"The Federal Reserve Is Clearly Trapped": Lawrence Lepard
Friend of Fringe Finance Lawrence Lepard released his most recent investor letter this week.
Friend of Fringe Finance Lawrence Lepard released his most recent investor letter this week. He gets little coverage in the mainstream media, which, in my opinion, makes him someone worth listening to twice as closely.
Larry was kind enough to allow me to share his thoughts heading into Q2 2024. The letter has been edited ever-so-slightly for formatting, grammar and visuals.
QUARTERLY OVERVIEW
Globally, the stock markets continued their 45-degree angle rise during the first quarter. Crude oil, and commodities broadly, also had a stair-step rise consistently during the quarter. Gold and silver and the miners were an interesting dichotomy. Bullion prices were flat to slightly down in January and February, and the miners were clobbered during those early months of Q1. However, in March the price of gold broke through the long-standing $2,070 ceiling and the miners responded, driving the Fund up by 25.4%. Gold miner indices were down 17% in the first two months before the March move.
Note that the gold mining stocks still have not provided any leverage to the price of gold. In fact, in the first quarter they did not even keep pace with the increase in the price of gold. With gold up 8.1% in the quarter, the gold mining indices were up 2%. Typically, gold miners provide 2x to 3x leverage in terms of returns; so with gold up 8%, the miners would typically have been up 16% to 24%. This supports our thesis that the miners are still undervalued and are going to mean revert with a vengeance as this bull market in gold continues. The gold mining shares have a long way to go before they reflect fair value.
THE MARKETS SPEAK: GOLD BREAKS OUT
We have been waiting for a conclusive Federal Reserve loosening of financial conditions (monetary expansion) to light a fire under our Fund’s assets. While we have seen some hints that the Fed is going in that direction, they are sending mixed signals. In our view, the big story in Q1 was that the markets said, “OK, we have seen enough, we know what’s coming, so let’s get going.”
In the first quarter, the price of gold definitively broke out from its long-term price cap of ~$2,070 per ounce. Gold’s price had bumped up against this cap four times over the past four years. Notably, gold topped out at $1,900 in 2011 before starting a multi-year correction. Breaking through a top that had been in place for over a decade is a big deal.
And it was not just gold. The other sound money assets have participated too. Bitcoin started the year at $42,802 and hit an all-time high of $72,740 in early March (up 67% in the Quarter!). Silver also broke through long-term resistance, although it has much further to go to hit an all-time high.
Markets reflect current conditions, but more importantly, they price in future expectations. We strongly believe that more investors are waking up to the monetary trap that the Fed has placed itself in. Consider, there have been three crises in the last 18 months that the sound money assets are reacting to:
• October 2022 – UK Gilt crisis…the Bank of England printing
• March 2023 – Silicon Valley Bank / Regional Bank Crisis….FDIC guarantees all deposits and Fed prints with the BTFP
• October 2023 – 10-year U.S. Treasury yield abruptly goes above 5%.....Fed begins Dovish talk, signals rate hike cycle over and soft pivots
Gold, Silver and Bitcoin are reacting to both that recent intervention plus front running the next round of money printing or monetary accommodation that will occur in the coming crisis (and given the debt load, the next crisis could be massive). This move in sound money assets is different.
This is best demonstrated in the chart below which shows the price of gold compared to the “real yield” on the U.S. 10 Year bond (inverted). Note that the “real yield” is the yield on the 10-year U.S. Treasury bond minus the current expectation for average inflation rates over the next 10 years. For example, today the 10 year treasuries are yielding about 4.5%, and 10-year inflation swaps are priced at ~2.5%, reflecting the expectation that inflation will average 2.5% for the next ten years. (we don’t think it will). This leads to a “real yield” of 2% as shown in the chart below.
One of the long-standing relationships in finance is that when real yields are higher, gold is less attractive. Gold pays no yield, but it protects against debasement. When real yields are positive or trending positive, gold suffers. When real yields are negative or trending negative, gold does well. Note the tight correlation from 2006 to 2020 in the chart below.
Now, the important point is to look at what happened starting in 2022. Due to the Federal Reserve’s rate hiking campaign, real yields have gone up substantially and YET, gold went up! In our opinion this is a huge clue. Something is different. We believe the gold market is sniffing out the global debt and fiscal problems that are present in the United States and that it is anticipating future monetary debasement.
Given this dramatic de-coupling of the price of gold from the underlying trend in real yields/interest rates, we cannot help but wonder: have conditions changed such that the Fed is impotent and interest rates no longer have such a strong impact on the price of gold? If so, this is another way in which this decade is beginning to look more like the 1970’s, where gold actually went up IN SPITE of higher rates of interest because inflation expectations drove gold higher.
NARRATIVE SHIFT
The change in the gold price behavior, when compared to real interest rates, demonstrates the economic conversation is changing. Broadly speaking, the narrative is shifting, and the mainstream financial world and investment markets are waking up to what we have been saying for years, to wit: