Treasury Market Dissonance

By Lyn Alden Schwartzer:

This article focuses on recent developments in Treasuries and precious metals, which are interlinked to some extent in terms of asset class performance.

There has been a lot of action recently in both of those markets, so there is plenty to discuss.

Historically, the bond market has been the “smart money” because it is largely driven by institutional investors rather than retail investors. It tends to be more focused on near-term math than on emotion or long-term projections, and as such tends to front-run the equity market, at least in terms of major transitions.

As a key example, an inversion of the Treasury yield curve (10-year yield minus 3-month yield) has preceded the past several U.S. recessions with a useful lead time, and with no misses or false positives. In other words, the Treasury market consistently front-runs what the Federal Reserve will do with regards to interest rates, in reference to prevailing economic data.

Here is the Treasury yield curve, with recessions shaded in gray:

Chart Source: St. Louis Fed

In simplistic terms, bond investors pile into long-duration Treasuries when they expect slower economic growth and lower inflation, and move out of them if they expect faster economic growth and higher inflation.

During this dis-inflationary cycle over the past four decades, economic growth rates and inflation levels tend to be rather correlated. So, the bond market either says growth and inflation are pointing up, or growth and inflation are pointing down. We haven’t seen a notable stagflationary period (high inflation with low growth) since the 1970s (although I do lean in that direction as a risk for the 2020s).

Over the past couple cycles, equity investors have caught on to bond investors being smart money, and have referenced the yield curve or other moves in the bond market as potential leading indicators of what might happen to equities going forward.

However, what happens if the Federal Reserve intervenes in the Treasury market? Can we still rely on what Treasury yields are telling us, if the Federal Reserve is the biggest buyer of Treasuries, and uses a combination of forward guidance and ongoing purchases to stabilize yields and ensure liquidity in that market?

Ever since the September 2019 repo rate spike, and especially during the pandemic fiscal stimulus period in 2020, the Federal Reserve has turned to deficit monetization, meaning it creates new dollars to buy Treasury securities, using primary dealer banks as intermediaries.

Here is the Fed’s holdings of Treasury securities:

Chart Source: St. Louis Fed

If we draw the line at the beginning of Q4 2019 for a clean starting point, which was a couple weeks after the repo spike, there has been a little under $4 trillion in net Treasury security issuance since then, and the Federal Reserve has accumulated about $2.2 trillion in Treasuries, which is more than half of the net issuance.

In fact, the Fed accumulated more Treasuries since the beginning of Q4 2019 than the entire foreign sector accumulated over the past eight years since 2012.

So, we’re eating our own cooking; the U.S. Federal Reserve is the biggest buyer of U.S. federal government debt, and they print new dollars to do so.

What should we do about this fact? Does this throw off market signals about what the bond market is telling us, since the “bond market” in reference to actual private bond investors is less than half of the recent Treasury demand, while a semi-government institution is more than half of Treasury demand, against a backdrop of record Treasury supply for the largest fiscal spending environment since World War II?

I would say so. But we’ll get back to that in a minute. Let’s first look at the counter-argument.

Some analysts are quick to point out that just because the Fed buys Treasuries, doesn’t mean it necessarily drives yields down.

During the period of quantitative easing in the Treasury market from late 2010 through late 2014, Treasury yields had a tendency to rise when the Fed was purchasing them, which is counter-intuitive. One would assume that with the Fed as an artificial marginal buyer on an otherwise private market, the Fed’s purchases should move the supply/demand equation in favor of demand, and thus drive bond prices up and yields down. That wasn’t the case:

Chart Source: St. Louis Fed

However, I think it’s important to understand the reasons for why the Fed is buying Treasuries at any given time, as well as keeping in mind the magnitude of their purchases. Back during the 2010-2014 period in particular, the Fed was buying Treasuries as a somewhat optional way to boost the wealth effect, provide extra liquidity, and recapitalize the banking system.

The U.S. federal debt-to-GDP ratio was still rather moderate back then, as the federal government went into the 2008 global financial crisis with around 65% federal debt as a percentage of U.S. GDP, and the foreign sector was still buying Treasuries rapidly, since it was a relatively weak-dollar period (which is when the foreign sector tends to buy Treasuries).

In the years after the crisis, the Fed bought Treasuries to boost liquidity by recapitalizing banks and other large Treasury holders. Treasury yields rose along with economic growth, which is normal.

The rate of Treasury purchases by the Fed back then was about a $500-1,000 billion annualized rate when active, which they spread over two separate periods. One period was a bit shorter than a year, and one was longer. The result was that during a four-year period from late 2010 through late 2014, they bought a little over $1.6 trillion in Treasuries.

However, the 2019 and 2020 period is a different matter. Foreigners have barely been accumulating Treasuries since 2015, which commonly happens in strong-dollar environments, meaning that domestic balance sheets (pensions, insurance companies, mutual funds, hedge funds, corporations and banks) had to fund U.S. federal deficits, and those deficits began growing quickly in recent years even during an economic expansion.

The U.S. ran out of domestic balance sheet room to hold an ever-increasing amount of Treasury issuance in late 2019 and encountered the repo rate spike in September 2019, so the Federal Reserve took over as the primary buyer of Treasury issuance. In other words, we ventured into deficit monetization during an economic expansion.

Then, COVID-19 happened, with the biggest unemployment shock since the Great Depression, and the biggest modern example of government transfer payments and fiscal spending as a percentage of GDP in response to that unemployment shock. All of this money for fiscal spending had to come from somewhere, and the private Treasury market wasn’t enough to provide that amount of lending, so it came in significant part from the Federal Reserve via new dollar creation.

Whether you want to call it a dollar shortage or Treasury security oversupply, there just haven’t been enough dollars in the domestic U.S. financial system or international financial system to hand over to buy more and more of Uncle Sam’s Treasury security issuance.

So, the Fed’s recent period of buying massive amounts of Treasury issuance with new dollar creation to keep yields stable and liquidity high within the Treasury market, against a backdrop of insufficient real buyers, is quite different than optional QE to inject some extra liquidity and boost the wealth effect. The Fed’s buying of Treasuries was far more rapid this time around, and for different reasons.

This type of buying keeps yields lower than they otherwise would be by fixing the supply mismatch between Treasuries and dollars, via the mechanism of taking a big chunk of that extra Treasury supply off the market with new dollar creation and letting the real Treasury market price the remaining amount.

During the mid-March 2020 sell-off, we saw an unusual phenomenon. The Treasury market briefly crashed alongside equities at the worst point of the equity market crash, meaning that investors sold long-duration Treasuries, their prices went down, the Treasury market became highly illiquid (extremely wide bid/ask spreads) and yields sharply spiked from otherwise low levels (because as bond prices decline, bond yields increase).

One would think that this was precisely the time that an investor would want to own safe-haven “risk free” Treasury securities, but when things got really serious in mid-March, that’s not what happened. And it wasn’t really by choice; it was by hard math.

The Treasury market correctly front-ran the economic dislocation and equity crash, with Treasury bond prices rising (and thus yields falling) due to an influx of demand in February and early March, but the heart of the crash in mid-March was so bad, and the dollar spiked so strongly that the foreign sector sold $250 billion in Treasuries within a short time frame, and leveraged risk parity hedge funds ran into trouble and had to sell Treasuries too.

Everything was suddenly about getting dollars, even if it meant selling Treasuries to get them. Many people think Treasuries and dollars are basically the same thing, but at the moments where it really matters, Treasuries are not the same as dollars, and can be sold to get them.

So, Treasury bond prices suddenly reversed their bullish move and fell, and their yields swiftly doubled (blue line below) from those low levels within a matter of days as the equity market (red line) kept going straight down. Boom:

Chart Source: St. Louis Fed

That yield spike was only the part of the iceberg above the surface though. It just happens to be the easy part to show on a chart.

The more serious part was that liquidity in the Treasury market dried up. The Treasury market is supposed to be extremely deep and liquid, but during that spike, liquidity ran dry and bid/ask spreads became very wide. Treasury yield volatility was extremely high; Treasuries had some of the best individual days and worst individual days in all of modern history right there.

However, the Federal Reserve is the lender of last resort. As the Treasury market became illiquid and yields began spiking with record volatility, the Fed cited this problem in their public press releases repeatedly, and started buying up to $75 billion in Treasury securities per day to supply liquidity to the Treasury market, fixing the big mismatch between sellers and buyers of Treasury securities.

The Fed ended up buying over $1 trillion in Treasury securities within a short 3-week window to fix the illiquid Treasury market and hammer down that yield spike. The red line is the 10-year Treasury yield, and the blue line is the level of weekly Treasury security purchases by the Fed:

Chart Source: St. Louis Fed

The Fed described it quite clearly in their emergency March meeting and their subsequent April meeting.

Here’s March:

In the Treasury market, following several consecutive days of deteriorating conditions, market participants reported an acute decline in market liquidity. A number of primary dealers found it especially difficult to make markets in off-the-run Treasury securities and reported that this segment of the market had ceased to function effectively. This disruption in intermediation was attributed, in part, to sales of off-the-run Treasury securities and flight-to-quality flows into the most liquid, on-the-run Treasury securities.

–March 2020 FOMC Meeting Minutes

And here are two snippets from April:

Treasury markets experienced extreme volatility in mid-March, and market liquidity became substantially impaired as investors sold large volumes of medium- and long-term Treasury securities. Following a period of extraordinarily rapid purchases of Treasury securities and agency MBS by the Federal Reserve, Treasury market liquidity gradually improved through the remainder of the intermeeting period, and Treasury yields became less volatile. Although market depth remained exceptionally low and bid-ask spreads for off-the-run securities and long-term on-the-run securities remained elevated, bid-ask spreads for short-term on-the-run securities fell close to levels seen earlier in the year.

Several participants remarked that a program of ongoing Treasury securities purchases could be used in the future to keep longer-term yields low. A few participants also noted that the balance sheet could be used to reinforce the Committee’s forward guidance regarding the path of the federal funds rate through Federal Reserve purchases of Treasury securities on a scale necessary to keep Treasury yields at short- to medium-term maturities capped at specified levels for a period of time.

–April 2020 FOMC Meeting Minutes

Since then, the Fed has gradually tapered their Treasury security buying program from those extreme $75 billion per day highs, although they are still buying at a rate that rivals previous instances of QE, at $40-80 billion worth of Treasuries per month.

In addition, the Fed has discussed performing formal yield curve control, meaning that the Fed would cap Treasury yields below a specified level by buying the amount of Treasuries needed to keep the rates from rising over that limit. They first brought this potential policy up in 2019, but the record Treasury issuance has brought this to the forefront of their discussions in 2020.

Here’s a big set of snippets from their June meeting about the topic:

The second staff briefing reviewed the yield caps or targets (YCT) policies that the Federal Reserve followed during and after World War II and that the Bank of Japan and the Reserve Bank of Australia are currently employing. These three experiences illustrated different types of YCT policies: During World War II, the Federal Reserve capped yields across the curve to keep Treasury borrowing costs low and stable; since 2016, the Bank of Japan has targeted the 10-year yield to continue to provide accommodation while limiting the potential for an excessive flattening of the yield curve; and, since March 2020, the Reserve Bank of Australia has targeted the three-year yield, a target that is intended to reinforce the bank’s forward guidance for its policy rate and to influence funding rates across much of the Australian economy. The staff noted that these three experiences suggested that credible YCT policies can control government bond yields, pass through to private rates, and, in the absence of exit considerations, may not require large central bank purchases of government debt. But the staff also highlighted the potential for YCT policies to require the central bank to purchase very sizable amounts of government debt under certain circumstances—a potential that was realized in the U.S. experience in the 1940s—and the possibility that, under YCT policies, monetary policy goals might come in conflict with public debt management goals, which could pose risks to the independence of the central bank.

In their discussion of forward guidance and large-scale asset purchases, participants agreed that the Committee has had extensive experience with these tools, that they were effective in the wake of the previous recession, that they have become key parts of the monetary policy toolkit, and that, as a result, they have important roles to play in supporting the attainment of the Committee’s maximum-employment and price-stability goals. Various participants noted that the economy is likely to need support from highly accommodative monetary policy for some time and that it will be important in coming months for the Committee to provide greater clarity regarding the likely path of the federal funds rate and asset purchases. Participants generally indicated support for outcome-based forward guidance. A number of participants spoke favorably of forward guidance tied to inflation outcomes that could possibly entail a modest temporary overshooting of the Committee’s longer-run inflation goal but where inflation fluctuations would be centered on 2 percent over time. They saw this form of forward guidance as helping reinforce the credibility of the Committee’s symmetric 2 percent inflation objective and potentially preventing a premature withdrawal of monetary policy accommodation.

Participants agreed that asset purchase programs can promote accommodative financial conditions by putting downward pressure on term premiums and longer-term yields. Several participants remarked that declines in the neutral rate of interest and in term premiums over the past decade and prevailing low levels of longer-term yields would likely act as constraints on the effectiveness of asset purchases in the current environment and noted that these constraints were not as acute when the Committee implemented such programs in the wake of the Global Financial Crisis. These participants noted, however, that large-scale asset purchases could still be beneficial under current circumstances by offsetting potential upward pressures on longer-term yields or by helping reinforce the Committee’s commitment to maintaining highly accommodative financial conditions. A few participants questioned the desirability of large-scale asset purchases following the current purchases to support market functioning, noting that they likely would lead to a further considerable expansion of the Federal Reserve’s balance sheet or have potentially adverse implications for financial stability.

–June 2020 FOMC Meeting Minutes

And then, researchers at the St. Louis Fed came out with an article a few days ago here in August that discussed historical yield curve control in the United States, current yield curve control in Australia and Japan, and importantly, some of the drawbacks and risks of implementing that policy. Here was their summary:

Current experiences in Japan and Australia, as well as the Fed’s experience in the 1940s, suggest that YCC has been an effective tool at targeting interest rates along some portion of the yield curve. As the minutes of the June FOMC meeting noted, the lessons from these three episodes suggest that a YCC policy can be implemented in such a way as to avoid a significant expansion in the central bank’s balance sheet—assuming the absence of an explicit exit strategy designed to reduce the size of the balance sheet. However, those minutes also noted that many FOMC participants had remarked that it was not clear there would be a need to adopt YCC as long as forward guidance remains credible on its own.

However, it is important to acknowledge that every policy has drawbacks. For example, if the Fed were to adopt such a policy and if the public perceives that the Fed is engaged in deficit financing, then it is possible that inflation expectations could rise, threatening the Fed’s long-run goal of price stability; this happened in the U.S. in the 1940s and early 1950s and led to the Treasury-Fed Accord in 1951.

Another worry is that YCC could distort market signals, thereby diminishing the value of information that monetary policymakers glean from the Treasury market. Finally, if the Fed were to adopt YCC, policymakers would have to grapple with the challenge of how to exit from policies designed to be temporary departures from normal. Thus, once the economy normalizes, it would be important to convey the YCC exit strategy to the public in a clear manner to avoid potentially destabilizing outcomes.

–St. Louis Fed researchers, August 2020

As the Fed continues its research for potentially performing formal yield curve control in the future, they have already basically been doing informal yield curve control, through massive Treasury purchases, buying as needed to ensure a liquid market and relatively stable yields, along with forward guidance where they keep saying they will support the Treasury market as needed. To the extent they let the private Treasury market take over in the past few months, it is basically with training wheels and close supervision, like a parent slowly taking their hands off the kid’s shoulders as the kid begins peddling the bike.

When Treasury yields spiked due to too many sellers and a lack of sufficient buyers in March, the Fed bought enormous amounts of Treasuries to fix that problem and hammer yields back down and re-liquify the Treasury market, which had otherwise ceased to function effectively. Since then, the Fed has been able to taper their purchases, still at a historically high rate but slowing, while relying more on forward guidance, although their level of purchases is starting to show signs of being insufficient compared to ongoing Treasury security issuance. That metaphorical kid on the training wheel bike is starting to wobble a bit, in other words.

If we look back since that March bottom, nominal Treasury yields remained low after the Fed hammered down that yield spike, even as inflation breakevens rebounded sharply back upward. Inflation breakevens are the difference between the yield of a nominal Treasury bond and inflation-linked Treasury bond, so it’s the inflation rate that the Treasury market is pricing into its expectations.

Look at this divergence, where the Treasury market has been pricing nominal Treasury yields at 0.50-0.75%, while they are simultaneously pricing in an inflation rate that is more than twice as high:

And so far, the Treasury market’s inflation breakevens have correctly priced in the recent rebound in reported inflation levels with a lead. Here are 10-year inflation breakevens and the reported overall inflation rate and core inflation rate:

So what gives? Why did nominal Treasury yields remain so low, well below the Treasury market’s anticipated and actual inflation level, even as the inflation-indexed component of the Treasury market began correctly pricing in a swift rebound in reported inflation?

In my view, Treasury markets are not currently accurate signals of what the private bond market desires to express. Instead, it’s largely a manifestation of Fed interference, with the Fed having been the largest buyer until very recently, and repeatedly offering forward guidance about supporting the Treasury market as needed.

That is likely why we have had dissonance in the market, where the Treasury market’s own inflation expectations don’t line up with how they are pricing nominal Treasury yields.

We can, however, look into these details and see what the Treasury market is trying to tell us through the interference. The private Treasury market is buying inflation-protected securities at a rapid rate, giving us insight into a rebound in inflation levels, even as nominal Treasury yields remained low for months thanks in part to the Fed’s purchases and forward guidance.

There is enough uncertainty in the private Treasury market that the Fed’s forward guidance has seemingly been successful for the past three months. We have bond experts calling for more and deeper deflation, and we have other bond experts calling for a trend shift towards inflation. As long as that debate exists, there is an open question of where yields “should” be.

So, at least since May, the Fed hasn’t had to directly override the Treasury market, and instead has been able to softly guide it. The Fed just kept buying Treasuries at a tapering rate, ensuring liquidity, keeping an eye on yields, while offering plenty of forward guidance about their commitment to support the Treasury market as needed. The Fed’s chairman, Jerome Powell, even outright encouraged Congress on multiple occasions to do more fiscal spending, and re-iterated that the Fed had plenty of capacity to support the economy.

Within the past week, however, Treasury yields moved up swiftly. This happened back in June and then corrected back down, and now it’s happening again.

It may not seem like a lot for a 10-year yield to move from 0.52% to 0.71% between August 4th and August 13th, but that’s a 36% yield increase in nine days, or 36% higher funding costs for the federal government on much of the Treasury curve. With rates as low as they are, these June and August spikes were a big move in relative terms, although not nearly as significant as the mid-March spike.

In addition, when those rates spiked in June and August, we saw brief growth-to-value rotations in the broad equity market, as the market quickly priced down growth stocks a bit, and priced up some beaten-down value stocks.

If we move further out on the duration spectrum, the recent 30-year Treasury auction wasn’t very smooth. Bloomberg reporters quickly covered it:

Earlier this year, the Fed was buying Treasuries even more quickly than they were being issued, which filled primary dealer banks with cash and took excess Treasury security supply off the market. Over the past few months, however, they’ve been letting the Treasury market try to support more of the net Treasury issuance, but with training wheels on.

The gray lines in this chart are cumulative year-to-date net Treasury issuance, while the blue lines are the Fed’s cumulative Treasury security purchases:

Chart Source: @jsblockland

The Fed bought well over half of net Treasury issuance year-to-date, and although they continue to buy each week through the current time, they started to let the private market absorb over $1 trillion in issuance over the past few months. That’s when the Fed stopped overriding the market, and gradually let the bond market ride on training wheels via gradually tapered purchases.

However, that large amount that has not been bought by the Fed has been testing the limits recently with some messy auctions.

We’ll see how long the private market continues to have enough demand to absorb this large ongoing Treasury issuance, until the Fed ends up having to stop tapering and instead step up their purchases to keep the Treasury market operating smoothly. If the kid on the training wheels starts to take a tumble, the parent will likely come over and set everything back up and offer reassurance.

Maybe there will be another deflationary crunch and insolvency event, perhaps in part due to a political delay in further fiscal stimulus, and the Treasury market will temporarily drive yields back down with sufficient demand on the back of another dip in inflation expectations. Maybe this current yield spike will be ephemeral like it was in June. The timeline here has a lot of variability.

On the other hand, if Treasury yields try to keep pushing up with messy auctions occurring, we’re likely getting into territory where the Fed could announce the implementation of formal yield curve control, to cap Treasury yields across the duration spectrum or a specific part of the duration spectrum at a chosen level. This would be in line with their intentions as described in their meeting minutes, as well as from historical precedent. Alternatively, they could simply step up purchases again and keep doing informal yield curve control.

Investors that have followed my work for a while are familiar with these charts, but for those that aren’t, here’s a quick recap. And it’s an example of Fed QE pushing rates way down via massive Treasury purchases, like holding a beach ball below the water line.

Back in the 1940s, which is the only other time that U.S. federal debts and deficits reached this high as a percentage of GDP, the Federal Reserve became a primary buyer of Treasuries and instituted formal yield curve control to keep Treasury yields at 2.5%, and notably below the prevailing inflation rate, for about a decade. They completely overrode the private Treasury market’s pricing decisions, in other words.

Here were 10-year yields vs. the prevailing year-over-year inflation rate during that time:

Data Source: Prof Robert Shiller

The Fed had to increase their holdings of Treasuries by nearly tenfold within 5 years from 1942 to 1947 to keep yields that low (which was over 15% of 1941’s year-end GDP), and then had to start rotating the duration composition of those holdings, to focus on where the problem areas were along the duration spectrum at any given time:

Chart Source: Cleveland Fed

And this next chart shows what happened to folks who bought and held Treasuries at the start of that process, in nominal and inflation-adjusted (real purchasing power) terms. They made positive nominal returns, but deeply underperformed inflation, and therefore lost purchasing power:

Data Source: Prof Robert Shiller, Prof Aswath Damodaran

If we zoom out and look at the big picture, Bridgewater Associates had a great chart back in 2019 that showed the past century of monetary policy. I updated it in 2020 to show post-pandemic changes, and to provide annotation about fiscal policies as well. This has been one of my favorite charts recently due to how eerily the pattern is repeating:

Complementing that chart, this is a chart of 10-year nominal yields (blue line), as well as the inflation-adjusted annualized returns that investors received for having purchased those 10-year Treasury securities and holding them to maturity over the subsequent ten years (orange bars):

Data Sources: Prof. Robert Shiller, Prof. Aswath Damodaran

There was a nearly four-decade period from the mid-1930s to the mid-1970s where buying and holding Treasuries was a fool’s errand, because they mostly lost purchasing power by failing to keep up with inflation. This was during a period of major long-term debt deleveraging and currency devaluation.

Perhaps unsurprisingly, ownership of gold by American citizens was outlawed from 1933 to 1975, a period that overlaps almost perfectly with the period where buying and holding Treasuries resulted in persistently negative real returns.

As recently as March 12th of 2020, the Congressional Budget Office was projecting a smooth and gradual rise in federal debt as a percentage of GDP going forward. Despite not having had a recession for ten years (the longest such stretch in U.S. history), their model was assuming there would be no recession in the next ten years either. I added some annotations to their chart below:

Chart Source: Congressional Budget Office

People have a tendency to think in linear terms, and extrapolate what is already happening far into the future, whereas reality tends to be more cyclical and messy. Most rapid federal debt accumulation historically happens during recessions and wars. This 2020 recession blew away the projections within a couple months, due to nearly $3 trillion in stimulus to counter-act the unemployment shock and widespread business insolvency.

As bad as the pandemic is affecting the global economy, the bigger story is how the pandemic is just a large catalyst that is triggering the later stages of a long-term debt cycle that has been building for decades.

I also marked on that CBO chart the period where Treasuries consistently failed to keep up with CPI purchasing power, or in essence, the United States inflated away part of its national debt. In the 1940s, it was through formal yield curve control. In the later 1960s and into the 1970s, it was by raising interest rates at a slower pace than inflation, and the Treasury market failing to keep up with inflation.

That is historically how long-term sovereign debt supercycles are paid down when they are denominated in one’s own currency and hit 100% of GDP or more: currency devaluation, and a soft default through purchasing power of that sovereign debt, rather than a nominal default.

One of the most popular subjects that I am getting emails about lately is precious metals, which makes sense due to the high volatility lately, both to the upside and the downside.

As a background to newer readers, I added gold, silver, and some miners and royalty companies to my newsletter model portfolio in October 2018, and this has been a significant generator of performance since then vs. the broad stock and bond allocations. Starting in early 2019, the asset class has been one of my frequent bullish themes in various articles I’ve written, either about the metals specifically, or about the broad macro backdrop that favors them.

In terms of comparative returns over that period, here is where we are with gold, silver, miners/royalties, vs. traditional stocks and bonds, represented via popular ETFs:

My recent bullish public article on precious metals was from about 6 weeks ago in early July.

However, in late July and into August, the price movements on precious metals became quite vertical to the upside, and then on August 11th, they had an unusually sharp correction to let off some steam. They have since partially rebounded.

The further this bullish price movement goes, the louder the natural question becomes: “When is it time to sell?”

The crux of my answer is that I’m less bullish here at over $1,900 gold and over $25 silver in August 2020 than I was at sub-$1,300 gold and sub-$15 silver in 2018, but I’m still bullish with a multi-year outlook.

Short-term and/or intermediate-term consolidations or corrections are natural and even welcomed after such a quick uptrend in recent weeks, and investors may do well to consider rebalancing if they have generated large precious metal positions from the past couple years of outperformance.

My method of managing the liquid portion of my precious metal position through various price dips and price rips over the past two years has focused on maintaining a relatively static asset allocation. When precious metal prices surge higher, I allocate capital elsewhere to bring the allocation down a bit, and when it dips, I buy more to bring the allocation back up.

Caution is warranted at these levels, in my view, even within the context of an overall bullish outlook on the asset class. I am very uncertain of intermediate-term precious metal price action going forward, and honestly wouldn’t be surprised by a deeper correction, a period of sideways consolidation, or even a new breakout after this recent correction.

A portion of my bullishness in this specific time period has shifted to Bitcoin, which lagged gold and silver during the past couple years but has some specific bullish catalysts over the next year or two, mainly involving where it is in its halving cycle.

From 2018 into 2020, I was long precious metals with no position in Bitcoin. Then, I initiated a long position in Bitcoin about four months ago in April 2020, and have topped it off with some ongoing dollar-cost averaging into it. I think it has a fairly high likelihood of outperforming precious metals from now through the end of 2021, but we’ll see. I currently hold precious metals and Bitcoin.

Going back to gold, the way I view it is that two of the three catalysts for my bullishness on precious metals have played out their initial roles to get gold to touch new all-time highs, and the volatility between now and that third catalyst to push gold into higher highs is likely to be significant, but with an unclear timeline.

The easy money was made, in other words. Now it’s the trickier part.

Put simply, gold primarily moves based on growth of the money supply (longer-term trend), as well as changes in inflation-adjusted interest rates and overall investor sentiment (significant movements above and below that trend).

This chart shows gold prices relative to per-capita money supply growth on the left hand side (normalized to 100 in 1973), along with real Treasury yields on the right hand side:

Data Source: St. Louis Fed

In other words, as policymakers around the world devalue their currency over time by printing a lot more of it relative to the goods and services and financial assets available in their economies, gold as a scarce asset keeps up with the creation rate of new currency in terms of price performance. In that sense, it’s not that gold goes up, it’s that dollars and other currency units go down due to dilution, over the very long term. That’s the structural trend, and a lot of it is intentional, including the adoption of official inflation targets by many central banks.

However, gold’s price movements around that longer-term trend can vary significantly based on real interest rates and investor sentiment.

When Treasuries and bank accounts pay you a hefty interest yield above the prevailing inflation rate, there is a significant opportunity cost to holding a yieldless asset like gold, and thus gold tends to perform poorly in that environment, such as in the 1980s and 1990s.

On the other hand, when Treasuries and bank accounts pay you a yield that is in line with or even below the prevailing inflation rate, it means your cash and Treasury holdings are losing purchasing power over time, and the opportunity cost for holding a scarce and yieldless asset vanishes, and thus gold becomes more attractive to preserve wealth, such as in the 1970s and again since the early 2000s.

Historically, currency devaluation in the United States and internationally doesn’t happen in a straight line over a century. It happens in bursts, and then barely at all, and then in bursts again.

Most currency devaluation occurs in environments of low or negative real yields, as money ceases to have a time value. And that environment historically occurs at high points in the long-term debt cycle, as a way to basically deleverage the system by having bonds underperform inflation and nominal GDP for a lengthy period of time.

Lately, as nominal Treasury yields have dipped to record low levels, their real yields collapsed to moderately negative levels, and gold has taken off sharply. Gold in year-over-year percent change terms (red line below) tends to be strongly inversely correlated with real yields (blue line below):

Data Source: St. Louis Fed

Herein lies the problem. The real 10-year rate (which is often reported based on core CPI rather than overall CPI) started this year at just over zero, bottomed on August 6th at -1.08%, and has since risen to -.94%. In an absolute sense, those negative real yields are still bad for currency and good for gold, but the trend change off of the -1.08% bottom is, on its own, not great for gold at the moment. The rate of change matters, especially for price momentum, rather than just the absolute number.

Chart Source: Multpl

This rise in real Treasury yields happened because although inflation has been on the rise from low levels recently, nominal Treasury yields recently had a sharper move upward, as described in the earlier section.

Back on August 2nd, in a lengthy “Current Themes” piece I put out in Stock Waves, I summarized my view of gold as follows:

On the other hand, with gold touching record highs after such a strong two-year rally, gold is becoming overbought on the monthly chart, and has high sentiment indicators, meaning it is in some ways becoming a crowded trade.

In a structural bull market for fundamental reasons, overbought conditions can mean that near-term corrections and consolidations are likely, even as the overall bull market remains intact, and this is healthy because it removes euphoria from the space and lets gold climb the wall of worry over time.

The short answer is that I think gold played out a significant part of bullish reasons one and two (money supply growth and negative real yields), but not yet reason three (structural deficits and yield curve control). When consensus realizes reason three as we move a couple years into the 2020s decade, the gold price could reach surprisingly high levels.

Gold is back at the price it hit in 2011, but since then, money supply has increased substantially, so the gold price hasn’t gotten ahead of itself this time yet, like it did back in 2011. I still think it has a long way to go before it ends this overall bullish cycle, but not necessarily in a straight line up from here after such a nice run already.

So, gold played out two catalysts: rapid growth of money supply and negative real yields.

There are two likely ways that this trend can play out. One is my base case for the longer-term outcome, and one is a possible short-term deviation on the way towards that outcome.

The longer-term base case outcome is that Treasury yields can try to rise, both nominally and in inflation-adjusted terms, but eventually get capped by the Fed via yield curve control. In other words, the Treasury market can say, “Hmm, with the overall inflation rate over 1% and rising from the pandemic lows, and core inflation over 1.5% and also rising, we demand yields higher than half of a percent for lending to the government.” That’s what I think is likely going to happen eventually, and we may be seeing early signs of that start now, with a quick rise in long duration Treasury yields over the past week and a half. However, the June yield spike showed that it could easily be a fake-out as well, so let’s monitor it.

The short-term scenario I’ve been monitoring as well is what if the opposite briefly happens. The economic recovery stalls, Congress gets into a gridlock in regards to passing the next round of fiscal spending (which is currently happening), unemployed people get their unemployment income cut dramatically for a multi-month period, massive debt and reduced consumer spending triggers more insolvency-driven bankruptcies without government aid, and the economy re-enters a disinflationary or even outright deflationary period until it gets rough enough that policymakers give up and throw more money at the problem with another fiscal round. In that case, reported inflation and inflation expectations can drop, and although nominal Treasury yields are likely to drop as well, real yields could be squeezed lower. Gold could experience another sharp sell-off similar to what happened in March of this year (and equities would likely perform poorly).

So far, that longer-term outcome is starting to play out here, but it could be ephemeral. The Fed is tapering its Treasury purchases, the private market is balking a bit at taking down this large Treasury security supply at current rates, rates are beginning to rise, and the most recent long duration Treasury bond auctions didn’t go so well, with quick rate increases and rather low bid-to-cover ratios.

On the surface, that’s not great for gold, because real rates are rising a bit. However, that’s where the third catalyst comes into play: formal yield curve control. In that scenario, which has been my eventual endgame expectation, the Fed will likely cap Treasury yields at some rate that they decide, let’s call it 1% on the 10-year Treasury and 2% on the 30-year Treasury as arbitrary examples, even as reported inflation and inflated expectations rise due to ongoing fiscal spending directly into the economy.

Between now and then, which is a very uncertain timeline (since it depends how the bond market behaves, how much fiscal spending the government does and how quickly they do it, what happens with the virus and consumer behavior, and so forth), real Treasury rates and consequently precious metal prices, could be quite volatile, and have already started to be.

If or when formal yield curve control happens, however, it can push real rates down to deeper negative levels than we’ve seen recently, as inflation eventually recovers and continues to outpace those capped yields by an increasingly wide gap. That scenario is basically the endgame for the liquid portion of my precious metals allocation in this particular cycle; we could very well see a big price increase during that time, and for lack of new catalysts at that point, I may be trimming my precious metal positions, depending on what there is to invest in elsewhere at that time.

However, the path between here and there is bumpy and uncertain, so some degree of rebalancing is likely warranted here, depending on each investor’s process and portfolio construction approach. In other words, investors should know what their timeline is and what their catalysts are.

As a fun fact, Warren Buffett’s Berkshire Hathaway (BRK.B) ([[BRK.A]]) released its 13F on Friday afternoon and reported that they bought precisely one new public stock in the second quarter of 2020: Barrick Gold (GOLD). All other changes to the public stock portfolio involved adding to or subtracting from existing positions.

It’s a rather small position in the grand scheme of the portfolio, but it was Berkshire’s largest public stock addition for the quarter, and the only new addition.

It’s kind of a quirky purchase by historical standards, since Buffett has historically not been favorable to gold. It is, however, somewhat on brand because Barrick is a profitable business that happens to mine gold, so they bought that stock rather than the metal itself. Given the size of the transaction (the holding is currently worth just over $560 million), it’s possible that Buffett himself wasn’t directly involved in the purchase, and merely approved it.

Still, as an investor who has owned Barrick since late 2018 starting at less than half of the current stock price, Berkshire’s purchase of Barrick stock was unusual enough to leave me scratching my head about the relatively late timing.

It does, however, mix well thematically with Berkshire’s much larger purchase of natural gas pipelines a little over a month ago. That purchase was nearly $10 billion, which makes it Berkshire’s biggest acquisition in years. It’s not part of their public stock portfolio. The Barrick stock purchase is chump change in comparison to that, but taken together, Berkshire has a bit of a hard asset commodity theme going on lately.

There are several catalysts that could affect stock market sentiment and economic data in the intermediate term. They could also affect the path of Treasury rates, as previously discussed.

Many of the traditional recession consequences haven’t been truly felt by many people yet, due to massive fiscal spending from the government to try to mitigate the impact.

For example, personal income and retail sales are up year over year, even as employment is way down, because the government replaced that lost employment income with transfer payments in the form of one-time helicopter checks and weekly extra unemployment benefits. Businesses at ground zero of the pandemic (travel, hospitality, restaurants, physical retailers, gyms, commercial real estate, and so forth) felt this recession strongly, but many other businesses and consumers have been sheltered from it.

However, with Congress currently in a gridlock and on recess, the economy rode off the fiscal cliff a couple weeks ago. Nearly 30 million people are no longer receiving those extra federal unemployment checks that they have been receiving for the past four months, and instead are receiving the normal level of state unemployment aid. Plus those one-time stimulus checks that both employed and unemployed people received are long-since spent.

Left unaddressed, this will eventually translate into more insolvency, such as a greater percentage of missed housing payments and a decline in overall consumer spending, and thus a possibility of W-shaped economic data, another deflationary shock, and more traditional recession effects being felt by more people. With the election coming up, I suspect that another fiscal round will be passed before then, but I’ll leave political forecasts to those that specialize in them.

Some indicators like the equity put/call ratio, or the Citigroup euphoria/panic index, are suggesting that equity markets are currently overbought, just as we begin to enter this uncertain fiscal/solvency environment. Be careful out there.

See also GBP/CHF May Find Weakness Into Year-End, Yet GBP FX Crosses Could Surprise In The Long Term on

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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