The Trump shock produced some unexpected market reactions, partly explained by investors buying into a risk-on argument, equities over bonds and buying dollars by selling other currencies and gold.
This is because President-elect Trump has stated he will implement infrastructure investment and tax-cut policies. If he pursues this plan, it will lead to larger fiscal deficits, and higher interest rates. The global aspect of the markets recalibration focuses on the strains between the dollar on one side, and the euro and the yen on the other, both still mired in negative interest rates. The capital flows obviously favour the dollar, and are putting the Eurocurrency markets under considerable strain.
Gold has been caught in the cross-fire, being a simple way for US-based hedge funds to buy into a rising dollar by selling gold short. While this pressure may persist, particularly if the euro weakens further ahead of the Italian referendum, it is essentially a temporary market effect. This article explains why this is so by analysing the next phase of the credit cycle, and the implications for interest rates and prices, which will be fuelled by higher US fiscal deficits in addition to China’s stockpiling of raw materials. It concludes that there are factors at work which were originally identified by Gordon Pepper, who was acknowledged as having the finest analytical mind in the UK Gilt market in the 1960s and 1970s.
Pepper observed that banks were consistently bad investors in short-maturity gilts, almost always losing money. The reason, he explained, was banks bought gilts when they were averse to lending, and sold them when they become more confident. This meant banks bought government bonds when economic confidence was at its lowest, bad debts in the private sector had risen, and interest rates had fallen to reflect the recessionary environment. These were the conditions that marked the high tide in bond prices.
As surely as day follows night, recovery followed recession. As trading conditions improved, corporate takeovers became common as businesses repositioned themselves for better trading prospects, and a period of increasing industrial investment followed. The banks began belatedly to sell down their gilt positions to provide capital for economic expansion. By the time banks felt confident enough to lend, markets had already anticipated higher demand for credit, as well as a more inflationary outlook. Inevitably, banks ended up selling their gilts at a loss.
Pepper had identified the mechanics behind bank credit flows between financial and non-financial sectors, an important topic broadly overlooked even today. Currently, the credit cycle has become prolonged and distorted, because most of the accumulated malinvestments that would normally be eliminated in the downturn phase of the credit cycle have been allowed to persist, thanks to the Fed’s aggressive suppression of interest rates. Consequently, bank credit was never reallocated from unproductive to more productive use, but has been added to and extended in the name of financial engineering.
Things are about to change. President-elect Donald Trump has stated that he will expand government spending on infrastructure and at the same time cut taxes, in which case he will set in motion a new expansionary phase for the US economy, leading to an additional increase in bank credit. The immediate effect has been to drive up bond yields and increase expectations of higher dollar interest rates.
This post was published at GoldMoney on DECEMBER 01, 2016.