Fed's Focus on Payroll Is Driving Hard Commodities Higher
The Federal Reserve is cutting rates in a robust-to-accelerating economy, sending these markets on runs.
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There has been much spilled ink on why the Federal Reserve insists on cutting U.S. interest rates and why it is doing so now, with the market at all-time highs.
The Fed keep insisting that it's working toward its dual mandate, one of strong labor market employment and of balancing inflation at an average of 2%. Initially, it was thought that the Fed would give credence to both. Now, the market knows all too well that the former takes precedence at the cost of the latter.
We saw the Fed's commentary change in September, following the August jobs market weakness. The Fed has failed to realize that the reasons for this slowdown in the job market, as it has been benchmarking the previous rate of change in payrolls. Given that the new economy, with less immigration and a lower participation rate, the breakeven employment rate is a lot lower. Hence, the economy is far more resilient than the Fed thinks. It got worried and reacted prematurely in September by cutting interest rates by 25 BPS.
The U.S. economic data has actually been holding up and forward earnings and margins are moving higher through this reporting season. With the latest 25 BPS of cuts announced this week, the Fed is effectively cutting in a robust-to-accelerating U.S. economy. Hard assets like gold, silver, palladium and more got a whiff of this and have been on nosebleed runs over the past few months. The physical commodity markets know something is not right as the Fed is too focused on the payroll numbers and less on inflation, which is averaging closer to 3.2% year over year. Rising asset prices and goods inflation will slowly feed through into the system. It seems the Fed never learns from its mistakes, and yet keeps egging on a system that is in constant need of liquidity.
There is one market that has been showing severe stress in the "plumbing" of the market, i.e., the SOFR repo market. That has seen rates move higher, up to 4.31% — 16 BPS above the interest rate on reserve balances (IORB), which is the highest spread of the year and higher than last year's December to January turn. This shows that there is severe stress in the system and we have seen banks hoarding cash via the repo market as the net level of bank reserves has fallen below the key threshold of $3 trillion.
If investors go back to 2019, the same happened, which caused a massive spike in funding rates forcing the Fed to do a U-turn and cut rates after just raising rates. The system is too tight with the current leverage and funding pressures. This is why the Fed is never able to reduce its balance sheet too much without causing further strain.
The U.S. debt is too big to fail now, and the Fed balance sheet is only down $2 trillion from the highs, and the Fed has announced a stop to its quantitative tightening. We are still at about $6.5 trillion, which is about $2 above pre-pandemic levels, and now it seems the Fed will have no choice but to move higher in event of yet another crisis.
The Fed was allowing the MBS assets to roll off as assets matured, i.e., quantitative tightening. But now it has decided not only to stop this but also to re-invest the proceeds into the T-bill market! The T-bill market is where U.S. treasury is issuing its debt to finance its fiscal deficit. The Fed is adding liquidity to support and stabilize the market. It may not be labelled as "QE," but it is liquidity entering the system.
Central bankers have no other way than to print their way out of any trouble — the system is too big to fail now. The path is clear, fiat currency continues to get debased. The only way to hedge against this depreciation is to be invested in hard assets.
