why fed will cause next recession 11.9 - microsoft€¦ · negative market reactions could result...

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November 9th, 2018

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Despite the title, we really do not believe that the Federal Reserve will “cause” the next recession, although they will be a commonly cited scapegoat when it does occur. However, within our business cycle framework they are a critical component. Whether the Fed is easing policy and enhancing market liquidity or tightening credit and reducing market liquidity has an affect on business cycles. Our economy is driven by debt. As debt expands and credit is easy to come by, the economy tends to expand. Conversely, when credit contracts, the economy tends to slow.

The Fed started their tightening path in 2015 under Janet Yellen. The systematic tightening of policy really did not accelerate until Jerome Powell took his position as the Chairman of the Federal Reserve Board. Since then, however, the Federal Funds rate has gone from near zero to 2.190 as of the end of October. What is interesting is that the Fed started tightening policy as we were exiting a global economic contraction that saw oil drop to $20 per barrel, stocks drop globally, and industrial production reach depths typically seen during a full blown recession. This slow down, in our opinion looked identical to a recession, yet, the Fed began to tighten policy.

© 2018 WealthShield LLC. All Rights Reserved. This is provided for informational purposes only and should not be considered a recommendation to buy or sell a particular security. Past performance is no guarantee of future returns. Please see attached disclosures.

Chart 1: Effective Fed Funds Rate. The Fed is tightening policy and has been since 2016

1. Growth is already slowing for the US.

2. The Fed will go too far.3. The Fed will be delayed in changing course.

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The US economic recovery has been impressive since the contraction in growth we witnessed during the 2015-2016 time period. US economic growth, as measured by nominal GDP, reached new post financial crisis highs this year, breaking above a year-over-year rate of 5 percent growth. This level served as stiff resistance since the global financial crisis, until this year when nominal GDP broke out.

In addition to GDP, we have also seen measures of inflation pick up during the recovery and now wages are breaking out to the upside on a year over year basis. It appears that the Fed has an “all-clear” signal to continue to raise interest rates and shrink their balance sheet despite the efforts of President Trump to deter that policy.


Chart 2: US Nominal GDP broke above 5 percent on a year over year basis.

Chart 3: Average Hourly Earnings growing as wage inflation continues.

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It appears that this formulaic approach to tightening policy should be able to be absorbed by the market with little negative implications. Besides, the US seems to be

firing on all cylinders as an economy, right?

Unfortunately, we think that growth in the US, and inflation for that matter, have peaked during this economic cycle. The Economic Cycle Research Institute Weekly Leading Index suggests that growth is slowing in the US. This particular index, which is a composite of

leading economic indicators compiled and calculated by ECRI, is now negative 1.4 percent year over year.


Chart 4: ECRI WLI is down 1.4% year over year. This is a clear indicator that growth is slowing in the US.

It is our opinion that the tightening policy of the Fed could accelerate the slowdown in growth and inflation. If taken too far, this could result in a recession in the US.

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We have every reason to believe that the Fed will tighten too far during this cycle. This will become evident when two conditions become apparent. One is a yield curve inversion. This occurs when the 2 year yield is higher than the 10 year yield. This typically occurs before a recession and is a commonly referenced precursor to a slow down in the economy. With the Fed raising rates again in December and several more potential increases in 2019, we believe the yield curve will surely invert and could possibly do so by the end of the year.

The other condition that will most likely signal the Fed has moved too far is when the 2 year yield diverges from the Fed funds rate. What we mean by this is that the 2 year yield will stop increasing and flatten out or fall while the Fed funds rate continues to increase. This could also result in an inversion between the Fed funds and 2 year rate, meaning the Fed funds rate is higher than the 2 year Treasury yield.


Chart 5: 2s10s yield curve. Pretty close to inverting.

Chart 6: Fed Funds Rate and the 2 year Treasury Bond rate.

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If and once the Fed overshoots, the business cycle will most likely reverse course and contract significantly. If a similar environment to 2000-2003 emerges, markets could already be experiencing stress throughout this time. This could create a potential problem with regards to how the Fed handles the slow down in the business cycle.

In order to maintain confidence in the Federal Reserve, the open market committee will most likely have to communicate a change in policy long before it reverses course and starts to ease. This could take several months as it reinforces its data dependence. This mechanism, although considerate to market participants, will most likely delay the easing support that the market and economy needs during a contraction.

Our estimate is that the Fed will get the bad data and then respond by communicating a potential pause in its tightening policy. Upon further negative data (including negative markets), it will respond by pausing. After a pause it will most likely communicate a path to easing policy upon further data. Then the Fed will likely ease policy. This delayed and methodical reaction could be a concern for markets. Risk can happen fast, meaning negative market reactions could result over a short-time frame creating a negative feedback loop and deep market losses.

Although the cause of the recession will be a slow down in growth and negative market events, the Fed will get a ton of blame. We have highlighted three main reasons the Fed can act as a catalyst to accelerate the growth decline in the US. Although we do not see immediate signs of a recession in the US, we fear that continued tightening by the Fed during a slowing in economic growth could accelerate the risk of recession, especially given the backdrop of high valuations and negative trends in global stock markets.


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© 2018 WealthShield LLC. All Rights Reserved. This is provided for informational purposes only and should not be considered a recommendation to buy or sell a particular security. Past performance is no guarantee of future returns. Pleasesee attached disclosures.

why fed will cause next recession 11.9 - microsoft€¦ · negative market reactions could result...

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