Peter Schiff: Risk On; Economic Understanding Off

We saw a big rotation into risk assets after last week’s Federal Reserve meeting. Then we had another big shock to the markets when the non-farm payroll report came out much stronger than expected. In his podcast, Peter Schiff broke down the market reaction to last week’s events and reveals that while risk was on, economic understanding was off.

Gold plunged by nearly $50 last Friday, dropping back below $1,900 an ounce and settling just above $1,860. That was after gold climbed above $$1,950 after the Federal Reserve meeting. Gold lost nearly 2/3 of its yearly gain in just two days. Peter said this is typical trading during a bull market.

Whenever you’re in a bull market, it’s the down moves that are more violent, that are larger, and they happen to shake people out. It’s not just that some people are taking profits, but other people are shaken out of the market. They get scared out by the big drop, and they think, OK, the move is over, I better get out, and they clear out a lot of the excess baggage. That paves the way for a move to new highs, which is what I think is going to happen with gold.”

There were a couple of big catalysts for the move down.

One was the big “risk-on” day on Thursday after the FOMC meeting. There was a big rotation out of safe-haven assets such as gold into riskier assets such as speculative stocks and cryptocurrency. In fact, there was a huge tech rally that wasn’t based on any fundamentals.

It was just based on a risk-on appetite, and of course, a lot of short covering.”

There was also some economic data on Thursday that fed the idea that the Federal Reserve will be able to stop raising rates sooner rather than later. In fact, the belief that the fight against inflation is about over was the primary driver in the markets on Thursday.

But the big news that blew up the gold market on Friday was the much stronger-than-expected non-farm payroll report. The number of jobs “created” nearly doubled expectations.

Peter said the big increase in jobs could be just a function of seasonal adjustments. But the drop in the unemployment rate from 3.5% to 3.4% was a factor that really spooked the markets. The last time the unemployment rate was this low was in 1969.

Now, of course, we didn’t measure the unemployment rate back in the 1960s the same way we measure it now. So, if it was an apples-to-apples comparison, today’s rate would be much higher than the 1969 rate. But as far as the markets are concerned, that just takes government numbers at face value, this is the lowest unemployment rate since the 60s.”

This was seen as a good report on the economy and therefore bad news for the markets. Stocks fell on the news, along with gold. Peter said he thinks this report is making people think that maybe we’ll get a soft landing after all — meaning the Fed can get price inflation back to 2% without tanking the labor market or the economy more broadly.

After all, so many people now believe that the Fed has made significant progress in its goal of returning inflation to 2%, yet that progress has not come at the expense of jobs. It has not come at the expense of an increase in the unemployment rate. In fact, unemployment is now hitting new lows even as the Fed continues to raise interest rates to bring down the rate of inflation. So, more investors are thinking maybe the Fed can pull off this miracle.”

Everybody also believes that once the Fed gets price inflation to 2%, it can start cutting interest rates.

Nobody seems so to understand that even if the Fed is successful in bringing inflation back down to 2%, which it will not be, but even if it were able to do that, it does not mean the Fed can take interest rates back down to zero or anywhere close to zero. In fact, even if inflation is around 2%, the appropriate interest rate under normal circumstances with a 2% inflation rate is probably at least a 4% Fed funds rate. It’s not a Fed funds rate that’s anywhere near where it was in previous years. That was the aberration. We can’t go back to those artificially low interest rates. And, if the Fed even attempted to return to those rates, then any progress on inflation would immediately be lost.”

The markets don’t get the fact that even if price inflation goes down to 2%, it won’t stay there if the Fed cuts rates. The central bank would have to raise rates significantly above neutrality before it could successfully cut rates back to a neutral level.

But I don’t even think we’ve gotten there yet. In fact, if you look at what the actual inflation rate is, the current rate is still stimulative. We haven’t even reached neutral. But if we were able to restore inflation to 2% with a 5% Fed funds rate, there isn’t much room for the Fed to cut in the aftermath of its victory. But of course, what the markets still don’t get is all of this improvement in inflation is transitory. We are going to see an increase in the inflation rate before the end of the year. The progress that the Fed believes it’s made is going to be lost.”

Peter said when the interest rate gets to 5% and price inflation is going up, the markets will be in for a real shock. It will mean the Fed has to raise rates even more.

If 5% didn’t have the desired effect, then maybe we need 7% or 8%. What is that going to do to the market? In fact, 5% is already more damage than the markets and the economy can bear.”

A lot of people are looking at the current situation and assuming that the economy can withstand the higher rates.

Higher rates haven’t been there long enough for the full impact to be felt by the economy. All of that is going to happen. It just takes a little more time. Yet, investors are jumping to the wrong conclusion — that because they haven’t seen that full impact yet that what they’ve seen is it. Well, they’ve barely seen anything because you can’t take this highly levered economy and then go from such low interest rates to where we are now.”

So, we’re going to see economic fallout from the moves the Fed has already made. And if price inflation starts going up again, it’s going to be an even bigger problem.

Peter goes on to dig deeper into the job numbers and some other economic data.