Danielle DiMartino Booth: Gold's Violent 5% Drop Is a 'Repeat of March 2020'

Key Concepts

• Divergent Market Realities: Two contrasting market narratives exist: one of corporate strength and stock market highs, and another of financial system stress and potential crisis.
• Credit Market Stress: Signs of strain in the private credit market, including blowups and increased delinquencies, are drawing comparisons to the 2007 subprime crisis.
• Data Vacuum for the Fed: The Federal Reserve is making policy decisions with delayed and incomplete official economic data, relying more on alternative data sources.
• Consumer Strain: While top earners are maintaining consumption, the broader consumer is showing signs of distress due to factors like student loan repayments and rising delinquencies.
• "Extend and Pretend" Practices: Banks may be reclassifying loans or easing underwriting on renewals to avoid classifying them as non-performing, masking underlying solvency issues.
• Contagion Risk: Concerns exist that stress in the private credit market could spread to the conventional banking system and broader financial markets.
• Liquidity as a Cleansing Agent: A lack of liquidity can force central banks to alter their policies, potentially leading to a shift from quantitative tightening (QT) to quantitative easing (QE).
• Gold as a Liquidity Indicator: Gold's recent sharp sell-off, despite hitting record highs, is interpreted as a sign of liquidity crunch, where investors sell winners to meet margin calls.
• Capital Expenditures as a Bullish Signal: Increased private sector investment in future growth and workforce expansion, beyond just AI adoption for cost-cutting, would be a strong counter-argument to bearish theses.
• Credit Spreads as a Key Indicator: Widening credit spreads, particularly in collateralized loan obligations (CLOs), would signal that private credit market stress is bleeding into public markets.

Two Distinct Market Realities and Conflicting Data

The current market presents a dichotomy:

• Optimistic Narrative: Industrial giants like General Motors and Coca-Cola are raising their full-year forecasts, and stock markets are hovering near all-time highs.
• Pessimistic Narrative: The Governor of the Bank of England has drawn parallels between recent private credit market blowups and the 2007 subprime crisis, questioning if they are "the canary in the gold mine." This coincides with gold experiencing one of its most significant sell-offs in five years, down over 5% after a record high. Fears are mounting that the Federal Reserve might be forced to abruptly end its balance sheet tightening not due to inflation being conquered, but because the financial system itself is showing signs of stress.

Danielle D. Martino Booth, former Federal Reserve insider and CEO of Qi Research, discusses these conflicting realities.

Wall Street vs. Main Street and the Data Vacuum

Wall Street's current sentiment is described as reminiscent of 2019, with record earnings, valuations, and a 4% GDP print. However, credit markets are showing cracks, and gold has experienced its worst day in years. This raises the question of whether the economy is running on borrowed time.

Goldman Sachs has suggested that labor market data is a more accurate reflection of the real US economy than GDP, advising to "fade the latter and pay more attention to the former." This contrasts with anecdotal reports of Americans cutting back on expenses to afford groceries while stocks remain at all-time highs.

The Federal Reserve is operating in a "data vacuum" due to government shutdowns, which have delayed official reports like the September jobs report and the upcoming September CPI report (scheduled for October 24th).

• Alternative Data Sources: Governor Christopher Waller highlighted the Fed's reliance on updates from ADP (Automatic Data Processing) for more frequent insights into the job market. Chair Powell has also indicated a greater focus on alternative data sources, acknowledging that official data can be misleading due to later revisions.
• Fed's Cautious Stance: The lack of official negative data prints may be forcing the Fed into a more cautious position, potentially allowing the market to run. However, the market currently running is the bond market, anticipating Fed rate cuts.
• Bond Market Anticipation: The bond market has priced in a near 100% probability of a Fed rate cut on October 30th, based on Chair Powell's previous remarks. The bond market's activity is seen as providing significant support to stock prices.

Bond Market Signals and Consumer Strain

The 10-year Treasury yield hovering around 4.4%, after spiking earlier, along with renewed deficit fears and the VIX index above 110, indicates liquidity is tightening.

• Recessionary Signal: The 10-year Treasury yield breaking below 4% and holding that level is interpreted as the market anticipating a recession in the United States. This is a traditional signal from long-term yields.
• Impact on Gold: This recessionary outlook is also contributing to the sell-off in gold prices, as concerns shift from inflation to slower growth and potential income declines.

Drilling down on the consumer:

• Record Household Debt: Household debt has reached a record $18.4 trillion, according to the New York Fed.
• Hardship Withdrawals: 401k hardship withdrawals are at a two-year high, driven by the resumption of student loan payments. Firms like Empower and Vanguard report this trend.
• Divergent Consumer Experience: The impact varies by income level. The top 10% of earners account for 50% of consumption, while the remaining 90% are significantly affected by student loan repayments.
• Limited Student Loan Relief: While there was excitement about income-driven repayment plans, only a small fraction of student loan borrowers are expected to benefit.
• Rising Auto Loan Delinquencies: Vantage Score reported the most rapid increase in auto loan delinquencies among prime borrowers, individuals often impacted by student loan obligations.

Credit Market Alarms and "Extend and Pretend"

Senior financial figures are sounding alarms about the credit markets:

• Bank of England Governor's Warning: Andrew Bailey drew a direct parallel between the collapse of US firms like First Brands and Tricolor to the 2007 subprime crisis, stating that "too small to be systemic" was the wrong assessment.
• Underwriting Standards: Bailey's comments suggest a recognition that lax underwriting standards in the private credit market, even with idiosyncratic issues like Tricolor's, are a significant concern.
• Contagion Risk: Banks like JP Morgan and Fifth Third Bank are experiencing blowback from the private credit space into the conventional banking system, as conventional banks fund the non-banking sector. This highlights a serious potential for contagion.
• Fed Senior Loan Officer Survey: The Q2 survey showed tightening credit standards across commercial real estate, autos, and consumer credit.
• Moody's Report and "Extend and Pretend": A Moody's October report indicated that several regional banks have eased underwriting on loan renewals to avoid classifying them as non-performing. This practice, known as "extend and pretend," is not new and has been prevalent in the post-pandemic era, particularly in the frozen commercial real estate market.
• Broader Application of "Extend and Pretend": Unlike 2007-2010, where it was largely isolated to commercial real estate, this practice is now being observed across the entire consumer loan spectrum, including auto loans, credit cards, and personal loans.

Fraud, Credit Bubbles, and the AI Narrative

Jamie Dimon of JP Morgan warned of "cockroaches" in the credit market, and Danielle D. Martino Booth's work has consistently highlighted fraud.

• Corporate Bankruptcies: August alone saw 71 corporate bankruptcies.
• Loose Underwriting and Due Diligence: The systemic issue appears to be very loose underwriting standards, insufficient due diligence, and a failure to ensure cash flows can service debts. This is attributed to bankers and individuals who facilitated the recent debt spree.
• Fraud at Credit Cycle End: Fraud typically emerges at the end of credit cycles, along with the strongest players resorting to borrowing due to insufficient cash flows.
• AI and Debt: Even in the AI space, which is being hyped as transformative, companies like Oracle are issuing massive debt ($18 billion) to fund their plays. This suggests that if borrowing is required to execute strategies, the underlying economics and assumptions may not be sound.

Risk of Contagion and the Fed's Balance Sheet

While bulls point to isolated incidents and argue that trends are not established, the risk of contagion remains a concern.

• Non-Depository Financial Institution Lending: The Federal Reserve reclassified $300 billion of loans into this category, increasing the outstanding amount from $1.3 trillion to $1.7 trillion. Additionally, there are $900 billion in untapped lines of credit for borrowers in the non-banking space.
• "More Cockroaches": If lending standards have been lax across regional and larger banks, more issues are likely to surface, as Jamie Dimon suggested. The tweet "RAID CAPITAL!" is used to signal such discoveries.

The Federal Reserve and Quantitative Tightening (QT)

There are growing beliefs that the Fed will be forced to abruptly end its balance sheet runoff (QT) due to mounting friction in money markets and the financial system's plumbing.

• Liquidity as a Cleansing Agent: A lack of liquidity has historically forced central banks to alter their policies. The Fed's actions prior to the pandemic, while not explicitly called QE, were aimed at injecting liquidity.
• Premature Discussion of QE: It is considered premature to discuss a shift from QT to QE, as the debate about a potential rate cut at the December FOMC meeting is still ongoing. A move to QE would typically follow reaching the zero bound for interest rates.
• Forced Halt to QT: The system appears to be running out of sufficient liquidity, which could force the Fed to halt QT.
• Mortgage-Backed Securities (MBS): A plea is made for central bankers to continue rolling off MBS from the Fed's balance sheet, even if replaced by Treasuries, citing the failure of the Fed's previous interventions in the housing market.

Gold's Volatility and Liquidity Crunch

Gold's recent sharp sell-off, after hitting a record high, is seen as a significant event.

• Selling Winners in a Crunch: In a liquidity crunch, investors often sell their winners to meet margin calls. This was a risk previously highlighted for gold, not because of its long-term value, but due to its significant price run-up.
• Dollar Strength: The dollar index firming up is noted.
• Repeat of March 2020: The current behavior of gold is compared to the March 2020 sell-off, where people sold assets to access cash, even if they had gained value. Gold behaving like a "meme stock" is seen as concerning.
• Potential for a Stronger Leg Higher: This wash-out of non-core holders could potentially set the stage for a more powerful rally for core gold holders, especially if the Fed halts QT or expands its balance sheet. This is a common pattern in asset classes where speculative buyers are washed out during corrections.

Arguments Against the Bearish Thesis and Key Indicators

The bullish argument centers on strong earnings and the productivity boom from AI.

• Counter-Argument: Capital Investment: The strongest argument against the bearish thesis would be private sector companies seriously committing to significant capital investment for future growth and workforce expansion by 2026, beyond just AI adoption for cost-cutting. This would involve increasing capital expenditures and hiring.
• Lowered Bar for Earnings: Current strong earnings seasons may be a result of a lowered bar, making it easier to exceed estimates. An example is an auto parts provider that lowered guidance but beat its reduced estimate, while still forecasting future declines.

The "deserted island indicator" for bond volatility, the MOVE index, is still elevated.

• Key Indicator: Credit Spreads: The most closely watched signal for a shattered illusion of control and the beginning of a reckoning is widening credit spreads.
  • CLO Spreads: Specifically, a widening of Collateralized Loan Obligation (CLO) spreads would be highly problematic. Recent outflows from CLO funds have been observed.
  • Validation with MOVE Index: A resumed increase in the MOVE index would validate widening credit spreads.
  • Bleeding into Public Markets: This would indicate that credit events in the private space are bleeding into the public space, which would capture market attention.

Danielle D. Martino Booth's analysis suggests that the battle between Wall Street's optimism and the warnings from the credit markets is reaching a critical point.