We are halfway through a busy back-half of the week from a central bank perspective. The FOMC yesterday raised rates as expected and maintained their view that three total hikes for 2017 are likely. Rates traders seem to disagree with aggregate odds of a further hike in Fed Futures at 43 percent, and OIS implied 47 percent.

The Fed hates surprising markets, so unless they can talk up the probability ahead of the event, they may be forced to correct. So far in this cycle, the market has been historically more accurate than the Fed's own dot plots, and some weak inflation data further hinders their ability to stay aggressive.

The trade-off may be that the Fed's first announcement of concrete plans to reduce the size of the $2.5 trillion balance sheet of open-market securities was both sooner and more aggressive than most economists had predicted. Since the announcement, interest rates have trended higher, and the recently popular short-dollar trade has experienced some short covering.

Bull Case

  • If current conditions hold, the Fed is less likely to hike again in 2017 and the marginal change should weaken the dollar and bolster gold.
  • Equity market valuations remain stretched, but so far lack a catalyst to cause selling.
  • Maybe the market will care about Robert Mueller investigating POTUS for obstruction of justice? Bill Clinton's perjury investigation didn't affect much, but perhaps this time is different?
  • 100- and 200-day moving averages at $1,246 and $1,240 respectively should provide some support.
  • Gold is still in uptrend from December lows and maintains the higher lows trend, even if we have struggled to break $1,300 twice since April.
  • 2s10s spread in rates look to go almost flat. This is usually an indication of rates traders thinking short rates are too high compared to long-run growth expectations.

Bear Case

  • Gold can't seem to break $1,300, even on the rallies, and now has some downside momentum issues.
  • Short rates are moving higher, and currency traders have been caught short the dollar today.
  • Crude is getting crushed on inventory builds despite summer driving season. If we were to break $40 WTI, the paradigm shifts as you have the opposing potential effects of an OPEC break to meet revenue projections (actually produce more at lower prices), and shale plays likely come offline as long-standing hedges unwind.
  • FOMC balance sheet reduction over the next five years will remove the buyer of some 50 percent of many maturities from the market. Short rates likely move even higher.
  • Expectations for a BoE hike are being pulled forward. While likely to weaken the USD against GBP, it would be one less central bank in accommodative mode.
  • Economic data for everything except average hourly earnings and CPI is strong. We haven't had three years straight years of U-3 below 4.5 percent since the 1960s, and that is now the FOMC's base case.
  • Why AHE still stubbornly low? Large employers still have pricing power, even if small firms do not.

Chart 1

The Fed's Treasury holdings. With a weighted average of just under eight years to maturity, time will do much of the Fed's work for it, but they own an astounding 48 percent of all treasury issuance at current market.

Given those two data points, it makes sense that we see the two-year rates jumping back above 1.35 percent and may even go higher, while the 10-year languishes, anchored to long-run growth projections at 2.2 percent without many Fed sales to buoy it. The 2s10s spread since 2008 is charted on the lower portion of the graphic and is looking to test the Q3 2016 lows.

Chart 2

GLD ETF holdings. As much credit as we would like to give institutional buyers for being ahead of the curve, the GLD ETF holdings can basically be proxied by the spot gold 40-day moving average, meaning that ETF buyers are basically just trend chasing.

As an n=1 observation, we saw a 400K liquidation print this morning on the back of a $15 down move in gold. And that trend is turning over.

Bonus Chart

Palladium's wild ride. Friday witnessed a complete breakdown in the palladium market on a rumored bar shortage for physical demand. EFPs got quoted in the $40 backwardated range at times, and forward rates were being quoted around 20 percent annually. If you were long spot/physical and short the futures, you walked into a $40 per ounce gift Friday while the market tried to sort itself out.

The gray and blue lines are spot and September futures, which had traded within a dollar or so each other until the disruption, where you see the two lines diverge. The white candles on the bottom portion are the September-December spread, which blew out $25 before settling back to $8 or so currently, which is still pretty rich historically, but at least within an order of magnitude of normalcy.

Coin Toss

Gold has some momentum and rates issues predominantly, and we may need to test and hold the moving averages $10-$15 below here before being able to regain any footing. The double failure at $1,300 will likely frustrate some longs as well.

Vols across the macro space remain depressed and frankly, I don't see any specific reason on the horizon for that to change unless the econ data shifts. Lower.