Markets and central bankers play chicken with inflation

Precious metals markets are putting in a mixed performance this week as inflation uncertainties drive divergences across other asset classes. 

The bond market is rallying strongly in spite of the Fed’s apparent plans to taper its Treasury purchases in months ahead. Bond buyers are betting that inflation won’t be a problem for years to come. 

With the 10-year Treasury yield trading below 1.3%, long-term holders of these debt instruments are effectively betting that inflation won’t even be running at the Fed’s 2% objective over the next decade. Either that, or they are satisfied with earning negative real returns. 

It’s quite a conundrum for income investors who seek low-risk opportunities to eke out small gains.  The Federal Reserve’s twin policies of suppressing rates and stimulating inflation mean that bonds may now offer more risk than reward.   

The negative real yield realities of the bond market make holding precious metals relatively more attractive by comparison. Yet even as bond yields plummet, gold and silver markets aren’t getting much of a paper price boost at the moment. 

As the summer doldrums drag on in metals markets, bullish analysts are anticipating that a seasonal low will be put in soon – if it hasn’t already. 

Gold and silver prices have been depressed by rising expectations of Fed monetary tightening and falling expectations for inflation.  

Minutes from the Federal Reserve’s latest policy meeting released this week reveal officials are wrestling with an inflation conundrum. 

On the one hand, they expect recent upward pressure on consumer prices to abate.  On the other, some FOMC members are concerned that skyrocketing housing costs in many parts of the country represent a gathering danger.  

These more hawkish policymakers want the Federal Reserve to begin tapering back its purchases of mortgage-backed securities sooner rather than later.

Average U.S. home prices are up 13% over the past year, stoking fears of another Fed-fueled housing bubble. Meanwhile, the Fed continues to downplay and understate real-world price inflation. Its so-called “core” inflation metric substitutes rents for house prices and excludes food and energy costs entirely. 

Even CNBC’s Tyler Mathisen is now calling out the Fed’s “core” inflation con game.

Tyler Mathisen - CNBC:    That the Federal Reserve and market participants are underestimating inflation risk… it seems like in these headlines that they are acknowledging that they underestimated the inflation risk. And by the way, just as a personal aside, I'm always sort of tickled/troubled by the idea that we throw out from the measure of core inflation, food, volatile food and gas prices. I can't imagine what's more core to the American experience than eating and driving.

Jack Ablin - Cresset: So, clearly, they want to err on the side of too much stimulus, too much inflation, knowing that they can circle back and tamp it down later. That said, I think there are two pieces that we need to focus on, that really are sticky, not just the food and energy side that you talk about, but also labor costs, which really are starting to tick up now and housing prices.

Ylan Mui - CNBC:    The Fed Minutes show that the participants do not believe that substantial, further progress had yet been made. However, there was a discussion about how to taper it and whether MBS, whether those mortgage-backed securities should be sold off first or perhaps more rapidly than treasuries because as the Minutes say, there was concern about valuation pressures in housing markets.

Fed watchers are now looking for the central bank to begin tapering its asset purchases toward the end of the year or in early 2022.  They also see rate hikes by 2023 or possibly as soon as next year depending on the economic picture that emerges. 

That picture can change dramatically from current expectations. It’s entirely possible that the Fed will be forced by rising inflation pressures to hike much more rapidly than anyone now forecasts. It’s also possible that market gyrations and a skyrocketing supply of new Treasury debt will force central bankers to abandon taper talk before any tapering even takes place.

The one thing the Fed will almost certainly succeed at doing is keeping the inflation rate – including even the sham “core” rate it reports – elevated above nominal interest rates. In other words, negative real interest rates aren’t going away.

As a consequences, risk-averse investors will continue to the face the same conundrum of where to go for safety. Bonds and savings instruments that yield significantly less than inflation offer the security of guaranteed real losses. 

Perhaps for some, taking steady and predictable losses of purchasing power is preferable to risking larger losses in more volatile asset classes.

Yet it is possible to survive and even come out ahead in an environment of low rates and relatively high inflation. The thing about beating inflation is that it won’t always be a smooth ride. One week your favorite assets might spike on inflationary inflows. The next week, liquidity might rotate out of those assets and into others. 

Broad diversification is an obvious way to dampen down volatility. Academic studies have shown that an investment portfolio with a modest allocation to physical precious metals performs better on a risk-adjusted basis than one containing only financial assets.

There have been and will be days when both stock and bond markets lose value while gold gains. And if years of stagflation similar to what occurred in the late 1970s are in store, then precious metals markets could be set to deliver years of outperformance.