Tocqueville's Hathaway on Gold: The Fed is ‘Caught in a lie’

During the first half of 2017, gold bullion rose 7.75% while the XAU (Philadelphia Index of Gold and Silver Stocks) rose 2.79% (including dividends). Among the notable developments of the first half were the pronounced weakness of the trade-weighted US Dollar (down 6.44%) and the continuing sluggishness of the US economy, both of which call into question the wisdom, feasibility, and credibility of the Fed’s push to tighten credit.

US dollar weakness was completely unexpected by the investment consensus, as reflected in record speculative euro shorts at year end (see chart below). The misreading of the currency outlook by numerous well-known and highly regarded investment thought leaders suggests to us that other important components of the macro and market outlook may have also been misjudged by both the investment consensus and policy makers.

We believe that the Fed’s view of economic activity is not rooted in reality (see Q1 commentary), and that its stubborn pursuit of interest-rate hikes is likely to precipitate a bear market in equities and bonds. Under the headline “Economic Conditions Signal Recession Risk,” Greg Ip wrote in the July 6 WSJ, “If you drew up a list of preconditions for a recession, it would include the following: a labor market at full strength, frothy asset prices, tightening central banks, and a pervasive sense of calm. In other words, it would look a lot like the present.”

Because of strong financial markets, investor interest in gold remains subdued. In our opinion, revival of interest will be closely related to financial-market damage of sufficient magnitude to shake prevalent investor complacency, best reflected in persistent record-low readings in volatility (VIX index). A mean-reverting VIX would in our opinion cause the Fed to abandon any pretense of monetary tightening. An unexpected U-turn in monetary policy would almost certainly cause precious metals prices to surge.

Financial-market complacency seems (inexplicably, to us) to be based on confidence in a continuing economic expansion and a smooth transition (meaning pain-free in terms of market damage) to normalization of monetary policy and interest rates. We believe that these two expectations are incompatible and unattainable simultaneously. In fact, we believe that the likelihood of either occurring is miniscule.

At the spring 2017 Grant’s conference, Peter Fisher (former manager of the NY Fed System Open Market Account, and now senior lecturer at the Tuck School of Business at Dartmouth) stated, “It appears to me that the Fed and other central banks have avoided being candid about the uncertainty [of the transmission mechanism of monetary policy and the challenge of decision-making in conditions of uncertainty] in order to maintain their credibility.” He went on to say, “normalizing monetary policy will require that the Fed disown the idea that the level of wealth (i.e., financial-asset valuations) is an appropriate objective of monetary policy,” and further, that “forward guidance is the process through which the Fed – through its more explicit influence on the expected rate of interest – becomes the much more explicit owner of the ‘conventional valuation’ of asset prices.”

Stated another way, and in far less erudite terms, the Fed owns the stock market. The institution’s credibility has in our opinion become inseparable and indistinguishable from financial-market stability. This less-than-“candid” institution cannot afford a major downdraft in financial-asset values. It is caught in the lie that the institution’s supposedly superior and privileged knowledge hold the key to future prosperity, economic growth, and policy normalization. The price of an honest reassessment would risk calling into question the extreme policy measures undertaken since 2008.

It is not farfetched, in our opinion, to suggest that the Fed and other central bankers, as Mario Draghi has famously stated, will “do whatever it takes” to maintain the illusion of wealth created by radical monetary measures, including market-rigging practices. The evidence in the table below suggests strongly that central-bank trading rooms have begun actively to defend key market support levels. The maximum drawdown for the S&P 500 in 2017 is the second lowest on record since 1928.