Freedom to Use Interest Rates
Last Friday, in response to a better-than-expected non-farm payroll jobs report that counterintuitively drove a sharp rise in interest rates and a sharp drop in stock prices, President Trump posted his dissatisfaction with the market reaction in the following Truth Social post:
With a great jobs report, like just announced, stocks should go up, not down. That’s the way it was for 200 years. Growth does not mean inflation! How else can a country attain GREATNESS???
That formerly counterintuitive market reaction has actually become increasingly familiar for market observers after the Great Financial Crisis. That’s because once policymakers and the Fed in particular became far more aggressive in their attempts to manage the economy and markets, new norms formed.
Rather than the old intuitive pattern of good news for the economy being good news for markets, we now live in a bad news is good news world. “Good” news implies a lower chance of the rate cuts and stimulus markets have now come to crave and depend on. So the negative market reaction to the “strong” jobs report was simply a negative market reaction to the increased chances that the Fed will keep rates higher for longer in response to it.
Trump’s post also echoed and endorsed new Fed Chairman Kevin Warsh’s view, offered by Warsh in a November Wall Street Journal op-ed, that stronger growth doesn’t need to drive higher inflation or higher rates.
In the op-ed titled “The Federal Reserve’s Broken Leadership,” Warsh said:
AI will be a significant disinflationary force, increasing productivity and bolstering American competitiveness. Productivity improvements should drive significant increases in real take-home wages.
The Fed should re-examine its great mistakes that led to the great inflation. It should abandon the dogma that inflation is caused when the economy grows too much and workers get paid too much. Inflation is caused when government spends too much and prints too much.
Putting aside for a moment that this government is almost certain to spend and print “too much,” which Warsh just admitted is inflationary, the picture Warsh and Trump are painting is one in which their goal of running economic growth “hot” doesn’t need to drive higher inflation or higher rates.
Now, while that idea plays well with the crowd, the vision is also not at all likely to ever manifest as reality.
Again, putting aside for a moment that this government is almost certain to spend and print too much and that Warsh admitted such action is inflationary, even if we assume that U.S. investment, growth, and productivity all surge, and that as a result the U.S. will experience a disinflationary growth boom, yields are still likely to move higher and, by extension, turn highly problematic.
First off, if the growth the administration seeks turns out to be inflationary rather than disinflationary (highly likely) then interest rates will rise due to the consequent inflation. But, even if the growth it seeks is in fact disinflationary (unlikely), the U.S. dollar will be very likely to strengthen on capital flows that will also cause yields to rise rather than fall.
That’s because if the U.S. experiences a disinflationary growth boom, it will likely push U.S. GDP growth to the strongest of any developed market in the world. The capital flows chasing that disinflationary growth would drive the dollar higher, as occurred in the mid-to-late 1990s, but now (unlike the late 1990s) foreigners hold over $10 trillion of U.S. dollar-denominated debt.
That rising dollar would make servicing and repaying that internationally held dollar-denominated debt dramatically more challenging. With an estimated $13-14 trillion in foreign U.S. dollar borrowing today, anytime the dollar strengthens meaningfully foreigners are forced to sell U.S. dollar assets, and they’re likely to start with the $9.5 trillion in U.S. Treasuries they own. Again, that means higher, not lower, yields.
So, the Warsh/Bessent/Trump vision of the future is to run the economy at a blistering pace, but with falling inflation and falling yields. In reality, even if they can deliver the growth they seek, it’s very likely to be either inflationary with rising yields or disinflationary (doubtful) with still rising yields. And importantly, as long as we have rising yields (and positive real yields) on U.S. debt, we still have a looming U.S. fiscal crisis at dead center stage of the global macro discussion.
Next week, new Fed Chair Warsh will step up to the podium for his first post-FOMC presser. HAI has sympathy for the extremely tall task he has at hand. He will be inheriting what the Bureau of Labor Statistics reported this week was May consumer price inflation that increased at its fastest pace in three years at 4.2% year-over-year, and that’s after more than five straight years of already above-target inflation. He will also inherit a fiscal (debt and deficit) crisis to go along with his inflation problem, and he will be given woefully limited tools to deal with either.
Since 2023, the Treasury’s plan to buy time on the fiscal crisis has been to shift U.S. Treasury issuance dramatically toward the front end of the yield curve (where the Fed controls rates) with the goal of then cutting rates to lower financing costs without actually cutting spending or borrowing. But now, with inflation re-accelerating and Fed credibility entirely on the line, the market expects the Fed to hike rates to fight inflation—meaning the entire plan to shift issuance to the front end and then cut rates may be about to backfire in dramatic fashion if Warsh hikes rates.
In the short term, any Fed rate hikes and rising real yields will likely be negative for gold, given that market participants have been trained over recent decades to sell gold on rising U.S. real rates. But in the new set of rules, yet to be discovered by a majority of market participants outside of the very short term, there is nothing more bullish for gold (along with inflating the debt away and implementing yield curve control) than rising real rates on a highly indebted, functionally insolvent reserve currency-issuing sovereign caught in a debt spiral.
In HAI‘s view, Warsh will either walk into that trap by hiking rates, or he will find an excuse not to and reveal for all to see that the Fed has effectively abandoned its inflation mandate in favor of a shadow third mandate to cap yields and protect the U.S. fiscal position. In either case, beyond the very short term, gold very much wins.
HAI is not alone in the view that the Fed is effectively trapped. Last week, in an important Financial Times article, famed economist Charles Goodhart said, “fiscal policy has become so unsustainable and so precarious that monetary policy cannot easily work, particularly not in its regular form of raising interest rates… Central banks are going to be subject to much greater pressure. Their freedom to use interest rates as they might want, to bring inflation back to target, is not going to be the same as it was earlier.”
In HAI‘s view, Goodhart’s assertion is not yet a consensus view, but given what Warsh is facing, despite his best efforts, it may not be long into his chairmanship before the Goodhart position is the consensus view. By then, in HAI‘s view, gold will have long shaken off the current correction and will likely be at new all-time highs far in excess of the January high.
In short, whatever vision Warsh paints for how the U.S. will thread the needle to arrive at a fiscal-friendly disinflationary growth nirvana with falling yields, reality continues to point squarely at yield curve control or its functional equivalent. And that also means reality continues to point squarely at gold as the tried and trusted exit from a broken system.
Apparently, China agrees. It already sees what most Western investors will likely see later. According to a Bloomberg article last week, China has greeted the recent weakness in the gold price with increased buying. As Bloomberg reported, China “added 320,000 oz. to gold reserves in May, after adding 160,000 oz. of gold in March and 260,000 oz. in April.” In HAI‘s view, Western investors watching closely would be wise to follow suit.
Weekly performance: The S&P 500 was up 0.65%. Gold was down 2.60%, silver was up 1.04%, platinum was down 4.32%, and palladium was up 2.53%. The HUI gold miners index was up 1.23%. The IFRA iShares US Infrastructure ETF was up 1.26%. Energy commodities were volatile and mixed on the week. WTI crude oil was off 6.92%, while natural gas was off 2.73%. The CRB Commodity Index was off 2.00%. Copper was up 3.05%. The Dow Jones US Specialty Real Estate Investment Trust Index was up 0.84%. The Vanguard Utilities ETF was up 0.28%. The dollar index was down 0.26% to close the week at 99.81. The yield on the 10-yr U.S. Treasury was off 3 bps on the week, closing at 4.49%.
Have a wonderful weekend!
Morgan Lewis
Investment Strategist & Co-Portfolio Manager
MWM LLC
