Market turmoil ahead?

US equity markets seem ripe for a significant pullback, or even a severe bear market, with bond yields unlikely to fall much before rising again. If so, how will it play out for gold?

The Fed’s 50 basis point cut in its fund rate was more than expected, other than by optimistic equity bulls. But realistically, it means that in the absence of solid statistical information that the US economy is entering a slump, there are unlikely to be further significant cuts in the foreseeable future. Additionally, there are signs that US Treasury yields along the curve are unlikely to fall much from recent lows and could even be turning higher. This would be consistent with a growing funding crisis, which so far has not tested demand for longer maturities other than from US pension funds.

Consequently, the US Government’s debt profile has been shortening. It is not for nothing that the Treasury has been paying higher rates by issuing T-bills of up to one-year maturity. The cut in the Fed’s rates lowers T-bill discount rates, and perhaps that was an objective. But it confirms that not taking advantage of lower yield maturities out along the yield curve for funding makes them artificial, temporarily suppressed by minimal debt funding supply. Whatever the short-term outlook for them, they should be higher.

The biggest myth in markets is that inflation is diminishing as a problem and that the outlook for interest rates is therefore to continue falling. This belief is fuelled by relatively recent experience, whereby suppressed rates persisted seemingly without inflationary consequences for a prolonged period. Furthermore, bond market bulls grab every piece of statistical evidence to interpret a risk of recession unless rates are lowered.

However, by cutting the funds rate by 0.5% the Fed has signalled it has demoted inflation’s priority, even abandoning it in favour of sustaining economic activity, and keeping the equity bubble from deflating. Market responses were immediate, with gold, oil, copper, and many other commodities soaring. The chart below from Finviz.com shows how commodities have risen priced in dollars in only the last week. When almost the entire commodity complex shifts to higher dollar prices, read correctly it is a decline in the dollar’s purchasing power for commodities.

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