Changing market dynamics continue to keep investors on their toes, as gold and silver fail to take out recent highs and as equities appear to be in what could be a major topping process. Although equities have recovered a great deal of ground recently, a lack of a new high could potentially point to the end of the decade-long bull market.

 

Investors remain concerned about the potential path of higher rates, but did get some degree of reassurance this past week. The most recent Fed meeting minutes released last week showed the central bank remains optimistic on the economy. Several Fed officials did, however, express concerns about upside risks.

 

Last week, the central bank presented its biannual report to Congress on the conduct of monetary policy. The report painted a positive picture on the economy, and described the labor market as being “near or a little beyond full employment.” The Fed is likely to hike rates three times in 2018, and possibly even four times. The next increase in the key interest rate will likely be seen in March.

 

A hot topic lately, however, has been how the central bank will handle the next downturn. Rates are currently in the 1.25-1.50 percent range, and are not expected to rise beyond three percent during the current expansion. This could potentially present a significant problem for the Fed, if it is forced to cut rates again to stimulate the economy. To put this into perspective, the last four economic downturns saw the central bank cut rates by an average of 5.5 percent in order to provide an economic boost.

 

After the financial crisis of 2008, the central bank slashed rates all the way down to zero, and also provided additional stimulus in the form of QE. Whether or not all of the bond and mortgage-backed security buying was effective remains the subject of much debate, but the effects of sharply lower interest rates seem to be indisputable. If the Fed does not have as much room to lower rates, however, such effectiveness could be called into question.

 

Put another way, the next recession could leave the Fed without as many tools to fight it, and that could potentially open the door to a lengthy and significant downturn. Although the next recession could be quite a ways off yet, policy-makers already appear concerned about their ability to combat it, and expanding U.S. deficits may further erode the government’s ability to curb a recession.

 

The current economic expansion is already one of the longest ever, and numerous issues already point to overheating that could put an end to the recovery seen over the last decade.

 

The idea of higher inflation and higher rates have begun taking a toll on markets. Recent stock market volatility was largely blamed on rising rates-specifically the yield on the benchmark ten year note. Rates appear headed even higher, and significantly higher yields could potentially send stocks lower by double digits.

 

Markets will likely face some major tests in the weeks and months ahead, and as inflation accelerates and rates continue their ascent, investors may exit equity markets in droves while seeking out alternative asset classes. Such a scenario could act as a major catalyst for a significant bull market in gold and other hard assets.

 

The recent carnage gripping global equity markets will likely remain a primary point of focus for investors this week. Last week saw some of the steepest declines in stocks in years, including the largest recorded point drop in the Dow Jones Industrial Average. The mayhem in equities also coincided with the largest-ever daily gain in market volatility as measured by the CBOE’s VIX.

 

Investors will be heading into this week wondering if the worst is over, and a cautious tone is to be expected following recent market activity. Whether the recent sell-off represents a bottom and buying opportunity or a glimmer of more selling to come, one thing seems to be certain: The era of easy gains and non-existent volatility is over.

 

Rising bond yields have been a major story for Wall Street in recent weeks, with the benchmark ten year note yield approaching 3%. The bigger picture, however, is more alarming. Bond yields are rising, and rising rapidly, due to increasing inflation expectations. Although recent economic data shows inflation still running below the Fed’s desired 2% target on a year-over-year basis, it is not far off. In fact, the worry now is that with full employment and strong GDP data, inflationary pressures could easily exceed desired targets and become problematic.

 

The economy may already be overheating, and the Fed may be forced to act more aggressively as it looks to normalize monetary policy. Such a scenario presents several problems. Excessive inflation increases the costs of everyday goods and services, as it erodes purchasing power. Not only that, but higher inflation and a weaker dollar also eat away at real returns. On the other hand, if the central banks raises rates higher and/or faster to combat inflationary pressures; stocks could be in for a rough ride. Higher rates make bonds more attractive, and investors could elect to shift capital away from the aging and arguably overvalued bull market in stocks into fixed income which carries less risk.

 

The current headwinds being faced by equity markets could be very bullish for gold and other hard assets. The gold market could see substantial inflows as investors seek its perceived safety and look to diversify away from stocks and risk assets. The notion of rising inflation could also fuel sizable allocations into the metal, as it may potentially provide a meaningful hedge against a weaker currency and declines in purchasing power.

 

The perfect storm of rising inflation, higher rates, a return of stock market volatility and the current geopolitical backdrop could send gold not only back to all-time highs near $2000 per ounce, but could also drive a rally that goes far above and beyond making $3000, $5000 or even $10,000 per ounce not only feasible but a distinct possibility.

 

Years and years of ultra-low rates and quantitative easing have backed central banks into a corner. As asset values come back down to earth, and as central banks look to shrink balance sheets and normalize monetary policies, market volatility may increase while equity market returns decline. As central banks now battle rising inflation, any large missteps could not only exacerbate such issues but could also send risk assets into a major tailspin.