Mighty, and despair!

But the contribution of this pronouncement is small. The reason that “inflation will moderate” in the months ahead is simply due to base effects. The table below shows the monthly CPI (seasonally adjusted, headline) prints from 2021, which will be “replaced” in the y/y figures over the next year. The numbers in red all represent inflation which, if annualized, would be 7.7% or higher.

Some of these high prints are driven by energy prices, which are historically mean-reverting, and some are also driven by spikes in “Covid categories” (most famously, used cars). And so most economists’ forecasts project a return to what the economist considers to be the “underlying run rate” of inflation. To illustrate this, look at the chart below. There are two lines. One, the blue line, represents what the y/y headline inflation rate would be each month if we simply naïvely replace every year-ago figure that is “dropping off” with 0.333%. Y/Y inflation is roughly flat for a couple of months since 0.33% is roughly what Jan and Feb 2021 saw; then it starts to fall sharply as we drop off 0.62%, 0.77%, 0.64%, and 0.90%. In fact, if we printed 0.333% on headline every month for the next year, Y/Y CPI would decline in every month except for two of the next 12.

The other line in the chart, in red, shows what is currently being priced in the market. You can see that not much more thought goes into market pricing than goes into economists’ forecasts!

Here’s the critical, salient point. Every forecast ends up showing this mean reversion because the usual way of doing projections naturally ignores unknown unknowns. From the top down, we have to choose something to replace last year’s number and the natural assumption is that the “top down” guess hasn’t moved terribly far from the prior guess (in the case of headline inflation, something like 2.0-2.5%; for 2022 maybe they’ll throw in 3.5% or 4% ebbing to 2%-2.5% in 2023). And from the bottom-up, we know what went up (for example, the spike in used car prices) and we also know that the rate of change of that item will eventually ebb. We’ve known that about used cars for a while. It hasn’t ebbed yet, confounding many, but it will. But do you know what else happened, the unknown unknown, that was not forecast back when everyone was thinking headline inflation would decline into the end of 2021? The acceleration in new car price inflation!

Indeed, one of the reasons that people thought that used car inflation would slow down and even that used car prices might decline is that used car prices were in some cases exceeding the prices of new cars, which is an obvious absurdity. But surprise! Due to “a chip shortage”, or the problem getting foam for seat cushions, or any one of a half-dozen other reasons – but perhaps also due to excessive government largesse – new car prices are now rising at 12% y/y. That was an unforecast “unknown unknown” early last year, and it is one reason that headline inflation ended the year at 7% rather than at 3%. Okay, so there was a “reason” for this surprise. But if you as an economist didn’t see that coming, what makes you think that you will see the next one…or that there won’t be a next one?

Rob Arnott used to make a similar point about corporate earnings. He pointed out that while the “extraordinary items” for any given company, which gets magically discounted when they report their “earnings before bad stuff,” may be a legitimate way to think about the profitability of that company going forward, for the stock market as a whole the amount of “extraordinary items” shouldn’t be discounted since someone is always having a surprise. It’s a surprise in the micro sense, but not in the macro sense. Surprises happen. Similarly, with inflation: we see economists decay away the surprises that have happened, while ignoring the possibility of other surprises.

If the distribution of those other surprises was random – some of them “inflationary” surprises and some of them “disinflationary” surprises, then this could make sense. The errors would be unbiased and so a forecast that ignores them would be less-volatile then reality, but not necessarily a bad “most-likely” guess. But in this case, the errors are likely to be on the high side because money growth remains around 12-13% per annum. Guessing that overall inflation is going to head back to 1.5%-2.5% over the next year or two is simply a bad guess. That it will decline from 7% is a high likelihood, but not exactly insightful.

There is a context in which this observation can be a useful contribution: by reminding the listener that when they see inflation decelerate in the months ahead, it doesn’t mean anything we don’t already know, a statement about the likelihood of declining year/year inflation can be helpful. This is the baseline forecast; only deviations from the expected path are worth reacting to.

And for my money, those deviations are more likely to be above the forecast curve than below it.

And Then There’s the Fed

By the way, if the most-recent inflation numbers were basically as-expected…and they were pretty much right on expectations…then why are Fed officials suddenly sounding more hawkish? An as-expected number shouldn’t change your views, unless your expectations were non-consensus. That seems unlikely when it comes to the flock of Econ PhDs who inhabit the Eccles Building.

I think the reason the Fed is sounding more hawkish isn’t because anything has changed recently – it hasn’t – but because they think we need to hear that hawkishness right now. It’s like a parent thinking that the kids “need” a stern talking-to. The kids, somehow, never think so.

As a Fed official, if you talk tough now you create several possible good outcomes. You might “re-anchor” inflation expectations by persuading investors and consumers that the Fed is determined to restrain inflation. It seems unlikely, given how often they talked in 2020 about having the tools to be able to prevent inflation – and then neither using the tools nor preventing inflation – that they’d get much mileage from that tack but it’s a free option. Or, you might be able to nudge market expectations in such a way that an actual hawkish turn won’t be as damaging as it historically has been. Or, to be cynical, one might think that a Fed speaker wants to get stern in front of the coming ‘base effects’ ebb, so that it looks to the gawkers in the cheap seats like they moved inflation by merely talking about it. And, in the worst case, you can back off the tough talk before you actually have to do anything.

I think there are a lot of reasons that the Fed is not going to be hawkish in any traditional sense; they’re not going to restrain money supply growth by shrinking the balance sheet and squeezing bank reserves (even if they wanted to, that margin is very far away), and they’re not going to raise interest rates in anything like the aggressiveness of a traditional tightening cycle – partly because they won’t be able to stomach the wealth effect of the market reaction to sharply higher discount rates, partly because sharply higher interest rates would cause big problems with the federal budget deficit going forward, and partly because they have convinced themselves that inflation is currently just ‘paying back’ a long period of being ‘too low’ (whatever that means). For now, expect them to aggressively and triumphantly forecast that “inflation will moderate in the months ahead.”

But you know the truth.

Categories: Uncategorized Tags: , ,

Summary of My Post-CPI Tweets (December 2021)

January 12, 2022 2 comments

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy. Or, sign up for email updates to my occasional articles here. Investors, issuers and risk managers with interests in this area be sure to stop by Enduring Investments! Get the Inflation Guy app in your app store! Check out the Inflation Guy podcast!

  • Welcome to the first #CPI Day of 2022 (although technically it’s really the last of 2021 since we’re releasing December #inflation figures). Exciting times, as headline inflation might sport a 7% handle and core inflation definitely will be well above 5% y/y.
  • The last three numbers have been so broad, so worrisome OUTSIDE of the “Covid Categories”, that even the Federal Reserve is saying the right things. Will they really hike rates 4 times this year? I’m skeptical but we will see.
  • Core CPI for October and November were 0.599% and 0.535% m/m, respectively…but most importantly, there wasn’t a clear outlier causing these jumps. Median inflation, which is unaffected by those tails, has had three straight months above 0.45% (5.4% annualized).
  • Not only the Fed, but also the market, is finally starting to listen a little. This chart shows the changes from 1 month ago for real rates, inflation expectations, and nominal rates. All higher from mid-December.
  • But the theme from economists over the next few months – brace for it – will be “But economists expect inflation to moderate in the months ahead.” You’ll see this everywhere.
  • That’s because after easy year-ago comps for the next 3 months, they get difficult in April-June. So, while core inflation should get to 6% in early Q2, the y/y numbers PROBABLY won’t get worse than that (in 2022).
  • So, mix that story with “see, the Fed is serious and inflation is already coming down” and you’ll get the touts for stonks going in full force. Don’t worry, be happy. Buy the stuff that Wall Street needs to sell. Etc.
  • And there IS some good news. For example, the rate of increase in overland truckload rates is declining. Still high, but declining. Since trucking goes into all kinds of goods, it’s often a leader of the rate of change (not always).
  • Similarly, some modest good news from global shipping rates, which are down from their highs although edging back up a little (chart shows east-west container rates).
  • but … Other than those big base effects in April/May/June, there’s not a lot of reason to think the m/m #inflation figures will drop down to 0.15-0.2 again.
  • Going forward there will be a peak…but won’t be as serious as you think. We can all imagine used cars fading eventually. But no one bothers to imagine what will go up. So if you forecast a reversion to the mean for the first and ignore the second, of COURSE you forecast a peak.
  • Example: what about insurance? President Biden’s latest plan is to force insurance companies to provide 8 free COVID tests per person per month. Ignore whether the tests exist, but … Who do you think pays for that? Insurance company? Nope. More policy error.
  • What about China re-shutting some parts of its economy due to Omicron? Remember, (as I wrote in February 2020): “COVID-19 in China is a Supply Shock to the World” https://inflationguy.blog/2020/02/25/covid-19-in-china-is-a-supply-shock-to-the-world/ This is not policy error, just bad luck. But bad luck happens.
  • Last month I said “This is not about the pandemic any longer; it is about policy response to the pandemic. It is almost entirely policy error.” I feel strongly about this. While there is tough talk on this from the Fed, let’s see if it’s followed by tough action.
  • I’m concerned about that, since the Fed is still getting the story wrong. Powell says higher labor costs are not driving inflation. Well – that’s because labor costs generally FOLLOW inflation. Labor pushes when they see their own cost of living going up. Not before.
  • And thanks to workers’ pricing power, wage increases should rise around another 1% y/y by Q3, based on the current unemployment rate (green). This is good news for workers, bad news for consumers. Wages don’t cause inflation but they DO give it momentum.
  • So inflation will peak around April, but core will ebb to maybe 4%, not 2%.
  • Back to today’s number. Consensus is 0.4%/0.5% headline/core for the month and 7.0%/5.4% y/y. The ‘inside market’ is really 0.46-0.52 on core. The interbank market has the headline figure reaching 7.03%.
  • But remember this is December, and there are lots of weird seasonals, so anything can happen.
  • We are still watching rents, which should remain solid for a while here. Catching up from the end of the eviction moratorium, but there’s still plenty of heat in the housing market generally. And amazingly, we’re still watching used cars.
  • Here’s a chart of the level of used car prices. Not exactly collapsing! I mean, wow! I don’t know anyone who thought we’d get another leg higher.
  • And even the rate of change is reaching new highs. So we will likely get another push in the CPI from used autos, and new cars as well since they’re a substitute.
  • But most important in today’s #CPI remains the breadth. That’s the main focus today. If we get 0.7% but it’s all used cars, that’s not nearly as significant as if we get 0.4% and there are no outliers at all. That has been the recent story and I expect it to continue.
  • Good luck!  I will have a summary of all my tweets at https://mikeashton.wordpress.com  sometime mid-morning and then I plan to put out an Inflation Guy podcast  (https://inflationguy.podbean.com) sometime today. Like, click subscribe, all that.
  • Also look for the Inflation Guy app in your app store (once we get enough users we will probably do livestreams to those users, rather than on Twitter).
  • And finally, book your free place at the Institutional Fixed Income Virtual Summit on January 22nd. https://lnkd.in/dab2WfEP
  • Hey! I finished with the walk-up early. Still time to grab a coffee. Number in 7 minutes.

  • A bit higher than expected 0.5%/0.6% on core. Headline did get to 7%, core hit 5.5%. Bloomberg kinda slow-rolling the seasonally-adjusted core number so  don’t know the 2nd digit yet.
  • OK, here we go. The seasonally-adjusted core number, m/m, was 0.5501. So it just BARELY squeaked out the 0.6%. Still, higher than expected but not drastically.
  • Jumping out at me is the 1.72% rise in Apparel prices m/m. Apparel is only 2.7% of the basket but has been in deflation for years, punctuated by occasional attempts at price increases. Right now Apparel is +5.8% y/y. Some of that is likely shipping b/c apparel isn’t made here.
  • Used Cars, true to form, +3.5% m/m after +2.5% last month. Y/Y up to 37.3%. New cars +1% m/m.
  • Overall, core goods and services continue to look…um…disturbing?
  • Here is core services by itself. 4% looks like the big level. However, it’s no longer the case that this inflation is all about goods. Ergo, it isn’t all about supply chain.
  • OK in the COVID categories, 1.18% m/m from lodging away from home; +2.72% m/m from airfares. Car and truck RENTAL though was -5.3% m/m. That’s only 0.13% of CPI though!
  • Rents: Primary rents +0.39%, 3.33% y/y. That’s slightly lower than the last couple of months but still pretty hot. Owners’ Equivalent Rent +0.40%, 3.79% y/y. Ditto – lower but still hot. 4.8% annualized from a third of core would make it hard to get core back to 2%!
  • Medical Care was +0.28% m/m. But Pharma (+0.01%), Doctors’ Services (-0.05%), and Hospital Services (+0.16%) were all lower. Which means it came from insurance.
  • Here is medical insurance, y/y. Up 1.6% m/m. Medical insurance is a residual in the CPI (not directly calculated), but this is where added costs to insurance companies is showing up.
  • So core inflation at 5.5% is still “the highest since 1991”, but starting next month it will probably be “the highest since 1982” since the 1991 high was 5.6%.
  • Vehicle insurance (-16.8% one-month change, annualized) and Car and Truck Rental (-48%) were the only core categories that fell more than 10% annualized.
  • Categories that ROSE >10% annualized: Jewelry/Watches (+59%),Used Cars/Trucks(+51%),Womens/Girls Apparel(+30%),Public Transport(+26%),Motor Vehicle Parts/Equip (+21%),Footwear(+20%),Lodging Away from Home(+15%),Household Furnishings(+14%),Mens/Boys Apparel(+14%),New Cars(12%)
  • I am afraid this also looks like we are going to have another 0.45% or so on Median inflation. Hard to tell b/c regional OERs are the median categories it looks like, so it might be as low as 0.38% but unlikely I think.
  • Core ex-housing is +6.4% y/y. It’s worth remembering that core is currently being pulled DOWN by rents.
  • Folks, grab the reins on the change in the CPI weightings. They are a totally normal biannual thing. The changes will be larger this time than normal because consumption patterns changed – but there’s no conspiracy. Consumption patterns DID change. That’s all that’s happening.
  • Stories remain approximately the same for the four-pieces charts. The first is Food & Energy – most volatile, and the best chance for dropping the y/y headline number. But still, pretty ugly and this likely affects wage negotiations as people pay more for food and gas!
  • Core goods – a chunk is new and used autos. And there is upward pressure from shipping and trucking rates. But those are ebbing a little. This will eventually come back to earth, on a rate of change basis, but that doesn’t mean the price LEVELS will decline.
  • Core services ex-rents. This is still looking a little perky although not breaking to new highs like a lot of the rest of the index. Medical Care is actually holding down inflation. But uptick in health insurance is concerning.
  • Rent of Shelter – totally expected if you’ve been watching housing. Still has more to go! Again, it’s going to be hard to get core CPI back to 2% while rents are running 4-5% or more.
  • Slight good news on distribution. The weight of the consumption basket that’s inflating more-slowly than 3% is back above 25%!
  • OK, one more chart and then a quick wrap-up. Remember later to check out the summary at https://mikeashton.wordpress.com  and look for the podcast version of it at https://inflationguy.podbean.com
  • I said the most important part of this report was the breadth. And it was again a very broad report; Median CPI will again be around 0.4%-0.5%. The Enduring Investments Inflation Diffusion Index reached a modest new high.
  • There is nothing in today’s number that suggests the underlying inflation pressures are ebbing. The y/y change will eventually come down because the comps will get more difficult, but there is NO SIGN that core will be dropping back to 2%.
  • My base case is that we end 2022 with something like a 4% core inflation rate. Could be as low as 3.5%, but the potential miss on the upside is larger than that.
  • The Fed is talking tough, but talk is cheap. They’re still easing at this hour! Eventually they’ll stop digging the hole. When will they start filling it in – not by raising rates which has small effect if any on inflation, but by selling bonds? Don’t hold your breath.
  • I think they’ll raise rates once or twice, maybe even thrice if bond and stock markets don’t seem to mind. But eventually, they’ll mind because discount rates matter. When that happens, I can’t imagine the Fed keeps sticking the knife in.
  • We have Volcker-like inflation, but we have no Volcker.
  • And that’s the problem. Thanks for tuning in! If you’re curious about what we do at Enduring Investments, come by http://enduringinvestments.com and say hi. I do these tweet storms for many reasons – but some of those reasons are commercial! See you soon.

This was, sadly, not a very surprising report. Inflationary pressures remain broad and deep, and the Fed today is still purchasing bonds and adding more reserves to the system. The FOMC is in a bit of a pickle since they labored so long under the false “inflation is transitory” story. The fact that they couldn’t foresee that the natural consequence of massive fiscal stimulus financed by massive monetary stimulus would be inflation is mind-boggling, but it does seem that they really did think that inflation was transitory and caused by supply-chain issues. Amazing.

So now, they’re behind the curve and really need to catch up and get ahead of this process. The inflation mindset is becoming entrenched (and I think already has), and all the Fed can do is talk about how they’re going to be gradual, gradual, a few hikes this year; maybe they’ll eventually think about shrinking the balance sheet; please don’t panic please don’t panic please don’t panic. But the slower the Fed goes, the harder they’ll have to squeeze liquidity to get inflation out of the system. And that will break a few eggs.

Volcker was not afraid to break some eggs. He saw that it was better to break eggs now than to be unable to afford eggs tomorrow. I do not currently see anyone at the Federal Reserve, or in central banking circles generally, made of that stern stuff. Ask me what inflation this year will be and I will say 4-5% on core. Ask me what it will be next year and I’ll say, probably about the same. Ask me what inflation will be in 2025 and I will say…

Do you have a Volcker? Because if not, we’re Volcked.

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