The white metal has spread the holiday cheer, but will it turn into the Grinch after Christmas?
While breakeven inflation rates collapse and recession fears mount, silver has defied all logical expectations. For example, the white metal is more economically-sensitive than gold, and historical recessions have resulted in epic drawdowns. As such, the fundamental dissonance highlights the momentum in play.
However, while recession calls were loud in the summer, they proved materially early; and with more misguided concerns present now, the recent decline in U.S. Treasury yields should reverse like they did then. To explain, we wrote on Dec. 7 :
The red line above tracks the U.S. 10-2 spread, which subtracts the U.S. 2-Year Treasury yield (2Y) from the U.S. 10-Year Treasury yield (10Y). In a nutshell: when the 2Y exceeds the 10Y, it's the bond market's way of warning about a forthcoming recession; and the development occurs because the 2Y is pricing in a higher FFR, while the 10Y is pricing in weaker economic growth.
…. The three arrows in the middle show that the 10-2 spread moved from negative to positive before the last three recessions occurred; and this happens because the 2Y falls by more than the 10Y, as investors start pricing in Fed rate cuts. For context, the 1980s was a mixed picture, as two recessions had the spread moving in and out of positive territory.
The important point is that the 10-2 spread is becoming more negative, and the last three recessions did not occur when the spread was declining.
We added:
The 2Y needs to demonstrate substantial weakness, where economic carnage causes bond investors to bid the 2Y Note in anticipation of the Fed cutting interest rates. Yet, this is far from the current backdrop.
Please see below:
To explain, the red line above tracks the 2Y, and if you analyze the right side of the chart, you can see that the metric remains in consolidation. Therefore, its behavior does not add credibility to the recession rhetoric.
So, while the narrative proclaims a recession is imminent, and rate cuts and QE are near, the recent data and the bond market's behavior do not support the arguments. Remember, the last three times the 10-2 spread turned negative, the recessions arrived ~12 to ~22 months later; and with the current 10-2 spread turning negative in early July, we're only ~five months into the current inversion. Thus, patience is warranted.
As further evidence, the behavior of high yield credit spreads signal that the U.S. economy is much healthier than the narrative suggests.
Please see below:
To explain, the red line above tracks the ICE/Bank of America U.S. High Yield Option-Adjusted Spread (OAS). For context, the metric measures the excess interest rate over U.S. Treasury yields charged to the riskiest U.S. companies, while also removing the impact of embedded options.
In a nutshell: the least credit-worthy companies operate in high yield land, and they are the most economically sensitive and have the highest probability of default.
If you analyze the left side of the chart, you can see that the red line spiked before the 2001 and 2007 recessions began. A somewhat similar development was present in 2020, though the pandemic-induced recession was more of a surprise.
The key point is that when the U.S. economy is about to crumble, high yield spreads increase dramatically to reflect the higher default risk. Yet, if you turn your attention to the right side of the chart, you can see that the red line has been in a downtrend since July.
As a result, bond investors are not worried about their high yield borrowers’ ability to pay , and if a recession was imminent, default anxiety would be rising. So, while the silver price has rallied sharply in anticipation of a lower FFR, that optimism should unravel in the months ahead.
To that point, the Conference Board released its Employment Trends Index (ETI) on Dec. 5. The index declined from 118.74 in October to 117.65 in November. But, Frank Steemers, Senior Economist at The Conference Board, said:
“The labor market is currently still robust….The demand for workers is still resilient and wage growth continues to be elevated. With the number of employees quitting still high – and the labor supply still constrained – employers may continue to offer strong pay increases to their existing workers and new hires over the coming months.
“However, with the economy expected to slow further in 2023 amid the Federal Reserve’s rapid interest rate hikes, we expect the US labor market to cool and possibly even record some monthly job losses.
“That said, labor shortages are unlikely to disappear altogether, with the unemployment rate projected to rise from the current 3.7 percent to a still-low 4.5 percent in 2023. Employers may still need to manage recruitment and retention difficulties, as well as rising labor costs, into the New Year and beyond.”
Therefore, with Americans still gainfully employed and spending money at durable rates, it’s essential to distinguish a slowdown from a recession. Yes, the rapid rise in the FFR has slowed the U.S. economy, and that was the intention. In contrast, many metrics are nowhere near levels that would normalize inflation from ~8% to 2%.
Consequently, we believe the Fed still has plenty of work to do, and the medium-term outlooks are bullish for the FFR, real yields and the USD Index. Conversely, the silver price should suffer mightily when these metrics resume their medium-term uptrends.
For a more thorough breakdown of the precious metals market, please see our comprehensive technical analysis that covers gold, silver, mining stocks, the S&P 500 and more. Remember, the fundamentals are only one part of our investment thesis, and they are best used in conjunction with the technicals.
Alex Demolitor
Precious Metals Strategist