Financial Market Equivalent of the Big Bang?

The confiscation of Russian reserves and the Russian response — unleash a chain of events leading up to the financial market equivalent of the "Big Bang"? 

An excellent Doomberg article3 states that a "singularity" or Big Bang means that what "transpires on either side is unknowable from here." If so, the financial market playbook following the Global Financial Crisis, in which the Fed provided liquidity through expansion of its balance sheet by driving financial asset valuations to unheard of extremes, must be tossed aside. 

Fed policy would no longer be the fulcrum of financial markets. Counterparty distrust would disconnect real assets from nominal claims. A financial market Big Bang could trigger a long-term decline in the financialization of commodities, including gold.

The traditional framework for understanding the economy, inflation, interest rates and other macroeconomic forces assumed an international order based on the U.S. dollar as the primary reserve currency. 

The Russia-Ukraine War could mark a tipping point that significantly diminishes the pool of offshore capital to finance U.S. deficits. The repercussion would be a severe mismatch between supply and investment demand for U.S. Treasuries. Two additional factors will exacerbate the mismatch: aggressive Fed balance sheet reduction and unexpectedly high deficits caused by the impending recession.

The Fed's Torturous Path

Given the negative supply and demand picture against a backdrop of persistent high inflation, one must ask, how high do interest rates need to rise to compensate rational investors? That level is most likely greater than whatever the Fed has determined to be the so-called "neutral rate." It is likely to be high enough to cripple the economy and deflate financial assets. 

The road to equilibrium interest rates promises to be far more torturous than that contemplated by the investment consensus. Thanks to Putin's currency gambit, that road has become the central investment issue of the moment. The belief that Fed policies are adequate for the task seems highly flawed. Respected observers, including Mohamed El-Erian,4 have concluded that it will be impossible for the Fed to thread the needle between taming inflation and causing a recession.

Since the June 2021 Federal Open Market Committee (FOMC) meeting, the prospect of higher interest rates, as per the policy design of the Fed, has been the major headwind for gold. We now believe that rising rates, driven by market forces, will become the tailwind. Investors have been able to overlook the negative investment outlook for debt and interest rates as long as the Fed and foreign investors have absorbed the flows. Now that these two sources of demand could be drying up, they may not be able to handle the truth.*

The state of U.S. sovereign debt is precarious and can no longer be swept under the rug. U.S. debt-to-gross domestic product (GDP) is now the highest in history (Figure 4). The stage is set for a significant devaluation of the U.S. dollar against gold, in our opinion. Investors must act accordingly.

In conclusion, it is our opinion that the investment fundamentals have improved dramatically for gold. That is why, in our opinion, significant upside lies ahead for gold bullion and gold mining equities (Figure 5).

Figure 4. U.S. Federal Debt to U.S. GDP (1789-2022)


Source: MacroTrends and Bloomberg as of October 2021, the latest available data at the time of writing. Reflects the average of debt/GDP per calendar year, with the exception of the October 2021 data point. Included for illustrative purposes only. You cannot invest directly in an index. Past performance is no guarantee of future results.

Figure 5. Gold Miners Offering Deep Value versus Gold Bullion (1987-2022)

Gold mining equities are now near a 35-year low vs. gold.

- Source, Sprott

Sprott Assets: Putin's Gambit

Gold has been driven by problematic inflation, prospects of a recession, excessive public and private debt, widening credit spreads, the onset of a bear market in equities and bonds, and a growing loss of confidence in the Federal Reserve ("Fed"). Our commentaries on these matters can be found in my previous Insights commentaries.

In our opinion, the gold price, despite its strong rise over the past two years, still fails to adequately reflect these risks. 

In nominal terms, the March 31, 2022, gold price of $1,937 exceeds the previous monthly average high of $1,825 set in August 2011 but still lags the inflation-adjusted equivalent of $2,328 based on the August 2011 high (Figure 1). 

The price of gold has been treading water for 10 years while the investment fundamentals have improved dramatically. That is why, in our opinion, significant upside lies ahead for gold and related equities.

Figure 1. Gold and Inflation-Adjusted Gold Price (Since 2011 Peak)


Source: Bloomberg as of 3/31/2022. 

Gold Spot Price measured by GOLDS COMDTY. Inflation-Adjusted Gold Price calculated by taking the spot price of Gold on 8/31/2011 ($1,826) and adjusting it by the month-over-month consumer price index (CPI CHNG INDEX). Included for illustrative purposes only. You cannot invest directly in an index. Past performance is no guarantee of future results.

Putin's war introduces yet an additional reason to stoke investment demand for the yellow metal. It is not only war in the kinetic sense, but the reserve currency and cyber aspects that have far-reaching implications for gold. Ukraine has elevated a long-simmering currency war to center stage. The dominance of the U.S. dollar (USD) as a global reserve currency — which represents ~59% of the world's allocated reserves (Figure 2) — has been contested for more than a decade, but the Russia-Ukraine War significantly ratchets up anti-dollar hostility. The end result could be the full exposure of the woeful state of U.S. credit.

Sanctions Against Russia Undermine the U.S. Dollar

The weaponization of the dollar "refers to the U.S. government's exploitation of the currency's global dominance in order to extend the extraterritorial reach of U.S. law and policy." 1 Longstanding objections to the U.S. dollar's reserve status include critics from not only China and Russia but most of the "Global South" countries and even European allies. Conflict in the sphere of currencies is beyond the power of any single nation or group of nations to control. In this domain, Fed policy is irrelevant.

Figure 2. World – Allocated Reserves by Currency Q4 2021


Source: IMF. Included for illustrative purposes only. Past performance is no guarantee of future results.

To counteract Russian aggression in Ukraine, Western countries imposed unprecedented sanctions that included confiscation of Russian financial assets and property held in Western jurisdictions. "The U.S., Europe and Canada pledged Saturday [February 26] to prevent the Central Bank of the Russian Federation from deploying its $630 billion stockpile (60% of its international reserves) 'in ways that undermine the impact of our sanctions,' they said in a joint statement Saturday." 2

In the opinion of many, including ours, this step delivered a critical blow to trust in paper currencies and in the safety of assets entrusted to Western financial institutions that may be impossible to restore, absent a complete shakeup of existing international conventions.

The Russian response announced on March 28 and April 3 circumvents the U.S. dollar to settle international trade. Russia temporarily pegged gold at 5,000 rubles per gram or $1,300/ounce at the time of the announcement. In the weeks following the announcement, the ruble rallied 73% to recover substantially all of the damage inflicted by the sanctions announced on February 26. 

Once the ruble revalued in line with prevailing USD gold prices, the Central Bank of the Russian Federation removed the peg but the message was loud and clear: Russia is prepared to back its currency with gold, as or when needed. 

Using a ruble-gold peg as a reference price, the U.S. dollar has been cut out of the trade loop. To import energy from Russia, buyers must pay either rubles or gold. Sellers will no longer need to park proceeds in U.S. Treasuries.

The Russian model for selling strategic raw materials sets an example for other nations with divergent political interests and currencies to follow. To the extent that the Russian prototype is imitated, it will erode trade denominated in USDs and shrink the pool of offshore capital forced to recycle U.S. domestic deficits by investing proceeds in U.S. Treasuries. 

Widespread adoption of the Russian model would expose the perilous state of U.S. creditworthiness and drive up interest rates independent of any design by the Fed.

- Source, Sprott Asset Management

Inflation Still Surprisingly Uncertain

In April, inflation continued to be the main narrative as global inflation data posted multi-decade highs, and global central banks started hiking aggressively. Expectations for more hawkish Fed hikes have reached three 50-basis points hikes and a total of 275 basis points of tightening to year-end. If the Fed can deliver such an aggressive, brute force attack on inflation, it may likely lead to collateral damage and consequences. 

But with 8.5% inflation, a little demand destruction will not be sufficient. Despite the fixation and focus on inflation for more than a year, there is surprisingly little consensus on the inflation outlook. Figure 2 highlights that inflation surprises are still elevated and that the level of uncertainty is likely to continue to increase. Looking ahead, inflation and expectations will continue to rile markets.

Figure 2. Inflation Surprise Index and Inflation Uncertainty Index (2005-2022)


Source: Bloomberg and Sprott Asset Management LP. Data as of 4/30/2022. Included for illustrative purposes only. You cannot invest directly in an index. Past performance is no guarantee of future results.

… And Stagflationary Pressures Still Rising

Global GDP saw further downward revisions for 2022. The IMF downgraded 2022 global GDP from 4.4% to 3.6% and the World Bank lowered its estimates from 4.1% to 3.2%. The effects of the Russia-Ukraine War, now entering its third month, continue to ripple through supply chains, commodity markets, trade and financial linkages. With few signs of a resolution or end, spillover effects will likely continue to accrue. Globally, inflation pressures continue to rise and inflation indices are reaching new all-time highs. Figure 3 highlights the growing global stagflationary stress: Rapidly increasing inflation expectations and GDP expectations tumbling.

Figure 3. Global Stagflation Pressure is Accelerating (2021-2022)


Source: Bloomberg and Sprott Asset Management LP. Data as of 4/30/2022. Included for illustrative purposes only. You cannot invest directly in an index. Past performance is no guarantee of future results.

Unprecedented Drawdown on Bonds

During the May 4, 2022, Federal Open Market Committee (FOMC) meeting, the Fed will announce its quantitative tightening (QT) or balance sheet runoff/reduction schedule. The expectation is that the runoff caps will be larger and quicker, and when combined with aggressive rate hikes, it will likely lead to a policy of tightening that is possibly greater than what the market is expecting. QT is likely to be a massive change in the flow of funds in and out of U.S. Treasuries, affecting every asset class. 

In short, QT will lower the tipping point of a potential overshoot in Fed rate hikes. The expected fastest rate hike since 1989 (0 to 300 basis points in 12 months, including three 50 basis point rate hikes) plus QT is an off-the-charts level of tightening and this will likely impact equities, credit and especially bonds. Mortgage-backed securities (MBS) runoff remains an underappreciated risk as the Fed may target home prices to reign in inflation and inflation expectations more quickly. As we mentioned before, an aggressive MBS runoff runs a high contagion risk to credit market risk because of its spread product nature.

The U.S. Treasury Index's YTD 2022 return is now -8.5%, representing a significant loss in the value of U.S. government bonds. But it is the drawdown that highlights the pressure facing most multi-asset funds. The drawdown is the worst in nearly 50 years, at twice the prior maximum drawdown levels ever experienced (see Figure 4). Bonds typically function as a hedge or protective asset in multi-asset portfolios. Global bond aggregates are experiencing even worse drawdowns (-15.48%), highlighting the dearth of safe-haven assets.

- Source, Sprott Asset Management

Gold Bullion Consolidating, Bullish Flag Forming

Gold bullion fell $40.51 (a loss of 2.09%) to close at $1,896.93 for the month. Gold performed well into the first half of April as safe-haven flows were still trending. But in the second half, a notable de-grossing event (i.e., a major sell-off in positions) occurred with an across-the-board outflow in all asset classes as equity, bond and currency volatility surged. April ended as a hostile and volatile month for risk assets, with the S&P 500 Index down 8.80% for April while the Nasdaq Composite Index7 fell 13.26%, its worst month since 2008. 

The Federal Reserve ("Fed") continued to message from a full-on hawkish position, and market participants ramped up tightening expectations. Global growth expectations were lowered by the IMF (International Monetary Fund) and the World Bank. At the same time, one major Wall Street firm called for a significant recession by late next year just before a surprise -1.4% Q1 U.S. GDP (gross domestic product) posting.8 The Russia-Ukraine War shows no signs of resolution, and the effects of sanctions are spreading. China is in wide-scale COVID lockdowns, adding to the stagflationary risk by disrupting supply chains further and weakening growth.

Towards the end of April, earnings disappointments joined the geopolitical and economic concerns. Against the challenging hawkish Fed background, slowing growth and long faded global monetary and fiscal liquidity impulses, QT (quantitative tightening) will start in May, further undercutting liquidity and exacerbating any selling pressure. With inflation readings so elevated and pervasive, the U.S., the world's largest economy, may have no choice but to tighten into a recession. With the -1.4% Q1 GDP surprise posting, the bar for a recession may be lower than expected. In addition, China, the world's second-largest economy, may send itself into an economic downturn via widespread, ongoing lockdowns due to its strict zero-COVID policy.

Gold Bullion Consolidating

Gold bullion is currently consolidating the bullish flag breakout shown in Figure 1. After approaching its 2020 all-time high price of $2,064 per ounce, gold has pulled back to test support and Fibonacci retracement levels9 (blue dashed lines). Though the price volatility is elevated, our Gold Bullion Positioning Index has stayed in a narrow range, indicating that price volatility was more due to a lack of liquidity than selling pressure.

Figure 1. Gold Consolidating the March Breakout (2020-2022)

- Source, Sprott Asset Management