In a week and a half, the US Federal Reserve is expected to cut interest rates. The question that many (including myself) seem to be hung up on is, why?

Relations between the United States and China have been going back and forth between hot and cold for the past year. The initial shock of a trade war seems to have been absorbed by financial markets and the downside impact to global economic activity and GDP outlooks seems to be realized, for now. Global manufacturing data (a forward-looking indicator for economic growth) for certain Western economies have deteriorated, but other metrics, such as the strong and robust performance of the US labour market seem intact.

Some Bay and Wall Street economists seem to be interpreting and anticipating this move from the Fed as an insurance cut. If this is the case, parallels can be drawn to when the Bank of Canada cut rates in January of 2015 and then again in July of that same year. This was in reaction to the impact of an oil price shock on the Canadian economy and economic devastation in oil producing provinces led by Alberta. Ultimately, they reverted to their path of higher interest rates as what would be deemed a transitory shock worked its way through the economy. Thus, the question whether a US-China trade war may be interpreted in a similar way.

There are certainly examples of pockets of the US economy that are struggling. Economists that align themselves in the bearish camp point to indicators related to trade and manufacturing data, or shipments of semiconductors. The challenge with that is the US Federal Reserve adjusts interest rate policy based on their mandate of price stability and maintaining low unemployment, both measures that seem not to fully prompt any action.

Relating to this, the question may be asked how much further room the labour market has to run and whether the inflation data may be pointing to a disinflationary scenario (when inflation is muted and gravitates towards zero, but not negative or deflation). Longer term, this may be a picture we are looking at, and may be the reason the Fed is no longer talking of raising rates.

It’s hard to take a myopic approach to the markets, and especially gold and precious metals when we participate in a market where the belief in physical gold is in its long-term store of value and its role as a way of adding diversity to one’s financial assets and mitigating exogenous risks. With that said, it seems justifiable that the anticipated action from the US Fed to immediately move to the dovish camp may be hard to justify, and for the financial markets and investors to digest.

For this reason, we see the month end meeting of the Federal Reserve as another possibility for a period of market volatility. Potentially, any interpretation of a ‘hawkish’ rate cut could see gold prices attempt to re-test their breakout of the $1,360 US/oz. Certainly the dovishness of the Fed has been priced in. Anything short of this may provide an entry point for investors that missed this rally.

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There were two notable bullish calls for the yellow metal this past week. One was from hedge fund manager, Paul Tudor Jones, and the other from DoubleLine Capital founder, Jeffrey Gundlach, who is regarded by some as the ‘bond king’ for his past forecasts.

Their investment outlooks for gold were related and echoing other large-scale investors over the past couple months. In Jones case, it’s based on the belief of the possibility the US could be headed for recession. In Gundlach’s case, after accurately forecasting the volatility in fixed income markets over the last couple months, he now sees a lower priced US dollar by year-end. The lower dollar will be the result of a US recession, interest rate cuts from the US Federal Reserve, and a towering US fiscal deficit.

These calls coincide with markets this week moving on investor expectations the US Federal Reserve will cut interest rates 3 times by year’s end. What’s head-shaking is how quickly this shift has taken place from the US Federal Reserve’s hawkish bias that was much more present into the beginning of 2019. At the close of markets Friday, investors were pricing in 68% odds of a rate cut at the Fed’s July meeting, and then two subsequent cuts by the end of the year.

What gives me pause during weeks like this, coinciding with a regain in confidence in the recent turmoil in equity markets, is asking the question, what’s changed?

Fed Chair Jerome Powell may have had his Mario Draghi moment a couple weeks back, when in a similar scenario back in 2012, European Central Bank President Draghi pledged to do “whatever it takes” to save the euro. What followed was President Trump’s threat of additional tariffs on $300 bln worth of Chinese imports to the United States. Alas, the US President may have succeeded in his wish that the US central bank, that’s supposed to remain apolitical, may be shifting to his corner in this escalating trade war.

Towards the end of the week, China’s economy showed continuing signs of softening. Manufacturing data for industrial output experience the slowest growth in 17 years as their export sector now shows clear signs of the impact and damage of US tariffs. Still, stimulus measures announced by the People’s Bank of China signal the Chinese government stands ready to dig in their heels. There is no shift in sentiment yet that tensions will ease between the world’s two superpowers, and thus the calls for a demand for safe-haven assets like gold.

Jones had a simple way of justifying his market outlook. To paraphrase, the cooperation and policies towards globalization and increases in global trade that fueled economic growth for the past 75 years are coming to an end. His forecast is for gold to take out $1400 US/oz and then not to wait too long to see $1700 US/oz. In some regards, it resembles a fearmongering depiction of the world, but it seems this scenario is becoming a little more prevalent again.

There has been no shortage of headlines over the past several weeks that have continued to unsettle financial markets and maintain focus on the trading relationship between the world’s two biggest economies. Last week ended with China’s crown jewel, Huawei, being added to the US Commerce Departments entity list, restricting US businesses relationships with the Chinese firm. Immediately, the impact was seen in US chip suppliers that provide parts to the hardware giant, and questions arose around Huawei’s phone sales outside of China as their devices would no longer be supported by proprietary apps from Google.

Beyond the company specific impacts, the sentiment in the market has been that the United States and China continued to be further apart than initially assumed, and as confirmed by the US President, Huawei will be used as a prop to reach a trade deal.

The central predicament that will shape investment themes into the summer and through the rest of this year is determining just how likely a trade deal may be. Akin to the very end of December when US equity markets had found a bottom, it was around the timing of a delay in the imposition of tariffs on China that supported stock markets moving higher this spring. And as progress between the two nations was assumed, investors’ appetite for risk continued to grow.

To circle back to this week’s topic, however, there remains no shortage of headlines that have thus created a more than a little concern. Nouriel Roubini wrote earlier in the week of potential consequences and fallout from a US-China Cold War. He details a scenario that sees an ultimate disruption to global trade, and other nations around the world required to pick a side with regards to whom they maintain a trading relationship. Reading the Roubini column on the West coast of Canada certainly creates a lot of shock-value given British Columbia’s export reliance to Asian economies and the investment currently going into LNG.

There are also arguments being made over how much short-term pain a centrally planned Chinese economy would endure to win a long-game negotiation with the United States. Where China lays out multiyear plans for the state’s role in the county’s industrial development and growth, the United States is subject to polarizing political rhetoric doomed and vulnerable to the next election cycle. One story in Bloomberg this week detailed a Chinese government expert opinion that talks could go on for the next 15 years.

Finally, and touched on Thursday evening in an announcement from President Trump, was the idea to impose tariffs on imports from nations that intentionally devalue their currency, which could include China. Beyond understanding how this is implemented and enforced, it circles back to an earlier theme of the last decade that’s been absent from headlines recently, but it is the notion of currency wars.

It centers around the idea of governments and central bankers opting for policy that directly or indirectly competitively devalues their domestic currency against their trading partners to boost their export sector.  It has been argued that this could be an added tool in China’s arsenal to prolong the impact of US tariffs by finally letting the Chinese yuan depreciate over seven-per-US-dollar, a situation we haven’t seen since 2008.

If there’s a lesson here, it may be the idea of short-termism versus playing the long game. There’s a lot of noise in the markets day-to-day, but investment themes like passive versus active investing, or having exposure to safe-havens like precious metals come to mind.

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Global Growth and Stock Market Melt Up?

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There were similar patterns over the past few weeks in the first quarter GDP prints from China, the United States, and the European Union. Economic growth fared better than expected. This is notable given the two countries and one region account for over half the world’s output. Unfortunately, it’s not necessarily the case for Canada. The prospects for “better than expected” reports may not be as great and the most recent GDP data for February released last week aligned with the Bank of Canada’s very conservative forecasts.

For reference, China Q1 GDP grew ahead of expectations at 6.4% vs 6.3% forecast. First estimates for US GDP advanced by 3.2% vs 2.5%, and Eurozone annualized growth grew at 1.5% while the unemployment rate dropped to a 10-year-low.

Both the IMF and World Bank amongst other predominant voices have issued concerns over global growth in the beginning of this year. These warnings have been consistent with the reverse shift from Western Central Bankers including Federal Reserve Chair Jerome Powell who spoke of inconsistencies in US growth prospects last week, and Bank of Canada Governor Stephen Poloz whose concerns also echoed the threat of a global slowdown’s impact on the Canadian economy.

It certainly raises a question and is worth reconsidering why policy makers appear so cautious and dovish. Fed Chair Powell created a bit of a stir this week when he used the word “transitory” to refer to inflation. What was gleaned was the Fed sees the inflation slowdown in the US as temporary and for some analysts this raised the prospects of higher US interest rates in the latter half of the year. That said, Friday’s US job numbers saw the jobless rate fall to a 49-year-low at 3.6%, but as wage growth again failed to accelerate the suggestion was there is further room for this US labour market to accelerate.

To contrast the US and Canada though, it’s also worth noting the difference between Powell and Poloz. Whereas Powell almost sounded hopeful on trade relations last Wednesday, Poloz in an interview with Global News this past week stated trade as the biggest risk to the Canadian economy (the last policy statement from the BoC highlighted oil markets, household spending, and global trade as the three biggest risks, which aligns their ranking).

Earlier in the year, it was the notion that the waning impact of the Trump tax cuts, US stocks in a bear market, the trade disputes between the US and China, in addition to steal and aluminum tariffs, and potential for frictions between the US and Europe would all be added impediments to global growth. Certainly, the Canadian economy, stunted by a beleaguered resource sector, seems one step back, but prospects in the US and Europe, buoyed by a strengthening Chinese economy seem a little more optimistic. As the US Fed pointed out, some of the bearish data points could be a result of transitory factors.

Morgan Stanley and Bank of America recently issued a call to investors worried about under exposure to equity markets. They suggested using the options market to capture a sudden move higher in a momentum trade in equities. At the beginning of 2019, it might have seemed eleven years past the Great Recession, we were finally losing some steam, but the question is whether we’re amidst something to the contrary.

The gold bulls may be looking for a rebound in the week ahead after the metal saw some sharp selling last week. Thursday’s action saw the brunt of the selling pressure as the metal declined by 1.5%. Although a host of factors could be at work, the steep drop was most likely fueled by increasing risk appetite and a stronger dollar index.

It is looking increasingly likely that ongoing U.S./China trade negotiations are going to bear fruit. Although no specific date has yet been set for President Trump and Xi Jinping to sit down and formalize an agreement, recent talks have reportedly been very constructive and at this point it may simply be an issue of finalizing the details.

Reports of an agreement getting closer to fruition and some positive data coming out of the world’s second-largest economy have boosted stocks in recent days and fueled appetite for risk. Recent data released on trade and construction activity, among other reports, sent equities higher and seemingly provided global markets with a collective sigh of relief. Although China has certainly seen some bumps in the road, its economy may be stabilizing and a formal agreement on trade with the U.S. may send global markets even higher while boosting overall economic output.

With the U.S. Fed on hold and potentially even being forced to cut rates sometime this year, any signs of strength out of China may drive the dollar lower against key rivals. Recent dollar strength has likely played a major role in the lack of upside follow-through seen in gold in recent months and a significant breakdown in the currency could potentially pave the way for a more sustainable rally higher.

Although a weaker dollar could be bullish for gold, stock markets may hold the key to a significant upside breakout. Gold has already shown that it can move higher despite a stronger dollar, but yield-hungry investors have shown a strong tendency to turn to stocks as markets have recovered since the first of the year. Recent market action has put the benchmark S&P 500 within striking distance of previous all-time highs, and given the buying seen in recent days the market looks intent on seeing a 3000 print in the index.

As stocks have approached those previous highs, the gold market has simply tried to “hang in there.” Recent dips into the $1280-$1290 region have been bought and the area seems to have a great deal of willing buyers. With or without a weaker dollar, however, the gold market may need to see a breakdown in stocks before moving significantly higher.

The week ahead will have markets watching for further U.S./China trade developments and more positivity out of the Chinese economy. Further signs of stabilization in China may send stocks higher yet but may weigh on the dollar at the same time. The major test, however, will occur once the initial euphoria has worn off. In classic “buy the rumor sell the fact” fashion, stocks may simply run out of gas once a trade deal is done and as things are looking better in China. Such market exhaustion could coincide with a major, long-term top in equity markets despite an increasingly dovish Fed.

Such a scenario could potentially set the stage for a sharp rally higher in gold and alternative asset classes that could propel the metal into the next phase of a cyclical bull market.