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by Giza Capital Research

An increasingly hawkish Fed leads Giza Capital to believe that the Fed has made defending the relative strength of the US Dollar in global stagflation its #1 priority for the short-term.

From a credibility standpoint, the US cannot allow its currency’s value to go down relative to other regional reserve currencies (such as the Pound, Euro, and Yen) or gold (the alternative Tier 1 asset for central bank reserves).

As astutely pointed out by Joseph Wang (a former trader at the NY Fed’s actual trading desk) in his recent article “Solvency Constraints,” the other regional reserve currencies have less room to increase rates due to the higher relative indebtedness of their respective economies, hence they have “solvency limits” (as he terms the dire financial situations in those regions); they have to sacrifice one of these three things: (1) their currency strength, (2) bond market stability, or (3) GDP.

For example, we saw cracks in the UK Gilts market as a result of the Bank of England trying to increase rates to fight inflation, but the “bond vigilantes” sniffed out the implication of such a move; the Bank of England had to step in and do an emergency bond purchase to stabilize yields.

Here is our speculation. The inability of other central banks to increase rates greater than those increases by the Fed, would imply that a relatively strong dollar will help meet the supply of bonds created by the Fed’s balance-sheet reduction program, due to the relative weakness of other sovereign issues.

Think about it … if you’re a a foreign purchaser of sovereign bonds and you have the choice between a relatively higher interest-bearing bond (i.e. 10 year Treasuries), denominated in a relatively stronger currency (i.e. USD) versus bonds issued by the UK, EU, or JP, you’d rather purchase the dollar-denominated sovereigns. In such a scenario, you as the bond purchaser, get more value for your money if you buy US-Treasuries, rather than other sovereign bonds.

Theoretically, the Fed can have its cake and eat it, too, so to speak. By keeping the relative strength of the Dollar high, it can decrease their balance sheet without causing a major supply-demand imbalance problem in the US Bond market and tame inflation; it can preserve both its bond market and currency. For the other regional economies and their respective central banks, it is highly likely that something may break, because they don’t have such a luxury.

So if you’re considering alternatives, why not purchase gold, instead of US Treasuries? In this stagflationary environment where your nominal bond yield is less than official inflation, shouldn’t you be better off with an inflation hedge, possibly gold?

Gold has a lot of misconceptions as to how it relates to various macroeconomic conditions. Some believe that gold is an inflation hedge, some believe that gold is correlated to “fear” or financial panic. Empirically, both beliefs are not exactly true. For some great information on understanding gold’s behavior, we highly recommend that you read the in-depth research paper, “Gold Price Framework Vol. 1: Price Model” by Stefan Wieler & Josh Crumb over at Gold Money. [N.B. We have no affiliation with Gold Money.]

In their paper, they correlate gold’s monthly price movements most closely with net central bank demand, long-dated energy futures, and inverse of real rates expectations against the 10-year Treasury (i.e. gold prices are inversely related to real yields on the 10-year). In an environment where real yields are negative and energy prices are higher, it would make sense that gold should outperform, but the strong dollar policy (of a hawkish Fed, determined to raise rates) and moderating demand (which is a headwind to energy prices) leads us to believe that in the future, real yields will become less negative; Chair Powell himself stated at the November FOMC Meeting Q&A that it would be ideal for yields to be positive across the entire curve. Such developments are not bullish for gold.

N.B. However, we cannot ignore the tangible possibility that geopolitical factors,black swans, or a failure by the Fed to actually tame inflation, could lead to even higher inflation, which would mean that relative to today’s level of rates, real yields could become even more negative, hence be a bullish factor for gold.

^Above is NOT investment or financial advice.