Original author: Gwen
原文来源： Youbi Capital
About gold movements, U.S. bonds, interest rate cuts, balance sheet reduction and the U.S. election.
TL; DR
- Since the end of March, gold has decoupled from the US dollar, and both have risen. Mainly due to the recent excessive number of non-US geopolitical emergencies, uncertainties have led to a rapid rise in global risk aversion, and gold and the US dollar have shown safe-haven attributes at the same time.
- The fact that central banks, led by China, have begun to sell US bonds to boost gold hints at the trend of local confrontation with the hegemony of the US dollar and the uncertainty of demand for long-end US bonds. As other sovereigns have earlier expectations of interest rate cuts, such as Europe and Switzerland, if inflation remains high, the strengthening of the US dollar will continue.
- In the short term, due to the Fed's mid-year slowdown in balance sheet shrinkage, the Treasury Department's TGA balance increased more than expected in April, which will partially hedge the liquidity shock of the Treasury's bond issuance. Attention should be paid to the ratio of the amount of bonds issued by the Ministry of Finance to the ratio of short-term and long-term bonds.
- However, in the medium and long term, the U.S. debt crisis has not been lifted, the current U.S. government fiscal deficit rate soared, the suspension of the cap bill will end in January next year, the market is expected to maintain the same demand for bond issuance this year as last year, when the reverse repo is close to zero, the TGA account balance becomes a key indicator, and the bank reserve ratio should be vigilant.
- In the first two months of the election, due to the uncertainty of votes and specific policies, risk assets have historically tended to show volatility and decline. In order to maintain its independence, the Fed will maintain economic growth as much as possible in an election year and keep the market liquid.
- The U.S. economy is showing strong domestic demand, inflation is repeated, and recession expectations have fallen sharply from last year. Institutional expectations for "precautionary" interest rate cuts have been collectively adjusted to the second half of the year or even after the year. CME data indicates that the market expects a rate cut in September and November at a maximum of ~45%, while the expectation of the first rate cut in December and January is gradually increasing. Combined with the historical performance of interest rate policy in election years, interest rate policy before election month (i.e., September) is generally more cautious. In addition, the sufficient conditions for interest rate cuts are employment gaps and weak inflation, and it is necessary to be vigilant about the tightening of financial markets.
- At present, the Federal Reserve has considered slowing down the shrinking of the balance sheet in advance, and the market is generally expected to slow down the shrinkage of the balance sheet in May or June to hedge the liquidity crunch, and completely stop shrinking the balance sheet at the beginning of next year, and then usher in the balance sheet expansion cycle. At the same time, history has shown that there is a high probability of a pivot in the short term after the election.
1 Gold "decoupled" from the dollar
Figure 1: U.S. dollar vs. gold price chart
In the past, the trend of international gold prices was usually negatively correlated with the US dollar index, but since the end of March, the gold and US dollar indices have seen an abnormal rise in the same trend. The negative correlation can be explained by the three attributes of gold, namely commodity attributes, monetary attributes and hedging attributes, which need to be discussed together.
- Commodity pricing: A stronger pricing currency lowers the price of the priced item gold (the same goes for commodities)
- Financial attributes: Gold is a substitute for the US dollar and a potential substitute for the decline in the credit of the US dollar. When the dollar is weak, investing in gold may be able to achieve higher returns;
- Safe-haven attributes: Usually a stronger dollar indicates that economic fundamentals are strong, so the demand for safe-haven assets declines. But the U.S. dollar, as a world currency, also has safe-haven properties. Specific risks need to be discussed on a case-by-case basis.
1.1 Gold skyrocketed
The recent unusual rise in gold prices has attracted a lot of attention, and there are two main reasons for this.
1) Market risk aversion triggered by geopolitical wars. Moscow's air strikes, Israel's air strikes on the Iranian embassy in Syria (the direct trigger), Iran's direct attacks on Israel mainland, etc., are all causing the world to start to increase the demand for gold purchases, which is one of the drivers of higher gold prices in the short term.
2) Central banks continue to buy gold, boosting demand. In order to avoid the risk of U.S. bonds, some central banks began to reduce their holdings of U.S. bonds and increase their holdings of gold, thereby pushing up gold prices, which also reflects the crisis of confidence in the U.S. dollar, which may evolve into de-dollarization in the future. For example, China's central bank (PBOC) added 10t to its gold reserves in January, adding it for the 15th consecutive month, and now stands at 2,245t, up almost 300t from the end of October 2022, when it began to announce additional reserves again.
Figure 2: Global central bank buying trends
https://china.gold.org/gold-focus/2024/03/05/18561
1.2 The U.S. dollar index rose
1) The domestic demand of the U.S. economy is stable, which delays the expectation of interest rate cuts. The economic data of the United States in Q4 '23 shows that the current economy has a certain degree of resilience, and Q1 '24 shows that the current supply in the United States is in short supply and needs to rely on overseas import supply. In addition, the repeated inflation data reduced the need for interest rate cuts, and the demand for the dollar to stabilize the tightening of monetary policy prompted the dollar to rise.
2) The US dollar has risen passively due to the impact of international exchange rates, such as Switzerland's unexpected early interest rate cut. If there is monetary easing in other currencies, the exchange rate of the US dollar will rise against other countries due to interest rate differentials, which in turn will push the US dollar index higher.
3) As the world's currency, the US dollar undertakes part of the safe-haven demand. When the geopolitical crisis does not involve the US mainland, the safe-haven nature of the US dollar will be partially revealed, and at this time, it will have the same effect as gold.
1.3 Why are they both strong
Reason 1: Both the US dollar and gold have the attributes of safe-haven assets, and when sudden risk events occur in a concentrated manner, resulting in a worsening geopolitical crisis or economic crisis, the market risk aversion is too strong, and a situation of both strength will be formed. At the same time, gold's commodity and financial attributes have less impact than safe-haven attributes. For the US dollar, the US maintains a tight monetary policy, while the currencies of other economies weaken, supporting the dollar's strength. Similar situations have occurred in history, such as the failure of US foreign intervention in 1993, the European sovereign debt crisis in 2009, and the instability of the Middle East.
Reason 2: Although the US dollar has shown a short-term strengthening trend, the behavior of some central banks to reduce their holdings of US bonds and increase their holdings of gold also implies resistance to the hegemony of the US dollar.
From the perspective of gold trends, the trend of gold in the short term mainly depends on whether Iran will retaliate against Israel on a large scale, and if the geopolitical situation continues to deteriorate, then gold may continue to soar. Judging from the trend of the dollar index, some other sovereign currencies are now expected to cut interest rates earlier, such as the euro and the pound, while the Swiss National Bank has cut interest rates earlier. The U.S. dollar still has room for interest rate differentials and may still have some support in the future.
2 Liquidity risk is uncertain
2.1 Blocked market liquidity
Financial market liquidity is an important indicator for us to judge future market trends. The small bull market at the beginning of the year was also due to the liquidity of traditional funds brought by the BTC ETF and the dovish speech of the Federal Reserve, which led to a short-term increase in liquidity, and finally a pullback due to the lack of liquidity in the overall financial market.
Financial markets often measure market liquidity by the Real Liquidity Indicator = Fed Liability Size - TGA - Reverse Repo = Financial Institution Deposits + Money in Circulation + Other Liabilities. For example, in the chart, we can find that BTC has a positive correlation with financial liquidity indicators in the previous cycle, and even has a tendency to fit. Therefore, in an environment of abundant liquidity, the risk appetite of the market will be enhanced, especially in the crypto market, and the impact of liquidity will be amplified.
Figure 3: BTC vs. Financial Liquidity Indicator
The recent decline in the scale of reverse repo is mainly used to offset the decline in liquidity caused by the additional issuance of U.S. bonds and the Fed's balance sheet reduction, and the liquidity release in March was mainly contributed by the release of reverse repo. However, the scale of reverse repo continues to decline, and the Fed is currently shrinking its balance sheet at 95 billion per month. At the same time, in order to cope with the arbitrage space caused by low interest rates, the BTFP interest rate has been adjusted to not be lower than the reserve interest rate from January 25. After the arbitrage space narrowed, the use of BTFP turned back and could not further increase the size of the Fed's balance sheet. In addition, the current tax season in April, the short-term rise in TGA accounts has reduced overall market liquidity, with the median TGA account increasing by 59.1% month-on-month in April since 2010 and gradually returning to normal over time.
Figure 4: U.S. Financial Market Liquidity
To sum up, in the short term, the end of the tax season in May, TGA growth exceeded expectations, and the agency predicted that the Fed will start easing QT progress in the middle of the year to ease the liquidity tightening trend. However, in the medium and long term, the market lacks new growth momentum for liquidity, and the U.S. financial liquidity continues to decline due to the Fed's balance sheet reduction process and the scale of reverse repo is close to exhaustion, which will further affect risk assets, and the Bank of Japan's monetary policy adjustment will increase the uncertainty of liquidity risk, which will bring certain downside risks to technology stocks, crypto assets, and even commodities and gold.
2.2 U.S. Treasury Risk
The high volatility of U.S. bonds was an important trigger in the March 2020 "triple kill" event, and the recent surge in U.S. Treasury yields has once again exposed the potential imbalance between supply and demand in the U.S. bond market.
2.2.1 Oversupply
The deficit ratio reached -38% in 2023, up 10% year-on-year, and the soaring high deficit rate means that the demand for additional US debt issuance will be maintained this year. The fiscal situation of high debt and high deficits caused by the pandemic has been combined with the interest rate hike cycle, and the weighted average interest rate on total outstanding debt in fiscal year 2023 is 2.97%, which continues to increase the total amount of interest to be repaid in the United States. In 2023, there will be 2.64 trillion new U.S. bonds, and in 2024, 0.59 trillion new U.S. bonds, bringing the current total to 34.58 trillion.
In the short term, the refinancing expectations given by the Ministry of Finance on April 29 show a trend of additional issuance, and it is necessary to track the quarterly refinancing plan officially announced by the Ministry of Finance. Yellen may lower her financing forecast, despite the fact that the current Treasury TGA account has increased sharply to $205 billion more than expected due to an unexpected increase in the Treasury's tax revenue in April due to last year's wage rises.
In the medium and long term, the market generally expects that the United States will still issue 2-2.5 trillion bonds this year, and then 1.41-1.91 trillion will be issued this year, which is close to the average speed of Q1 in 24 years. In order to prevent a recurrence of the U.S. debt crisis, the Treasury Department has an incentive to issue sufficient U.S. debt to ensure short-term government spending and normal operations after the suspension is ended. Wall Street expects the U.S. government to continue issuing bonds in large quantities regardless of who wins the presidential election in November.
Figure 5: The scale of U.S. bond issuance
2.2.2 Weak demand
Foreign investors and the Federal Reserve are the largest buyers of U.S. Treasuries, accounting for half of the market share of tradable Treasuries. Although the Fed is currently considering slowing down its balance sheet reduction, it has stopped increasing its holdings of U.S. bonds for a long time since 2022, and the supply pressure has been passed on to domestic investors, and the amount of investment purchased by the residential sector has expanded significantly. Domestic investors are more inclined to short-term bonds, and the amount of debt is limited and volatile. Since the suspension of the debt ceiling in June 2023, the Treasury has accounted for 53.8% of the Treasury short-term bills (85.9% in Nov '23), and the Treasury Borrowing Advisory Committee has recommended that the proportion of short-term bonds should remain at 15-20%.
The Fed's balance sheet reduction process continues, and a total of 1016B has been reduced since Q1-23 Q4, which may slow down the balance sheet reduction process in the short term but will not suddenly turn. According to the March FOMC meeting, the FOMC unanimously agreed to halve the monthly balance sheet reduction, the MBS reduction ceiling remained unchanged, and the US Treasury tapering was lowered. If the Fed slows down the process of shrinking its balance sheet as scheduled in the near future, it will hedge some of the demand for long-term bonds.
Japan, China and the United Kingdom are the top three permanent buyers, with more than one-third of foreign investors holding U.S. bonds. Demand from major foreign investors, which picked up at the end of '23, has recently shown a downward trend again, especially with China selling $20 billion in US debt in the first two months of '24.
- The European Central Bank is expected to cut interest rates in June, the yen exchange rate depreciates sharply again and has not reversed the trend for the time being, and when the yen fell below the 150 mark in October 2023, the monetary authority chose to sell US bonds to maintain the stability of its sovereign currency exchange rate;
- Recently, U.S. inflation has been repeated, and some central banks represented by China have sold U.S. bonds to increase their holdings of gold, indicating that they are de-dollarizing and reducing the risk of asset depreciation.
- The uncertainty of the geopolitical crisis has also affected the demand for US bonds.
As a result, if the Fed slows down its balance sheet reduction ahead of schedule, the dollar will begin to weaken or geopolitical easing, or the demand for some long-end Treasury bonds may be restored.
Household sector bond purchases are volatile, with retail investors and hedge funds alleviating the current supply-demand imbalance. However, there is a cap on the purchase of domestic individual investors, and hedge funds are sensitive to interest rates, susceptible to market influences and the possibility of a large number of sell-offs, so the demand of the residential sector in the future has an upper limit and instability.
The liquidity buffer caused by larger short-term bonds comes from money market funds, which are characterized by flexible access and withdrawal, and the demand for overnight reverse repo or short-term treasury bonds with a maturity of six months is very small. At the same time, the floating loss of money market funds is easy to trigger a market run, so in more cases, they tend to choose overnight reverse repo with a more stable interest rate.
Money market funds have increased their holdings of short-term U.S. bonds by $203 billion after the ceiling on U.S. bonds was suspended in Q2 2023. By shifting ON RRP to meet some of the demand for short-term U.S. bonds, the reverse repo size will fall by 271B again in 2024, and Morgan Stanley expects the reverse repo scale to fall to zero in August, and the Fed will start tapering QT in June. However, it cannot be ruled out that the Fed will slow down its balance sheet shrinkage ahead of schedule and move the time point of the reverse repo scale to zero to Q4.
Figure 6: The size of the Fed's overnight reverse repo
In summary, there are many medium- and long-term factors that lead to supply and demand imbalances on both the supply and demand sides. If the Fed starts planning to slow down the balance sheet reduction process in May, the dollar starts to weaken or geopolitics eases, there is a chance to alleviate the US debt crisis from the demand side of long-term bonds. However, the downward trend of reverse repo scale will not be reversed in the short term, and after the reverse repo regulation is close to zero, the TGA trend will become a key indicator to release liquidity, and at the same time be wary of changes in the reserve ratio of U.S. depository institutions.
3 Trends in monetary policy
3.1 The impact of the U.S. election on risky assets
The biggest effect of the U.S. election on risk assets is the negative in the first two months (September-October) and the positive in the second month (December). The first two months are often risk-off due to uncertainty over the outcome of the election, and this is especially true in the most competitive years with low vote differences, such as 2000, 2004, 2016 and 2020. And after the election, the market is inclined to rebound as the uncertainty subsides. The influencing factors of an election year need to be judged in conjunction with other macro factors.
Figure 7: S&P 500 Index Direction Before and After Election Day, from JPMorgen
https://privatebank.jpmorgan.com/apac/cn/insights/markets-and-investing/tmt/3-election-year-myths-debunked
Bank of America analyst Stephen Suttmeier analyzed the average monthly return of the S&P 500 in an election year, and the results showed that the strongest month in an election year was usually August, with an average increase of just over 3% and a win rate of 71%. Subsequently. At the same time, December is usually the month with the highest profit opportunities, with a win rate of 83%.
Figure 8: Average annual election returns, from BofA analyst Stephen Suttmeier
https://markets.businessinsider.com/news/stocks/stock-market-2024-outlook-trading-playbook-for-crucial-election-year-20241
Market ImpactsIn addition to the uncertainty of the outcome of vote differences/partisanship battles, there are also specific policy differences among candidates. Biden and Tran will remain the main candidates in 2024, and their economic policies have also diverged greatly.
- Biden's re-election will basically maintain the status quo, continue to impose higher corporate taxes and ease the deficit, but the fundamentals are bearish for the stock market. At the same time, Biden retains greater independence for the Fed than Trump.
- Trump advocated across-the-board tax cuts while raising infrastructure spending, and in the last term, the effective tax on corporate income fell significantly, while the deficit ratio rose rapidly, which in turn increased the pressure on the US debt. At the same time, the coordination of monetary and fiscal policies may be strengthened, and the risk of inflation will persist for a long time, accelerating the erosion of US dollar credit.
3.2 Fed rate cut expectations
Normalization of interest rates depends on economic fundamentals (such as growth, employment, and inflation) and financial conditions. As a result, most market expectations for Fed rate cuts are "precautionary" in terms of the strength of the US economy or the degree of recession, although this approach is often susceptible to the Fed's capricious expectations management.
So does the U.S. economy need to be prevented? Judging from the current GDP data, the economy is stable, the possibility of recession is small, and the demand for preventive interest rate cuts is postponed. In the United States, the seasonally adjusted real GDP in the fourth quarter of '23 was revised at an annualized rate of 3.4% quarter-on-quarter, an increase of 0.2 percentage points from the previous one, and real personal consumption expenditures increased by 3.3% quarter-on-quarter, an increase of 0.3 percentage points. Although the GDP data for Q1 2024 has been revised down to 1.6%, the decline is mainly due to the high growth of imports and weakening inventories, indicating that the current domestic demand in the United States is still stable, and there is a market situation in which the internal economy is in short supply. As a result, major professional financial institutions have shifted their expectations for interest rate cuts, Goldman Sachs expects July, and Morgan Stanley also believes that after June, CICC predicts that the interest rate cut node will be postponed to Q4.
According to the latest pricing of CME interest rate futures, traders are now pricing in a 25bp cut of 28.6% in July, 43.8% in September and 43.6% in November. As a result, market expectations for a rate cut in September and November are similar, but expectations for the first rate cut in December and January are rising.
Table 1: Distribution of CME interest rate cut expectations, as of April 29, 2024
However, the coming of the rate cut window will undoubtedly require the non-farm payrolls gap and weak inflation data, that is, the economy will cool, or financial conditions will need to tighten again. The uncertainty comes from the November U.S. election, first of all, the Fed's change of monetary policy before the election is suspected of affecting the outcome of the election, so the distribution of changes in the federal funds rate in election years is smaller than in non-election years, and the decision to cut interest rates in September will be more cautious. At the same time, it is not ruled out that some Fed officials maintain a "dovish preference" in order to maintain growth and employment, and support interest rate cuts when economic data remains resilient. Historically, however, the past 17 U.S. elections and U.S. monetary policy studies have shown that the Fed has a low probability of pivoting before the election (before November of the current year), and a relatively high probability of pivoting shortly after the election, with only two instances of a shift from a rate hike to a rate cut within a year, and four times a Fed funds rate or monetary policy pivot immediately after the November election month.
In summary, the domestic demand of the U.S. economy is stable, inflation is repeated, and the interest rate cut forecasts of financial institutions are generally moved back to the second half of the year or even next year, CME data shows that the interest rate cut expectations in September and November are the largest, but the probability of December and January of the following year is rising. However, it is still necessary to be wary that the sufficient condition for a rate cut is a poor economy, so there may still be a tightening of financial markets before a rate cut is on. At the same time, interest rate and monetary policy (i.e., a rate cut in September) have historically been more cautious in the run-up to the election month, and a shift is more likely in the short term after the election month is over.
3.3 Fed balance sheet reduction cycle
Expanding the balance sheet is more effective than cutting interest rates?
At present, most of the market's attention is focused on the expectation of interest rate cuts, but in fact, the direct impact of the balance sheet expansion on market liquidity is greater than that of interest rate cuts. The market liquidity indicator mentioned above = Fed Debt Size - TGA - Reverse Repo Size. Balance sheet expansion means that the Fed expands its balance sheet and purchases assets such as Treasury bonds or mortgage-backed securities through liabilities to increase reserves in the banking system and money in circulation, creating money increments and directly expanding market liquidity, so it is also called "money printing". Interest rate cuts are to reduce borrowing costs, incentivize enterprises and individuals to increase investment and consumption, and transfer funds to risk markets to improve liquidity.
When will monetary policy be changed?
Progress in balance sheet normalization depends on the supply and demand of reserves, according to New York Fed President Williams et al. in their 2022 article "Scarce, Abundant, or Ample?" A Time-Varying Model of the Reserve Demand Curve: "The reserve demand curve is non-linear, measuring adequacy by the ratio of reserves to bank assets, 12%~13% is the critical point of overabundance and moderate adequacy, and 8%~10% is the warning line of deficiency. "Financial markets tend to be non-linear, and this is reflected in the market, where the reserve ratio fell rapidly to 8% after approaching 13% in 2018, to 9.5% when the Fed announced a reduction in its balance sheet, and finally restarted its balance sheet expansion in October 2019.
Figure 10: Ratio of bank reserves to total assets of commercial banks
The current U.S. reserve ratio of 15% is still in a state of overabundance, and will continue to decline as the liquidity crunch reverse repo scale is depleted to zero. Goldman Sachs expects to start reducing QT in May and end in Q1 2025. Morgan Stanley believes that QT will be completely closed by early 2025 when the scale of reverse repos is close to zero. CICC predicts that the tipping point will be reached in Q3, and if the Fed cuts the pace in May, the threshold can be postponed to Q4. At the same time, the Fed has historically tended to pivot money in the short term after the U.S. election month ends.
In summary, the Fed has signaled that it is considering slowing down its balance sheet reduction, and the market generally predicts that it may slow down its balance sheet reduction in May or June, and that it will stop shrinking its balance sheet at the beginning of next year to end QT, and then usher in a balance sheet expansion cycle. The current risk uncertainty is still due to the increase in the supply of U.S. Treasury bonds, and the scale of reverse repo is close to zero, which has led to significant volatility in the U.S. Treasury market. In particular, the stability of the economy is particularly important in an election year, and the Fed may stop shrinking its balance sheet early and bring forward the balance sheet expansion schedule in order to avoid a repeat of the 2019 "repo crisis" in the market.
4 Summary
Gold and the U.S. dollar have both risen recently, and in addition to geopolitical surprises, we should pay attention to the trend of some central banks selling U.S. bonds to increase their holdings of gold, suggesting local de-dollarization.
In the short term, as the increase in TGA balances and the expectation that the Fed will ease its balance sheet reduction will partially hedge the liquidity crunch caused by U.S. bond issuance, it is also necessary to keep an eye on the total amount of refinancing to the ratio of short-term and long-term bonds in the second quarter. In the medium to long term, the imbalance between supply and demand of U.S. debt has not been cured. Due to the high deficit ratio and the bill to stop the suspension of the cap next year, there will still be a large demand for US Treasury issuance in 2024. The reverse repo scale will continue to decline, and after that, we should keep an eye on the trend of TGA balances and the non-linear decline in bank reserve ratios.
Domestic demand in the U.S. economy is stable but inflation is repeated, and interest rate cut expectations are generally postponed until the end of the year. The expectation of stopping balance sheet reduction remains unchanged at the beginning of next year for the time being. Historically, monetary policy has tended to be vigilant in the run-up to the U.S. election, with a relatively high probability of pivoting short-term after the election.