Has the Fed already pivoted?

Only a week ago we published a two-part report (Gold prices reflect a shift in paradigm – Part I, March 15, 2023, and Part II, March 16, 2023) in which we explored the possibility of the gold market’s pricing in a shift in paradigm. More specifically, the gold market seems to be pricing in the Fed’s either having already orbeing about to lose control over inflation, despite all the hawkish rhetoric and action. 

In order to fully understand why this is now such a critical moment for our fiat currency system, we have to step back and look at the events that have led up to this point. As a reaction to the great financial crisis (GFC) in 2008-09, the Fed – and most other major central banks – slashed their prime rates to zero, where they remained for much of the first half of the decade. The Fed departed from the zero-interest rate policy only in 2015, raising rates only very slowly over the next few years (see Exhibit 1). It could do so because the concerns over a sharp uptick in price inflation never materialized at the time. The promise remained that the Fed could and would raise rates quickly if inflation ever picked up.

Exhibit 1: The Fed slashed rates to zero in the GFC and only raised them marginally in the proceeding 10 years

%, effective rate

Source: FRED, Goldmoney Reserach

In addition, the Fed (and other major central banks) also have been sitting on a mountain of assets on their balance sheets from multiple rounds of quantitative easing (QE) (see Exhibit 2), which they promised to unwind eventually, as it otherwise would equate to straight up money printing. Hence, in order to convince markets that it was serious about combating inflation when it becomes necessary, the Fed would not just have to raise rates but unwind its enormous balance sheet as well.

Exhibit 2: The Fed sits on a mountain of assets on its balance sheet after multiple rounds of QE

$ millions, Total Assets (Less Eliminations from Consolidation), Wednesday Level

Source: FRED, Goldmoney Research

From the beginning we have been very skeptical about the Feds ability to deliver on this promise. As we have highlighted in previous reports, the fed is not in the same position as it was in the late 1970s / early 1980s, the last time inflation ran rampant. More specifically, both sovereign and private debt are at much higher levels than in the 1980s (see Exhibit 3). A sharp rise in interest rates will, thus, have a much larger impact on paid interest than it did in the past. 

Exhibit 3: Total Debt to GDP is at much higher levels than in the 1980s

All Sectors; Debt Securities and Loans / GDP

Source: FRED, Goldmoney Research

More importantly, financial markets and the real economy have become addicted to these artificially low interest rates and the constant influx of freshly printed money[i]. This has created very fragile conditions in both financial markets and the real economy in our view and we expect a sharp reversal of these policies to have major ramifications for both. On one hand, we believe that the monetary policies since the great financial crisis have led to massively inflated asset prices, and a reversal of those policies should, thus, lead to a asset price deflation. On the other hand, the real economy will have to deal with rising debt costs and credit availability. Sectors that have particularly benefited from low rates and a steady influx of new money – such as the real estate market and the tech sector – should particularly come under pressure in our view. We expect this will eventually have knock-on effects on other sectors. Falling asset prices would exacerbate the problem by creating a negative wealth effect.

This is the reason why, for a long time, we held the view that the Fed – once the inevitable inflation shows up – will not be able to raise rates high enough for long enough to fight high inflation, unless it is willing to push the US and global economy into a sharp contraction and risk destabilizing the banking sector. In that case, we would expect to even enter a period of price deflation. However, even actively pushing the economy into recession will only lead to temporary deflation as long as the central banks don’t solve the underlying cause of inflation, meaning they will have to unwind their balance sheets. Any resumption of the “accommodative” monetary policy of the previous 15 years will, in our view, lead to a quick return to inflation.

Hence, when we finally saw a sharp rise in reported inflation starting in 2021, it was time for the Fed to show that it meant business. And indeed, the fed started by hiking rates at an unprecedented pace. Never has the fed funds rate risen by so much in such a short time. The Fed also persistently signaled over the past 15 months that it is very concerned about the sharp rise in inflation and that it is willing to do whatever it takes to combat it by raising interest rates. 

In addition, the Fed did start unwinding its balance sheet a few months after its first rate hike in 2021. At its peak in April 2022, the Fed held $8.965 trillion in assets. That number declined gradually to $8.342 trillion by early-March 2023. 

(As an interesting side note; this decline of $623b was an actual reduction in treasury bills roughly at face value. The Fed reports its holdings at cost and not at market value. Hence, the reduction in assets was the result of bonds maturing and the Fed not reinvesting the proceeds. Arguably the balance sheet based on market value is down much more as the market prices of the bonds declined with rising interest rates. The Fed is expecting to hold these bonds until maturity and, thus, doesn’t report the market value of these assets in real time. However, we found a figure for combined unrealized losses in the Federal Reserve Banks Combined Quarterly Financial Report. The latest reported number is for the end of the third quarter 2022 and shows an unrealized loss of $1.025t. Since then, interest rates have gone up much further, so the current unrealized loss is probably significantly higher. This probably won’t matter for the Fed. In all likelihood, it will hold these assets until maturity. But for the balance sheets of commercial banks and other financial players such as, for example, life insurance companies, this does matter, as we will explain later in this report)

While the Fed has been less aggressive in its divestment efforts than it was in raising rates, it did reduce its balance sheet meaningfully. More specifically, the Fed reduced its balance sheet at a much faster pace than when it attempted to do it the first time starting in 2015. The first time the Fed tried to unwind its asset holdings, it took 225 weeks to reduce by $600b in assets. This time, the Fed has done the same in just 47 weeks (see Exhibit 4).

Exhibit 4: The Feds latest attempt to unwind its balance sheet was much more aggressive than on its first attempt

y-axis: $, millions from peak, x-axis: weeks from peak

Source: FRED, Goldmoney Research

So, what happened the first time the Fed tried to unwind the balance sheet? Although it did so only gradually while simultaneously raising rates by just a meagre 2.25% over more than four years, it was already enough to create problems in the financial sector. More specifically, by fall 2019, the Repo market began to spin out of control. Interest rates on overnight repo (repurchase agreements) suddenly spiked (see Exhibit 5). 

Exhibit 5: The Secured Overnight Financing Rate suddenly spiked in September 2019

%

Source: FRED, Goldmoney Research

This forced the fed to inject liquidity into the repo market directly. But also marked the end of the Fed’s attempt to unwind its balance sheet. Over the subsequent six months, the Fed bought back over $500b of the $700b it had previously sold, before engaging in an unprecedented buying spree on the back of the Covid19 pandemic.

It comes as no surprise to us that in this unwinding / hiking cycle, the Fed ran into trouble much quicker than during the lats unwinding attempt as it had embarked on a much more aggressive rate hike path. While this time there was no issue in the secured overnight funding rate, things started to break in the real world. Initially the Fed had the luxury to ignore the asset sell-off at the beginning of the hiking cycle (see Exhibit 6) as well as the many indicators that pointed to a sharp slowdown in certain sectors (i.e. real estate and transportation sector). 

Exhibit 6: US equities sold off as the Fed began to hike rates to combat inflation

S&P500 index, 10-year T-Bill constant maturity %

Source: FRED, Goldmoney Research

But this nonchalant attitude evaporated quickly when Silicon Valley Bank experienced a bank run on March 10, 2023. SVB had invested a significant share of the exceptionally large inflows of new deposits it received over the previous two years in US treasuries. When interest rates rose, the returns on their liabilities lagged the interest rates they had to pay to customers on their deposits. The bank announced on March 8, 2023 that it had sold $21b worth of securities and borrowed an additional $15b to make sure it had enough liquidity. However, the market quickly realized that the bank must have sold those securities at a loss given the sharp rise in interest rates since it had purchased them. As a result, customers withdrew $42b over the next two days. The situation spun quickly out of control and forced the US government to step in (see Exhibit 7). The FDIC received exceptional authority from the Treasury department to de facto guarantee all deposits. Prior to that, customer deposits were only insured through the FDIC up to an amount of $250,000. 

Exhibit 7: Bonds of Silicon Valley Bank crashed as the bank run unfolded

Bond value, $, 4.57% 04/29/2033

Source: Goldmoney Research

However, while this bailed out SVBs customers, it wasn’t the end of the story. A few days later, another regional bank – Signature Bank – collapsed. Customers had pulled out $10b in a short amount of time as they feared contagion from the SVB debacle. The FDIC thus also took over Signature Bank on March 12, 2023. This meant that within the span of a week, the US experienced its second and third largest bank failure in history (the collapse of Washington Mutual in 2008 is still the largest bank failure to date). In addition, a third regional bank – First Republic Bank – received a $30b rescue package a few days later. Had that bank failed, it would have been even larger than the first two. 

But the US banking sector is not the only one in trouble. Credit Suisse, Switzerland’s second largest bank after UBS, saw its CDS explode and its share price collapse while the crisis unfolded in the US. Things had been challenging for the bank for a while, and markets began to worry about Credit Suisse losing the trust of its depositors. This prompted the Swiss government to hold emergency meetings over the weekend of 18-19 March, 2023 to prevent a bank run ((after having provided CS with CHF50b in liquidity, which apparently wasn’t enough to calm the market, see Exhibit 8). On the evening of Sunday 19, 2023, the Swiss government announced that it brokered a deal in which UBS would take over the flailing competitor. The Swiss National Bank also promised it would provide a staggering CHF200b (about $210b) in liquidity to UBS, if needed.

Exhibit 8: Credit Default Swaps on Credit Suisse exploded the week prior to the government brokered takeover by UBS

%, 5Y D1

Source: Goldmoney Research

The turmoil in the banking sector has led to a sharp reassessment by the market about the Fed’a rate path going forward. The Fed funds future market gives us an implied Fed funds rate expectation. At the beginning of the month, the market expected the fed to hike 3-4 more times this year, before levelling off into 2024. Now, the market sees a lower than 50% chance for even one more hikes, and expects three rate cuts for the remainder of the year (see Exhibit 9).

Exhibit 9: The banking crisis has led to a sharp reassessment by to market of the Fed’s hike path

Market implied number of 25bps hikes

Source: Goldmoney Research

All eyes were on the FOMC meeting on March 22, 2023. Would the Fed already stop hiking rates in light of the stress in the banking sector? Yet, the FOMC decided to hike rates again by 25bps (two weeks earlier the expectations were for a 50bps hike). Importantly, the Fed also expressed its commitment to quantitative tightening (QT). QT is the reverse process of quantitative easing (QE), where the fed reduces its balance sheet. Thus, a week after not one but three regional banks and a large multinational bank collapsed, the Fed tried to signal that it remains committed to fighting inflation.

However, this commitment is at odds with the Fed’s own action. As we have highlighted before, the Fed had reduced its balance sheet by $600b since the peak in March 2022. But a day after the FOMC meeting, the St. Louis Fed reported that the Fed has again added $93b to its balance sheet. This comes on top of the $300b the Fed added the week before. This feels very similar to the fall of 2019. Back then the Fed undid 75% of its quantitative tightening (QT) as certain aspects of the financial markets, particularly the banking sector, began to wobble. This time it also undid about 75% if the previous QT. But unlike in 2019, where it took at least a few months to undo years of QT, this time it just took two weeks. The question, therefore, is: Has the fed – against all its verbal communication – already pivoted?

It needs to be seen whether recent resumption of QE was just a temporary blip. The next few weeks will tell whether QT can resume without causing more issues in the banking sector. We remain skeptical and it seems so is the gold market. It happened twice now that somewhere around $500-600b of QT, things began to break. And while the problems at previously mentioned four banks now seem under control, things look increasingly dire at one of the largest banks in the world. Shares at Deutsche Bank lost 15% last Friday. We also see that CDS of some non-bank financial firms such as life insurance companies signal distress. We also expect that the impact of the sharp rate hikes will become increasingly more visible in a number of other sectors as well. 

Whether it pivots now or in a few months, we believe the Fed will have to pivot long before it managed to unwind the $8tn+ it accumulated since the GFC. This means that the underlying cause of inflation remains, and it is only a question of time before takes over again.

As it looks increasingly unlikely that the Fed and other central banks can get inflation under control in the long term, gold prices will eventually reflect that. However, even if things in the banking sector spin out of control over the coming months, we don’t think it’s a sure thing that gold will initially thrive. While the root of inflation is monetary, and thus accommodative central bank policy will drive up the price long term (what actually happens is that it drives down the value of fiat currency), a steep recession as we have seen in 2008 or even worse would, in our view, lead to a period of price deflation, no matter the reaction of the Fed. It needs to be seen whether gold prices can withstand that and price in the inevitable future inflation caused by the Fed’s intervention, or whether – much like in early days of the GFC – gold prices initially correct lower with deflation. 

[i] In fact, one can argue that the fiscal and monetary policies since the 1980s led to this. But the monetary conditions since the great financial crisis were really extraordinary