Hand in hand they blindly go

Forefront in my mind over the next month is central bank policy and the narrative from Powell and other FOMC members from now up to and including their next meeting in September. Yields rose last week in reaction to signs of rising inflation. That then pushed down on the price of gold. The risk for gold is that the Fed allows yields to rise. I don't think they will.  I expect they will allow inflation to rise up to 2% before they talk about raising rates.  Or at least that will be their stated position. Powell's latest view on rates is that they are "not even thinking about thinking about raising rates". Whilst I appreciate central banks can change their mind, this is the current position and it was made with the intention of forward guidance that rates will remain floored until inflation rises. The Fed's current rhetoric on the inflation target has matured from a 2% target to 2% being a 'symmetrical target'; i.e. they are indifferent between 1.5% and 2.5%. It was said with the intention to create inflation expectations.

Now let's remember it was core inflation which was the reason for the inflation spike.  Core rose 0.4% MoM versus headline 0.3%. Spot crude over the last year has had an extraordinary move from over $60 to below $20 in April and back to over $40. Therefore a rise in the annual headline CPI to 1.0% should not cause the Fed to change their narrative away from very dovish. There is simply too much noise in economic data in the short term; now more that usual.  Indeed, whilst retail sales have bounced we are now seeing the ratcheting down of government support to citizens in terms of general handouts, unemployment assistance and rent eviction protection. The Fed will not want to add to this negative fiscal change by appearing anything other than maintaining their uber dovish stance.

I therefore expect the September FOMC statement and the answers to the press post statement and any comments in the intervening period, to state that the Fed remains focused on maximising employment and attaining a 2% inflation rate and that this will be achieved by providing an appropriate level of monetary stimulus. They may even begin to hint at yield curve control and seeding the idea that rates around the 10y will be held down. Whilst I do not expect an explicit number to be given in September the markets can interpret this as anywhere between 0 and 50bps. With the recent low being 50bps, there is upside to be had in bonds and all assets from here.

There is a second reason for this thinking other than the economic need to provide monetary stimulus; the cost of government debt cannot allow rates to drift higher. Take a look at the chart below. Government debt has been on an ever increasing trajectory since 2000 and has really taken off since the 2008-2009 recession. Debt has doubled over 10 years. Despite ever lower yields, the cost of debt as a % of GDP has not fallen, indeed it has started to rise. The chart does not show the most recent increases in debt post pandemic, only running to Q4 2019.

Now, remember we are at the lower bound of interest rates. The Fed so far has indicated they do not like the idea of negative rates. Therefore the cost of debt will increase as debt increases and as rates no longer fall. But rates cannot be allowed to rise either since if they did the interest cost would rise exponentially and it would mean a reduction in government spending on healthcare and education - politically a 'no-go'.

It is for the government to design the incentives to get people back to work and increase productivity. The central bank will play its part in financing whatever spending the government requires. But it must now do this, not at a market rate, but at a rate they determine through open market operations (a.k.a. yield curve control). If they do not, they will hamper the joint objective they have with the government of maximising employment. Central banks and governments have never been more aligned to print and spend. That's good for gold and bad for risk.

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