Leveraged assets beginning to buckle under high rates

Welcome to this week’s Market Wrap Podcast, I’m Mike Gleason.

Precious metals markets are trading quietly this week even as inflation data comes in hotter than expected.

Gold prices are up a slight 0.3% since last Friday's close to trade at $1,935 an ounce. The silver market shows a small weekly gain of 0.7% to bring spot prices to $23.32 per ounce. The PGMs have performed better. Platinum is up 3.5% this week to trade at $940. And finally, palladium is putting in a weekly gain of 3.2% to come in at $1,276 an ounce as of this Friday morning recording.

The latest Consumer Price Index and Producer Price Index reports show inflation ticked back up in August. After several months of moderation in the data sets, rising energy prices this summer helped drive the CPI and PPI gauges higher.

News Anchor: Inflation rose again in August, fueled by higher gasoline prices.

News Reporter: Inflation ticked up for a second straight month in August, that's according to the Bureau of Labor Statistics. Consumer prices climbed 3.7% last month from the year prior. It also rose 0.6% on a monthly basis. That's the biggest month to month increase this year.

Rick Santelli (CNBC): The August read for producer prices, the wholesale version, of course, headline number expected to be up four tenths is up significantly more, up seven tenths of one percent. That's the hottest read going back to June of '22.

Soaring housing costs aren't fully reflected in the CPI. It doesn't factor in actual home price increases at all. Instead, the CPI tracks owners’ equivalent rent -- the monthly payment that theoretically would have to be paid to rent a house that is owner occupied.

The problem with that is that in most places around the country, it is currently much cheaper to rent than to make a mortgage payment at prevailing rates. In fact, average monthly housing payments as a percentage of incomes have soared to record highs in major cities.

It's now common for home buyers to have to shell out 50% or more of their monthly paycheck on their mortgage payment. In previous years, rising home prices were much less of a burden with borrowing costs extremely low.

For a while, everyone was happy. Homeowners enjoyed appreciation plus the ability to refinance at lower rates. Buyers, meanwhile, could lock in low rates and benefit over time from nominal price appreciation plus have some protection from inflation and rising interest rates.

As recently as 2021, a 30-year fixed mortgage could be obtained for as low as 3%.

Today, would-be buyers face much harsher realities. Average rates on a 30-year fixed home loan have shot above 7%. For some buyers in some markets, a mortgages will run over 8%.

In addition to making the acquisition of a home more expensive, higher rates also impede the ability of borrowers to build equity. That's because they're paying so much more in front-loaded interest and less in principal every month.

Some analysts are warning that a housing market crash is coming. In order for homes to return to historically normal levels of affordability, either prices have to plunge or interest rates have to reset to previous lows.

For now, the Federal Reserve seems intent on keeping rates elevated. The latest inflation readings may even prompt policymakers to implement another hike.

Fed officials are notoriously bad at economic forecasting and never act ahead of a foreseeable crisis. They will instead react only after the damage that has already been done to the economy.

If the Fed is frantically cutting rates by this time next year, it will be because it stood by and watched something in the economy break -- whether it's the housing market, the banking system, or something else.

When excessive leverage builds up in an environment of artificially low interest rates, it will eventually be forced to unwind after rates move up to punishing levels. A process of forced deleveraging typically doesn’t unfold in an orderly and smooth manner. It tends to get triggered suddenly and plays out chaotically as panic sets in among consumers, investors, and institutions.

An unleveraged position in physical precious metals represents a stake in an asset class that isn’t tied directly to the financial system.

It’s true that there is tremendous leverage employed in futures markets where gold and silver contracts are traded. But much of that leverage is applied on the short side by speculators, hedge funds, and commercial banks that are selling gold and silver they often don’t have.

If metals prices start moving higher in a material fashion, the leveraged short sellers will be under pressure to cover their positions, which means buying back the paper ounces they tried to sell. In an extreme scenario, a short squeeze can take hold in which rapidly rising prices force short sellers to cover in order to avoid margin calls – which further feeds into rising prices.

Given that physical inventories of metals have been depleted in recent years, the potential for a run-on-the-bank type event in futures markets cannot be ruled out.

Although supplies of retail bullion are readily available at the moment, that too could change quickly. Amid the chaos of the pandemic lockdowns of 2020, surging demand for physical precious metals drove retail shortages and premium spikes.

The exact timing of the next financial crisis is impossible to predict. But it’s much better to be too early in preparing for it than too late.