Implications of PCE Inflation amid Market Turmoil

Today’s release of the Personal Consumption Expenditure (PCE) Price Index report reflected a steady trajectory in line with expectations.

The core PCE, a key metric for the Federal Reserve in measuring inflation, saw a 0.2% month-over-month increase, aligning with Dow Jones estimates.

Annually, the core PCE recorded a 2.8% uptick, slightly surpassing projections by 0.1 percentage point.

The report also detailed updates on income and spending trends, with personal income rising 0.3% and spending increasing by 0.2%, although below initial estimates.

This data corroborates a persistent trend of ‘sticky’ inflation, marking the third consecutive month of Core PCE inflation at 2.8%.

While the market reaction has been mixed following the report and the Nasdaq showing a minor downturn, the situation could have been more turbulent, offering a silver lining amidst the uncertainty.

Continued moderate inflation numbers may push the Fed towards rate cuts in September, with policymakers likely reiterating the familiar statement of ‘awaiting further data’ in the coming weeks.

Consequently, the market finds itself in a state of limbo, seeking direction post the release of this data.

Upsides of Investing in Gold

Gold emerges as an appealing option in the current macroeconomic environment, showcasing resilience regardless of inflationary trends, Fed policies, or rate adjustments.

An anticipated Fed rate cut could bolster gold prices, as reduced interest rates diminish the allure of interest-yielding assets in comparison to gold during high-return phases.

Historical data indicate that gold has experienced varied returns in the lead-up and aftermath of Fed rate cuts, with an average 11% increase in the year following an initial rate cut.

In six out of the last seven easing cycles, gold has recorded a surge in value post the first Fed rate cut.

Gold’s Significance in an Extended High-Interest Rate Scenario

Even as gold stands to benefit from rate cuts, its role remains vital in periods of sustained high interest rates driven by persistent inflation.

Historically, gold has proven to be a reliable store of value during inflationary periods, safeguarding investors against currency devaluation.

Comparing gold’s price appreciation with that of assets like real estate over the past century reveals gold’s enduring value and appreciation.

As evident from the data, gold’s price has increased significantly over the years, outperforming the dollar’s purchasing power which has significantly eroded since 1920.

For individuals considering investment alternatives, the performance of gold has surpassed major stock indexes since the turn of the millennium, emphasizing its resilience and strength in uncertain financial climates.

Impending Government Debt Crisis and Gold’s Appeal

Government financial needs lead to either taxation or borrowing through security issuance, a practice that underlines America’s burgeoning fiscal deficit.

Despite significant tax revenues, the government struggles to meet its expenditure demands, resulting in a widening budget gap necessitating increased borrowing through Treasury securities.

The escalating trend in U.S. Treasury security issuance mirrors the mounting debt burden faced by the government in recent years, posing a challenge to economic stability.

The Current Dilemma

Let’s harken back to The Wall Street Journal last autumn:

Foreign appetite for U.S. government debt isn’t what it once was. That’s unsettling news for Washington.

The U.S. Treasury market finds itself in the throes of significant shifts in supply and demand dynamics. The Federal Reserve is rapidly reducing its holdings by $60 billion every month.

Formerly pivotal buyers from overseas, such as China and Japan, have lately become less dependable. In contrast, the supply has ballooned, with the U.S. Treasury issuing a net of $2 trillion in new debt this year – an all-time high when excluding the pandemic splurge of 2020.

“U.S. issuance has soared while foreign demand has stagnated,” remarked Brad Setser, a senior fellow at the Council on Foreign Relations. “Critical buyers like Japan and China are unlikely to increase their net purchases in the future.”

Market Reactions and Consequences

There will always be demand for U.S. securities in some form – the real concern is at what cost.

This becomes crucial due to the inverse bond prices to bond yields relationship. As bond prices plummet (forcing the Treasury to offer discounts), bond yields rise. Elevated bond yields spell trouble for the Federal government’s debt obligations (and even for stocks).

This scenario played out recently with the issuance of a new batch of securities. On Tuesday, CNBC reported that the 10-year Treasury yield surged above 4.5% following a lackluster auction. The subsequent day, MarketWatch highlighted poor demand in the Treasury’s $44 billion sale of 7-year notes.

Limited demand translates to reduced prices, resulting in escalated yields, thereby increasing the interest that the government must payout to its lenders.

Rising Borrowing Costs and Fiscal Projections

The Peter G. Peterson Foundation underscored the correlation between escalating interest rates on U.S. Treasury securities and a surge in the federal government’s borrowing expenses.

The U.S. managed to borrow inexpensively during the pandemic owing to historically low interest rates. However, as the Federal Reserve hiked the federal funds rate, short-term Treasury rates also climbed, leading to costlier federal borrowing.

The Congressional Budget Office estimated that annual net interest costs would reach $870 billion in 2024, almost doubling over the coming decade. The projection indicated a staggering increase from $951 billion in 2025 to $1.6 trillion in 2034, totaling $12.4 trillion over that period.

If inflation surpasses CBO predictions, and the Fed retains interest rates longer than anticipated, these costs could rise even faster.

Alternative Safe Havens

The burgeoning U.S. government debt has thrust interest payments into the limelight, at times exceeding national defense spending in certain months. Consequently, demand for bitcoin and gold as inflation hedges against the diminishing purchasing power of the U.S. currency has surged.

“Worries surrounding U.S. debt trends, currency devaluation – particularly fiat money – are steering the narrative,” commented Brad Bechtel, global head of FX at Jefferies.

Gold Rush and Central Banks

Adding to the mix, there’s another tailwind brewing – a historic surge in gold purchases by global central banks.

Macro expert Eric Fry, in the latest May issue of Investment Report, shared insights on global central banks’ robust gold acquisitions. The World Gold Council reported a record-breaking first-quarter buying spree with a total of 290 tonnes – the strongest start to any year on record.

Regardless of the forthcoming inflation outlook and the Fed’s rate strategy, incorporating gold into your portfolio today could be a wise move.

Wishing you a pleasant evening,

Jeff Remsburg