What’s Next?

Golden rules: What is the move in gold telling us, as it marches ever closer to 3000? It may not be parabolic, but gold is spiking. Historically money moves into this safe-haven store of value when other asset classes are seen as more volatile, harder to gauge, and vulnerable to inflation. We believe it’s a far better risk indicator than an artificially low VIX. Investors are looking for a place to park capital in recognition of perceived risk in other asset classes that could be an early warning sign before a potential equity buying climax. 

Bessent Turning Japanese

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Treasury Secretary Scott Bessent said that the Trump administration will respect Fed independence, but their reasons for doing so make us nervous. He said that Trump’s focus is on 10-year Treasury yields, not monetary policy (which controls short rates). This recalls Japan’s Yield Curve Control policy, which also focused on the 10-year yield. However, Japan tried to increase 10-year yields to help banks stay profitable, while Bessent’s strategy of keeping 10-year yields as low as possible could end up hurting U.S. banks.

The administration said it will not interfere with the Fed’s decisions, but this new directive to focus on long rates sets up an eventual collision. The current mix of government securities auctioned quarterly by the Treasury comprises over 20% in Treasury Bill maturities, roughly twice the amount auctioned 10 years ago. Bessent has been a vociferous critic of Janet Yellen’s policy of auctioning too many short-term securities. Still, the Treasury just announced that they are keeping Yellen’s oversized Treasury Bill auction schedule “for at least the next several quarters.” To reach his new goal of capping 10-year yields, Bessent cannot sell more 10-year notes, or else the heavy supply would push the rate higher. Therefore, he is locked into depending on short rates staying low, which is the Fed’s domain.

This is a precarious strategy to depend so heavily on issuing short-term paper. If short rates rise, the federal interest expense will blow through the roof, reversing any hopes of narrowing the deficit through more efficient spending initiatives. A wider deficit will increase term premiums, and that certainly will push the 10-year above 5%, leading to a stock selloff. That scenario could result in the administration either desperately cutting essential spending, which could depress growth, and undoubtedly set up an attack on the Fed as a scapegoat.

When Doves Cry

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Chicago Federal Reserve Bank President Austin Goolsbee is a well-known dove, consistently supporting easy monetary policy. However, when this Federal Open Market Committee (FOMC) voter spoke last Wednesday, he was downright alarmist. He warned of “new challenges to the supply chain” stemming from wide-ranging tariffs. Goolsbee repeated what the head of the Bank of Canada said: tariffs generate supply chain pressures that trigger longer lasting inflation. If the U.S. government pursues global tariffs, supply chain problems could become deeply rooted. Remember, the Fed underestimating how far-reaching the supply chain issues had spread in 2021 led to a major policy error by not raising rates sooner.

Goolsbee is concerned “the impact on inflation might be much larger this time.” He agreed with our view that the most damaging property of tariffs is the danger of raising inflation expectations. He may have reflected the general sentiment at the FOMC by saying the “effects of tariffs on prices may be less important than the possible impact on expectations.” 

Where does that leave us? This means that the central bank would be ill-advised to “look through” the temporary inflationary effects caused by tariffs and wait for transitory inflation to blow over. Holding off from rate hikes was one of the two recommendations laid out in 2018 when the central bank last examined Trump’s tariff policy. The other was to raise rates and cause a recession. Given the lessons learned from the pandemic two years later, the thought of delaying rate hikes in 2025 is unlikely. Note what we said in our first Point: our budget deficit is extremely sensitive to rising short rates, which will cause long rates to rise, resulting in a stock selloff. Therefore, rate hikes are the last thing investors need, but when previously dovish FOMC members turn cautious, it may be unavoidable.

More is Less

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Well, it appears that there is something uniting both parties; the University of Michigan’s Survey of Consumers fell, with Republicans and Democrats both posting lower confidence for the second straight month. But that was not even the worst news: the jump in inflation expectations was so severe that it is certain to catch the attention of the FOMC. Just as Chicago Fed President Goolsbee had warned, the most damaging effect of tariffs lies in pushing inflation expectations higher, and that is what will get the Fed leaning toward rate hikes, not cuts.

This is the new market driver. One-year inflation expectations saw the fifth-largest jump in the survey’s 14-year history. Long-run inflation expectations rose to 3.3%, the highest level since 2008’s high of 3.4%. Aside from the two 3.4% readings in 2008, the latest release is the highest level in 30 years.

The Fed is very concerned about long-term inflation expectations and weighs consumer polling data more heavily than fixed income market data. Even so, they follow the 5-year breakeven inflation rate that just hit its highest level since March 2023. It is more than a coincidence that the increase in inflation expectations occurred with tariff headlines, and the next key release is the Conference Board’s  Consumer Confidence report on February 25. The FOMC will have two more inflation expectations readings from the Michigan Survey before their March 18-19 meeting. Equity and bond markets will move on those numbers and will be sensitive to any Fed comments regarding inflation expectations.

What to Look for This Week

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1. Wednesday, February 12 at 8:30 a.m. E.S.T. January Consumer Price Index. Because the Fed has communicated the likely result is no rate change for the March 18-19 FOMC meeting, this number would have to be a surprise to impact markets significantly. The H2 2024 data range for annualized core CPI was 3.2%-3.3%. The Cleveland Fed’s Inflation Nowcast forecasts a 3.1% reading, which would be the lowest inflation rate since Core CPI peaked at 6.6% in September 2022. As low as 3.1% sounds, the last pre-pandemic reading of 3.1% was 30 years ago.

2. Thursday, February 13 at 8:30 a.m. E.S.T, January Producer Price Index. While this data will be a non-event, we list it because PPI will become more important than CPI for us going forward once tariffs are applied, because we will get a sense of how intermediate goods that are imported by manufacturers are impacted by tariffs. We will have to wait until March for the February report to see any impact. November and December Core PPI has risen to its highest level since March 2023, so any January increase (before tariffs hit) will be a negative in bond and stock markets.

3. Tuesday, February 11 at 6:00 a.m. E.S.T. The NFIB Small Business Optimism Index for January is released. As most small business owners lean Republican, there was a massive 8-point spike higher when the November Survey was released, and it was followed by a strong 3-point rise in December. It will be interesting to see the January headline number to see whether the gains continued and what subcomponents changed. 

FOMC Voters Speaking: Jerome Powell’s semi-annual Humphrey Hawkins Testimony is the major highlight this week. The Fed Chair speaks starting at 10:00 a.m. E.S.T. both on Tuesday, February 11 to the Senate Banking Committee and Wednesday, February 12 to the House Financial Services Committee. NY Fed President John Williams speaks Tuesday, February 11 at 3:30 p.m. E.S.T. and at the same time, Fed Governor Michelle Bowman speaks to a Bankers Association. Finally, on Wednesday, February 12 at 5:05 p.m. E.S.T. Governor Christopher Waller speaks, but it is on Stablecoins, but it is after CPI, so it could attract some attention.