Posted March 15, 2023
By Jim Rickards
The Fed Finally Broke Something
It’s often said that the Fed raises interest rates until something breaks. Well, something has broken.
The collapse of Silicon Valley Bank (SVB) has really thrown Jay Powell and the Fed for a loop.
Just last week, Powell issued some very hawkish testimony before Congress about the need to maintain an aggressive stance against inflation. Markets were even factoring in an 80% chance of a 0.50% rate hike at next week’s FOMC meeting.
But what a difference a week can make.
Today, the market is giving zero chance of a 0.50% rate hike. Literally zero odds. The odds of a modest 0.25% rate hike are now 70%.
I agree with that prediction, incidentally. I believe the Fed will raise rates by 0.25%.
Let’s not forget that the Fed itself is partly responsible for the SVB collapse (aside from terrible risk management by the bank itself).
The Fed “Broke Something”
The Fed’s aggressive tightening since last March has put upward pressure on bond yields, which has driven down the value of the bonds themselves (remember, bond yields and bond prices move in opposite directions).
SVB held an exceptionally large amount of longer-duration government bonds, which are especially sensitive to interest rate increases. SVB’s balance sheet was taking great losses as the prices of the bonds in their portfolio were falling.
I’m not going to get too deep into the weeds about the specifics of SVB’s collapse, but falling bond prices resulting from higher yields played an underlying role. And that’s how the Fed factored into the collapse.
The Fed “broke something.”
SVB obviously isn’t the only bank holding these long-duration government bonds. So is the Fed going to continue to aggressively raise rates and risk more bank failures, even potentially another financial crisis? Not likely.
The Fed has to ensure that the banking system is sound, or at least as sound as it can be in today's hugely distorted financial world.
That means backing off on its plans to tighten. That means the Fed is going to have to let inflation run. That means a weaker dollar.
I'll be writing a lot more about SVB and the ripple effects in the weeks and months ahead. For now, let’s zero in on one particular asset class that always comes to the fore in times of financial stress — gold.
The Golden Constant
Gold and other commodities never go away. Whether it's gold, silver, oil, natural gas, copper or agricultural goods, these goods will always be in demand and should always be on an investor's list of possible alternatives to stocks, bonds and cash.
In the past, I have always recommended a large allocation to cash as a way to weather financial storms. I still do. But now we have to add a warning about being highly selective in your choice of banks.
Right now, commodities such as gold are overwhelmingly priced in dollars on world markets. This does not mean that every transaction is conducted in dollars, but commodities are priced in dollars.
If you're paying in any other currency, you have an exchange rate issue; you'll pay an amount in some other currency (the Canadian dollar, the Australian dollar, the euro or the British pound, etc.) that equals the dollar price based on current exchange rates.
Currently, there are important movements around the world to abandon the dollar as a medium of exchange. This has to do with the dollar's role as a payment currency. There's a difference between the roles of a payment currency and a reserve currency.
The Dollar’s Role
The dollar’s role as a reserve currency is not in immediate jeopardy, although it will diminish in the long run. But there are numerous efforts to replace the dollar as a payment currency.
Saudi Arabia and China are discussing the use of the Chinese yuan, CNY, to pay for oil. The BRICS+ are actively considering a new commodity-backed payment currency for use among their members. Other multilateral organizations are doing the same.
As payments move from dollars to other currencies, the exchange value of the dollar should decline, and the exchange value of the other currencies (mostly the euro) should go up. This means that the dollar price of commodities will go up as the exchange value of the dollar goes down.
This is basically inflationary. Still, inflation can be a good thing if you're the owner of hard assets including gold. The U.S. dollar value of those assets should rise.
While gold and silver are money substitutes (or actual money), this does not mean that the commodity price inflation will be limited to gold and silver. We'll see it in:
Gold, silver, oil, natural gas, water, copper, strategic metals, agricultural produce, farmland and other commodity assets. Mining stocks are definitely in the mix.
Gold Is the Canary in the Coal Mine
The price of gold tends to move (either way) far ahead of the pack. But investors are by no means limited to gold. I watch gold because it's the best way to track the dollar. But once we see a weaker dollar (higher dollar price for gold), there are hundreds of ways to play that trend.
By the way, there's a conundrum in all of this that is hard to grasp at first but should prove valuable to investors. When people ask if the dollar is going up or down, I ask them, "Compared with what?"
The point is that on a given day it's entirely possible for the dollar to be up against the Japanese yen and down against the euro at the same time. This is one reason analysts use dollar indexes such as DXY and Bloomberg’s because they blend all of the currencies together in a basket.
Still, there's still a problem because you're always comparing currencies with currencies. That won't help you much if there's a global financial crisis (starting with SVB?) and confidence in all currencies is under threat at the same time.
That kind of panic might not even show up in the index. It's like ten people who jump out of an airplane and hold hands. They're not moving at all relative to each other but they're all falling at the same rate relative to the ground.
What is the ground in this analysis? It's gold. Since gold is not a central bank currency, it's the only way to measure the dollar objectively.
This means that you can well have a situation where the dollar index is getting stronger (that's happening now in the U.S. Dollar Index), but the dollar price of gold is going up (meaning the dollar is getting weaker). So, the dollar is getting stronger (compared to the index) and weaker (compared to gold) at the same time.
The solution to this conundrum is that all currencies are getting weaker compared to gold, but some are getting weaker faster, which can make the dollar index rise.
My recommendation in a financial panic: keep your eye on gold.