Gold, USDX: Did Powell Spoil The Party?

The party was just gathering steam, and then… Powell entered the ultimate spoilsport, making the Fed dovish again. How long till he gets kicked off?

The War on Debt

With Jerome Powell, Chairman of the U.S. Federal Reserve (Fed), struggling to adequately define “transitory” during his press conference on Jul. 28, the market narrative has shifted from ‘hawkish Fed’ to ‘dovish Fed.’ And with the U.S. dollar bearing the brunt of investors’ wrath, the ‘all-clear’ sign flashed in front of the PMs. However, with post-Fed rallies mainstays in the PMs’ historical record, the recent euphoria is much more semblance than substance. Thus, while Powell’s persistent patience elicits fears of financial repression, today’s economic environment lacks many of the qualities that made the gambit viable in the past.

To explain, financial repression includes measures such as direct government financing (the Fed prints money and lends it directly to the U.S. Treasury), interest rate caps (yield curve control), and extensive oversight of commercial banks (reserve requirements, controlling the flow of credit). In a nutshell: governments use the strategy to keep interest rates low and ensure that they can finance their debt. And with the U.S. Federal debt as a percentage of GDP currently at 128% (updated on Jul. 29), some argue that’s exactly what’s happening. Moreover, with the U.S. 10-Year real yield hitting an all-time low of -1.15% on Jul. 28, is the Fed simply turning back the clock to the 1940s?

To explain, during World War Two, surging inflation helped the U.S. government ‘inflate away’ its debt. Think of it like this: if an individual borrows $100 at a 2% interest rate and repays the balance in full after one year, the total outlay is $102. However, if inflation is running at 4% (negative real yield), putting that money to work should result in an asset that’s worth $104 by the end of the year. As a result, the individual nets $2 (104 – 102) due to the inflation rate exceeding the nominal interest rate. And as it relates to the present situation, if the Fed keeps real yields negative, then asset price inflation and economic growth should outpace nominal interest rates and allow the U.S. government to ‘inflate away’ its debt.

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