Author: Gwen

Corresponding Authors: Bjeast, Enzo, Youbi Research Team

About the fluctuations in gold, US Treasuries, interest rate cuts, balance sheet reduction, and the US elections.

TL;DR

• Since the end of March, gold and the US dollar have decoupled, both showing an upward trend. This is mainly due to the recent surge in geopolitical events outside the US, leading to a rapid increase in global risk aversion, with both gold and the dollar exhibiting safe-haven characteristics.

• The behavior of central banks, led by China, selling US Treasuries while increasing gold holdings suggests a trend of localized resistance against the dollar's hegemony and uncertainty in the demand for long-term US Treasuries. As other sovereign nations have earlier expectations for interest rate cuts, such as Europe and Switzerland, if inflation remains high, the strength of the dollar will persist.

• In the short term, due to expectations of the Federal Reserve slowing down balance sheet reduction in mid-year, the Treasury General Account (TGA) balance increased more than expected in April, partially offsetting the liquidity shock from Treasury issuance. Attention should be paid to the specific amount of Treasury issuance and the short-long bond ratio.

• However, from a medium to long-term perspective, the US Treasury crisis has not been resolved. The current soaring fiscal deficit rate of the US government, the expiration of the debt ceiling suspension in January next year, and the market's expectation of maintaining the same level of issuance demand as last year indicate that when reverse repos approach zero, the TGA account balance will become a key indicator, and vigilance should be maintained regarding the bank reserve ratio.

• In the two months before the election, due to the uncertainty of ballots and specific policies, historically, risk assets tend to show a volatile decline. To maintain its independence, the Federal Reserve will try to sustain economic growth in the election year, keeping the market in a state of ample liquidity.

• The US economy shows strong domestic demand, fluctuating inflation, and a significant decrease in recession expectations compared to last year. Institutions' "preventive" interest rate cut expectations have collectively shifted to the second half of the year or even after the year. CME data indicates that the market expects a 45% chance of interest rate cuts in September and November, while expectations for the first rate cut in December and January are gradually increasing. Combined with historical interest rate policy performance in election years, interest rate policies before the election month (i.e., September) are usually more cautious. Furthermore, the sufficient condition for rate cuts is poor employment and weak inflation, and vigilance should be maintained against tightening financial markets.

• Expanding the balance sheet has a more direct impact on market liquidity than cutting interest rates. The Federal Reserve is currently considering slowing down balance sheet reduction ahead of schedule. The market generally expects a slowdown in balance sheet reduction in May or June to counter liquidity tightening, with a complete halt to balance sheet reduction at the beginning of next year, followed by a period of expansion. Additionally, history shows that there is a high probability of initiating a shift operation shortly after the election.

1 Gold and the Dollar "Decoupling"

Figure 1: Dollar and Gold Price Trend Chart
In the past, the international gold price trend was usually negatively correlated with the US dollar index, but since the end of March, gold and the dollar index have shown an abnormal upward trend together. This negative correlation can be explained by three attributes of gold: commodity attribute, monetary attribute, and safe-haven attribute, which need to be discussed in conjunction.

• Commodity Pricing: A stronger pricing currency will lower the price of the priced item, gold (the same applies to commodities).

• Financial Attribute: Gold is a substitute for the dollar and a potential alternative when dollar credit declines. When the dollar is weak, investing in gold may yield higher returns.

• Safe-Haven Attribute: Typically, a stronger dollar indicates a strong economic fundamental, leading to a decrease in demand for safe-haven assets. However, as the world's currency, the dollar also has safe-haven attributes. Specific risks need to be discussed in detail.

1.1 Gold Surge

The recent abnormal rise in gold prices has attracted significant attention, with two main reasons.

1) Market risk aversion triggered by geopolitical conflicts. Moscow's airstrikes, Israel's airstrikes on the Iranian embassy in Syria (the direct trigger), Iran's direct attacks on Israeli territory, etc., have led to increased gold purchasing demand globally, which is one of the driving forces behind the short-term rise in gold prices.

2) Central banks' continuous purchases of gold, enhancing demand. To avoid risks associated with US Treasuries, some central banks have begun to reduce their holdings of US Treasuries while increasing gold holdings, thereby pushing up gold prices. This also reflects a trust crisis in the dollar, which may evolve into de-dollarization in the future. For example, the People's Bank of China increased its gold reserves by 10 tons in January, marking the 15th consecutive month of increasing gold reserves; the current total gold reserves amount to 2,245 tons, nearly 300 tons higher than when the increase was first announced at the end of October 2022.

Figure 2: Global Central Bank Gold Purchasing Trend, https://china.gold.org/gold-focus/2024/03/05/18561

1.2 Dollar Index Rise

1) The US economy's strong domestic demand has delayed interest rate cut expectations. The economic data for Q4 2023 indicates that the current economy has certain resilience, while Q1 2024 shows that there is currently a supply-demand imbalance in the US that relies on overseas imports for supply. Additionally, fluctuating inflation data has reduced the necessity for interest rate cuts, and maintaining a tight monetary policy stabilizes the demand for the dollar, prompting its rise.

2) The dollar has passively risen due to international exchange rate influences, such as Switzerland's unexpected early interest rate cut. If other currencies adopt monetary easing policies, the interest rate differential will lead to an increase in the dollar's exchange rate relative to other countries, thereby pushing up the dollar index.

3) The dollar, as a world currency, absorbs part of the safe-haven demand. When geopolitical crises do not involve the US mainland, the dollar's safe-haven attributes will partially manifest, acting similarly to gold.

1.3 Why Both Strengthened

Reason One: Both the dollar and gold have safe-haven asset attributes. When sudden risk events occur, leading to a deterioration of geopolitical or economic crises, excessive market risk aversion can result in both assets strengthening simultaneously. Additionally, the influence of gold's commodity and financial attributes is less than that of its safe-haven attribute. For the dollar, the US maintains a tight monetary policy while other economies' currencies weaken, supporting the dollar's strength. Similar situations have occurred in history, such as the failed US intervention in 1993, the European sovereign debt crisis in 2009, and instability in the Middle East.

Reason Two: Although the dollar shows a strengthening trend in the short term, the behavior of some central banks reducing their holdings of US Treasuries while increasing gold suggests resistance to dollar hegemony, indicating a localized trend of de-dollarization, and vigilance should be maintained regarding a potential dollar credit crisis.

From the perspective of gold trends, in the short term, gold's movement mainly depends on whether Iran will retaliate against Israel on a large scale. If the geopolitical situation continues to deteriorate, gold may continue to surge. From the dollar index's perspective, some other sovereign currencies have earlier expectations for interest rate cuts, such as the euro and the pound, while the Swiss National Bank has already cut rates early. In this context, the dollar still has interest rate differential space, which may continue to provide certain support in the future.

2 Liquidity Risk Uncertainty

2.1 Market Liquidity Constraints

Market liquidity in the financial sector is an important indicator for judging future market trends. The small bull market at the beginning of the year was also due to the approval of the BTC ETF, which brought liquidity from traditional funds, and the Federal Reserve's dovish statements led to a short-term increase in liquidity, ultimately resulting in a pullback due to a lack of overall financial market liquidity.

The financial market often measures liquidity through real liquidity indicators = Federal Reserve liabilities - TGA - reverse repos = financial institution deposits + circulating currency + other liabilities. For example, in the chart, we can see that the previous cycle showed a positive correlation between BTC and financial liquidity indicators, even showing signs of overfitting. Therefore, in an environment of abundant liquidity, market risk appetite will be enhanced, especially in the crypto market where liquidity effects will be amplified. Figure 3: BTC and Financial Liquidity Indicators
The recent decline in reverse repo scale is mainly used to offset the liquidity decline caused by the issuance of new US Treasuries while the Federal Reserve is reducing its balance sheet. The liquidity release in March was also primarily contributed by reverse repos. However, the continuous decline in reverse repo scale, with the Federal Reserve maintaining a monthly reduction of $95 billion, is noteworthy. Additionally, to address the arbitrage space caused by low interest rates, the BTFP rate has been adjusted to not be lower than the reserve requirement rate since January 25. After the narrowing of the arbitrage space, the usage of BTFP has turned to decline, and it cannot further increase the Federal Reserve's balance sheet size. Furthermore, April faces the tax season, and the short-term increase in the TGA account has reduced overall market liquidity. Since 2010, the median month-on-month growth of the TGA account in April has been 59.1%, and it will gradually return to normal over time. Figure 4: US Financial Market Liquidity
In summary, in the short term, the end of the tax season in May, along with TGA growth exceeding expectations, leads institutions to predict that the Federal Reserve will begin to ease QT progress mid-year, alleviating liquidity tightening trends. However, in the medium to long term, the market lacks new growth momentum for liquidity. The liquidity of the US financial market will continue to decline under the influence of the Federal Reserve's balance sheet reduction process and the near exhaustion of reverse repo scale, which will further impact risk assets. The adjustment of the Bank of Japan's monetary policy will increase the uncertainty of liquidity risk, bringing certain downward risks to technology stocks, crypto assets, and even commodities and gold.

2.2 US Treasury Risks

The high volatility of US Treasuries was a significant trigger in the "triple kill" event of stocks, bonds, and gold in March 2020. Recently, the surge in US Treasury yields has once again exposed potential issues of supply-demand imbalance in the Treasury market.

2.2.1 Excessive Supply

In 2023, the deficit rate reached -38%, up 10% year-on-year, and the soaring deficit rate indicates a continued demand for issuing US Treasuries this year. The high debt and deficit fiscal situation caused by pandemic-era monetary easing, combined with the interest rate hike cycle, has resulted in a weighted average interest rate of 2.97% for the total outstanding debt in the 2023 fiscal year, continuously increasing the total interest that the US needs to repay. In 2023, $2.64 trillion of new US Treasuries were issued, and $0.59 trillion is expected in 2024, bringing the current total to $34.58 trillion.

In the short term, the refinancing expectations given by the Treasury on April 29 show an increasing issuance trend, and specific attention should be paid to the Treasury's formal quarterly refinancing plan. Although institutions represented by Nomura generally predict that due to last year's wage increases, the Treasury's tax revenue in April unexpectedly increased, the current TGA account has significantly increased, exceeding expectations by $205 billion, and Yellen may lower financing expectations.

In the medium to long term, the market generally expects that the US will still have a bond issuance scale of $2-2.5 trillion this year, which means that an additional $1.41-1.91 trillion will be issued this year, close to the average speed of Q1 2024. The debt ceiling suspension law will end on January 1, 2025, and to prevent a repeat of the Treasury crisis, the Treasury has the motivation to issue sufficient US Treasuries to ensure short-term government spending and normal operations after the suspension ends. Wall Street expects that regardless of who wins the presidential election in November, the US government will continue to issue a large amount of bonds.

Figure 5: US Treasury Issuance Scale

2.2.2 Weak Demand

Foreign investors and the Federal Reserve are the largest buyers of US Treasuries, accounting for half of the market share of tradable Treasuries. Although the Federal Reserve is currently considering slowing down balance sheet reduction, both have long ceased to increase their holdings of US Treasuries since 2022, shifting the supply pressure to domestic investors, with significant increases in household sector investment. Domestic investors prefer short-term bonds, with limited absorption capacity and high volatility. Currently, the issuance of short-term bonds has exceeded the ideal range. Since the suspension of the debt ceiling in June 2023, the proportion of short-term bills has reached 53.8% (compared to 85.9% in November 2023), while the Treasury Borrowing Advisory Committee recommends that the proportion of short-term bonds should be maintained at 15-20%.

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The Federal Reserve's balance sheet reduction process is ongoing, having reduced $1.016 trillion since Q1 2022 to Q4 2023. In the short term, the pace of balance sheet reduction may slow down but will not suddenly reverse. According to the March FOMC meeting, the entire FOMC agreed to reduce the monthly balance sheet reduction scale by about half, keeping the MBS reduction cap unchanged while lowering the US Treasury reduction. If the Federal Reserve slows down the balance sheet reduction process as expected, it will hedge some long-term bond demand.

Japan, China, and the UK are the top three buyers, holding over one-third of foreign-held US Treasuries. Demand from major foreign investors had rebounded at the end of 2023 but has recently shown a downward trend again, especially as China sold $20 billion of US Treasuries again in the first two months of 2024.

• Major economies are affected by local monetary policy changes and the current strengthening of the dollar. The European Central Bank is expected to cut rates in June, the yen has depreciated significantly and has not yet reversed the trend. In October 2023, when the yen fell below 150, monetary authorities chose to sell US Treasuries to maintain the stability of their sovereign currency exchange rate.

• Recently, the fluctuating inflation in the US and the actions of some central banks, represented by China, selling US Treasuries while increasing gold holdings indicate a trend towards de-dollarization and reducing asset depreciation risks. Currently, there is no sign that China will reverse the trend and increase holdings.

• The uncertainty of geopolitical crises also affects the demand for US Treasuries.

Thus, if the Federal Reserve slows down balance sheet reduction ahead of schedule, the dollar begins to weaken, or geopolitical tensions ease, it may restore some demand for long-term US Treasuries.

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Household sector bond purchases are unstable, with individual investors and hedge funds alleviating the current supply-demand imbalance. However, domestic individual investors have purchase limits, and hedge funds are sensitive to interest rates, making them susceptible to market influences and prone to significant sell-offs, so future demand from the household sector will have limits and instability.

The larger short-term bonds create liquidity buffers from money market funds. Money market funds are characterized by flexible deposits and withdrawals, with demand for overnight reverse repos or short-term government bonds with maturities within six months, while demand for long-term government bonds is minimal. Additionally, the asset floating losses of money market funds can easily trigger market runs, so they tend to prefer more stable overnight reverse repos. In the future, when the US Treasury market is highly volatile, money market funds may also sell US Treasuries.

Since the suspension of the debt ceiling in Q2 2023, money market funds have increased their holdings of $203 billion in short-term US Treasuries. By transferring ON RRP to absorb some short-term Treasury demand, the reverse repo scale has decreased by $271 billion in 2024, and Morgan Stanley expects the reverse repo scale to drop to zero by August, with the Federal Reserve starting to reduce QT in June. However, it cannot be ruled out that the Federal Reserve may slow down balance sheet reduction ahead of schedule, pushing back the timeline for bringing the reverse repo scale to zero to Q4. Figure 6: Federal Reserve Overnight Reverse Repo Scale
In summary, both supply and demand sides have many medium to long-term factors leading to supply-demand imbalance. If the Federal Reserve plans to slow down balance sheet reduction in May, and the dollar begins to weaken or geopolitical tensions ease, there may be opportunities to alleviate the Treasury crisis from the long-term bond demand side. However, the downward trend in reverse repo scale will not reverse in the short term, and once the reverse repo scale approaches zero, the TGA trend will become a key indicator for releasing liquidity, while vigilance should be maintained regarding changes in the reserve ratio of US deposit institutions.

3 Monetary Policy Trends

3.1 The Impact of the US Elections on Risk Assets

The greatest impact of the US elections on risk assets occurs in the two months prior (September-October) with negative effects and in the following month (December) with positive effects. In the first two months, due to the uncertainty of election results, the market typically shows risk aversion, particularly evident in years with fierce competition and narrow ballot differences, such as 2000, 2004, 2016, and 2020. After the election results are announced, the market tends to rebound as uncertainty dissipates. The factors influencing election years need to be assessed in conjunction with other macro factors.

Figure 7: S&P 500 Index Trends Before and After the Election, from JPMorgan

https://privatebank.jpmorgan.com/apac/cn/insights/markets-and-investing/tmt/3-election-year-myths-debunked
Bank of America analyst Stephen Suttmeier analyzed the average monthly returns of the S&P 500 index during election years, revealing that the month with the strongest growth in election years is typically August, with an average increase of just over 3% and a win rate of 71%. Meanwhile, December is usually the month with the highest profit opportunities, with a win rate of 83%.

Figure 8: Average Return Rates in Election Years, from Bank of America analyst Stephen Suttmeier

https://markets.businessinsider.com/news/stocks/stock-market-2024-outlook-trading-playbook-for-crucial-election-year-2024-1
Market influences arise not only from the uncertainty of ballot differences/party disputes but also from the specific policy differences of the candidates. In 2024, Biden and Trump remain the main candidates, and there are significant differences in their economic policies.

• Biden's re-election will essentially maintain the status quo, continuing to impose higher corporate taxes to alleviate the deficit, but this may negatively impact the stock market from a fundamental perspective. Additionally, compared to Trump, Biden preserves greater independence for the Federal Reserve.

• Trump advocates for comprehensive tax cuts while increasing infrastructure spending. During his previous term, the effective tax rate on corporate income significantly decreased, while the deficit rate rose rapidly, thereby increasing pressure on US Treasuries. At the same time, the coordination between monetary and fiscal policies may intensify, leading to long-term inflation risks and accelerating the depreciation of dollar credit.

3.2 Federal Reserve Interest Rate Cut Expectations

The normalization of interest rates depends on economic fundamentals (such as growth, employment, and inflation) and financial conditions. Therefore, the market's expectations for Federal Reserve interest rate cuts are largely "preventive," judging the need for cuts based on the strength or recession of the US economy, although this approach is often easily influenced by the Federal Reserve's erratic expectations management.

So, does the US economy need prevention? From the current GDP data, the economy appears robust, and the likelihood of recession is low, delaying the demand for preventive interest rate cuts. The revised Q4 2023 GDP data shows a quarter-on-quarter annualized growth rate of 3.4%, up 0.2 percentage points from previous estimates, with real personal consumption expenditures growing by 3.3%, an increase of 0.3 percentage points, indicating that consumption continues to provide momentum for economic expansion. Even the pre-revised GDP data was in a growth state (Q4 2022 GDP grew by 2.9%). Although the Q1 2024 GDP data was revised down to 1.6%, the decline was mainly due to high imports and weakened inventories, indicating that current domestic demand in the US remains robust, leading to a supply-demand imbalance in the internal economy. Consequently, major financial institutions have shifted their interest rate cut expectations to later in the year, with Goldman Sachs predicting July, Morgan Stanley also believing it will be after June, and CICC forecasting the cut to be delayed to Q4.

According to the latest pricing of CME interest rate futures, traders currently predict a 28.6% chance of a 25 basis point rate cut in July, a 43.8% chance in September, and a 43.6% chance in November. Thus, the market's expectations for rate cuts in September and November are close, but expectations for the first rate cut in December and January of the following year are increasing. Table 1: CME Rate Cut Expectation Distribution, as of April 29, 2024
However, the arrival of the rate cut window undoubtedly requires poor non-farm employment and weak inflation data as conditions, meaning economic cooling or a need for financial conditions to tighten again. Uncertainty arises from the November US elections; first, the Federal Reserve changing monetary policy before the election may influence the election results, thus the range of federal funds rate changes in election years is smaller than in non-election years, and the decision to cut rates in September will be more cautious. At the same time, it cannot be ruled out that some Federal Reserve officials may maintain a "dovish preference" to support rate cuts to preserve growth and employment while economic data remains resilient. However, historically, research on the past 17 US elections and US monetary policy indicates that the probability of the Federal Reserve initiating a shift operation before the election (before November of that year) is relatively low, while the probability of initiating a shift operation shortly after the election is relatively high, with only two instances of transitioning from rate hikes to cuts within a year and four instances of a shift in federal funds rate or monetary policy immediately following the November election.

In summary, the US economy shows robust domestic demand, fluctuating inflation, and a general postponement of interest rate cut predictions to the second half of the year or even next year. CME data indicates that the expectations for rate cuts in September and November are the highest, but the probabilities for December and January of the following year are rising. However, it is essential to remain vigilant that the sufficient conditions for rate cuts are poor economic conditions, so there may still be tightening in financial markets before the arrival of rate cut policies. Additionally, historically, interest rate policies and monetary policies (i.e., rate cuts in September) tend to be more cautious before election months, while the likelihood of a shift shortly after the election is higher.

3.3 Federal Reserve Balance Sheet Reduction Cycle

Does expanding the balance sheet have a greater impact than cutting interest rates?

Currently, the market's attention is mostly focused on interest rate cut expectations, but in reality, expanding the balance sheet has a more direct impact on market liquidity than cutting interest rates. As mentioned earlier, the market liquidity indicator = Federal Reserve liabilities - TGA - reverse repo scale. Expanding the balance sheet means the Federal Reserve is expanding its balance sheet by purchasing government bonds or mortgage-backed securities to increase reserves in the banking system and circulating currency, directly creating monetary increments that expand market liquidity, hence it is also referred to as "printing money." In contrast, cutting interest rates lowers borrowing costs, incentivizing businesses and individuals to increase investment and consumption, shifting funds to risk markets to enhance liquidity.

When will the monetary policy shift?

The progress of normalizing the balance sheet depends on the supply and demand for reserves. According to an article by New York Fed President Williams and others published in 2022, titled "Scarce, Abundant, or Ample? A Time-Varying Model of the Reserve Demand Curve": "The reserve demand curve is nonlinear, measuring adequacy by the ratio of reserves to bank assets, with 12%-13% being the critical point for excessive and moderately abundant reserves, while 8%-10% serves as the warning line for transitioning to scarcity." Financial market performance is often nonlinear, as evidenced by the market, where the reserve ratio quickly fell from nearly 13% to 8% after the Federal Reserve announced a slowdown in balance sheet reduction, ultimately dropping to 9.5% when the Fed restarted balance sheet expansion in October 2019.

Figure 10: Ratio of Bank Reserves to Total Assets of Commercial Banks
Currently, the US reserve ratio is at 15%, still in an excessively abundant state. As liquidity tightens and the reverse repo scale approaches zero, the reserve ratio will continue to decline. Institutions tend to predict that balance sheet reduction will end early next year, with Goldman Sachs expecting QT to begin reducing in May and end by Q1 2025. Morgan Stanley believes that QT will be reduced when the reverse repo scale approaches zero, with a complete end to QT by early 2025. CICC predicts that the critical point will be reached in Q3, and if the Federal Reserve slows down in May, the critical value could be delayed to Q4. Additionally, historically, the Federal Reserve tends to shift monetary policy shortly after the end of the election month.

In summary, the Federal Reserve has released signals indicating consideration of slowing down balance sheet reduction. The market generally predicts that a slowdown in balance sheet reduction may occur in May or June, with a complete halt to balance sheet reduction at the beginning of next year, followed by a period of expansion. The current risk uncertainty still lies in the increased supply of US Treasuries and the significant volatility in the US Treasury market due to the near-zero reverse repo scale. Especially in an election year, the stability of the economy is particularly important, and the Federal Reserve may preemptively stop balance sheet reduction to avoid a repeat of the "repo crisis" in 2019.

4 Conclusion

The recent trend of simultaneous increases in gold and the dollar, aside from sudden geopolitical factors, should also draw attention to the trend of some central banks selling US Treasuries while increasing gold holdings, indicating a localized trend of de-dollarization.

In the short term, the increase in TGA balance and expectations for the Federal Reserve to ease balance sheet reduction will partially offset the liquidity tightening caused by Treasury issuance, and attention should also be paid to the total refinancing volume and the short-long bond ratio in the second quarter. In the medium to long term, the supply-demand imbalance in US Treasuries has not been resolved. Due to the high deficit rate and the expiration of the debt ceiling suspension law next year, there will still be a significant demand for US Treasury issuance in 2024. The reverse repo scale will continue to decline, and attention should be maintained on the TGA balance trend and the nonlinear decline in bank reserve ratios.

The US economy shows robust domestic demand but fluctuating inflation, with interest rate cut expectations generally postponed until the end of the year. The expectation to halt balance sheet reduction remains temporarily at the beginning of next year. Historically, monetary policy tends to be cautious before US elections, while the likelihood of a shift shortly after the election is relatively high.

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