Ten-year U.S. Treasury bond yields usually peak, on average, three months prior to the stock market peaking. The first week of August will mark the tenth month since ten-year Treasury yields peaked, while stock prices show no signs of slowing down. Treasury yields normally lead stock prices into a recession anywhere from zero to fourteen months, which makes me wonder why this time it is taking so long. It occurred to me that the Federal Reserve will trigger a recession when they cut rates.
Recessions normally happen after the Federal Reserve begins tightening monetary policy by raising interest rates or selling U.S. Treasury bonds and Mortgage-Backed Securities from their balance sheet. The purpose of monetary tightening is to remove currency from the financial system to prevent inflation from spiraling out of control. In a debt-based economy, such as ours, any form of monetary tightening will lead to an economic slowdown.
As we saw during the past two recessions, the greater the amount of monetary tightening, the more severe the ensuing recession is. In this recent economic expansion, the Fed tightened monetary policy more than they normally do and at a faster rate than they normally do, due to the rapid pace that the Fed sold bonds from their balance sheet. Despite the Fed’s rapid tightening and the slight slowdown in the U.S. economy, a recession has yet to occur.
Even though the U.S. economy has yet to feel the brunt of the Fed’s tightening, which is lagged by approximately eighteen months, the global economy has experienced a sharp slowdown. The slowdown in the global economy is due to the Fed’s monetary tightening since the U.S. Dollar is the world’s reserve currency. When the Fed tightens monetary policy, they also remove dollars from the global economy, which is why the global economy is rapidly slowing and soon to enter a recession.
To stave off the global economic slowdown, twelve central banks have already started cutting rates and the Fed has made strong indications that they too will cut rates at their July meeting. Even if the Fed does not cut, as the incoming U.S. economic data suggests they should not cut, it is likely the Fed will cut by the end of September. While it is generally believed that cutting rates is stimulative, history shows that cutting interest rates may trigger a recession.
While this may seem strange, every recession is preceded by the Fed lowering interest rates. At first, this relationship between the Fed cutting and recessions can be rationalized as the Fed overtightened and the economy contracted faster than expected, but that is not entirely it. After all, cutting rates is supposed to be stimulative unless it is not. This does not make much sense until you understand how rate cuts affect the bond market and how large investors, or the “Smart Money,” lure the Fed into cutting rates to trigger a recession.
In the late stages of an economic expansion the large commercial banks, who are considered the “Smart Money” along with corporate insiders, and those who understand our monetary system, start buying large quantities of U.S. Treasury bonds from the public who is eager to sell them. The public is eager to sell their bonds since they finally believe that stock prices are going to rise indefinitely, but the banks know otherwise since the Fed usually tightens monetary policy by this point.
The large commercial banks do not have to buy bonds, as they could hoard cash instead. Banks buy Treasury bonds since bonds rise in value during periods of deflation, which happen when debt-based economies recess. The large commercial banks are planning to profit off their bond holdings when the public decides to dump their stocks at the bottom of the recession for the safety of U.S. Treasury bonds.
Once the large banks have accumulated all the bonds they want, they need the economy to recess to cash in on their investment. The banks have intimate knowledge of their customer’s finances, so the banks know well in advance of when the economy is going to collapse under the weight of the Fed’s rate hikes. In order to profit off their bonds, the banks need interest rates to fall, since Treasury bond prices rise when interest rates fall. The banks cannot make interest rates fall on their own, so they look to the Fed for a little help.
Most investors believe a rate cut injects money into the economy, and it does, but only when the banks lend the money back out. The banks are not required to lend the money they receive from selling bonds to the Fed, as the Fed cannot force the banks to lend. Lower interest rates are only stimulative when banks lend the money out, but when they use it to buy more Treasury bonds to sell to the Fed, it is not stimulative.
Once the banks have loaded up on Treasury bonds, the banks, and the “Smart Money” begin their campaign to convince the Fed it is time to cut interest rates. The Fed looks to Wall Street, who is influenced by the banks, for direction on monetary policy. The Federal Funds futures, which is a way for investors to bet on future monetary policy, is one way the Fed can be influenced. When the Federal Funds futures show that many investors want a rate cut, the Fed feels that forward economic outlook is pricing in a rate cut, which makes the Fed’s decision easier.
The banks and the “Smart Money” also use the financial media, in the form of print, radio, and television, to sway the Fed into cutting rates. As the chorus of investors who wants a rate cut gets louder, more journalists, bloggers, and analysts join in on the rate cut party. Once the pressure on the Fed is high enough, they acquiesce and cut rates.
When the Fed cuts the Federal Funds rate, they will end up buying approximately $60 billion of very short-term U.S. Treasury bonds to force the Federal Funds rate lower. Since the large banks and other savvy investors have bought up most of the available supply of bonds, the Fed will pay a premium to lower interest rates. The Fed never cuts rates just once, so investors start buying bonds in anticipation of future rate cuts.
When the supply of a security, in this case, U.S. Treasury bonds, is thin and a large price-insensitive buyer arrives, in this case, the Federal Reserve, prices quickly rise. Investors love free money, and when the Fed starts buying bonds to drive interest rates lower, buying Treasury bonds is an easy way to generate a near risk-free positive return.
When the Fed starts cutting rates, the entire Treasury yield curve, from short- to long-term yields, falls. As more investors jump on the bandwagon hoping to profit from the Fed buying bonds, yields fall even faster. When interest rates fall in a debt-based monetary system, financial conditions tighten. When financial conditions tighten, the Fed is forced to ease even more, which is drives Treasury bond prices higher.
With cash positions in brokerage accounts already very low, to benefit from the rising in Treasury bond prices, investors begin selling stocks. This is why shortly after the first or second rate cut, stock prices begin to fall. Once stock prices start falling, a recession becomes a foregone conclusion. Once stock prices are in a free fall and the public panics, the public is all too happy to dump their stocks to buy U.S. Treasury bonds at very high prices.
Once the public begins selling and the Fed ramps up their buying to counteract a contracting economy, the banks and the “Smart Money” unload their cache of bonds to buy stocks. It is the large pool of buyers from the public and the Fed that allow the banks and other holders of Treasury bonds to rapidly selling billions of dollars worth of bonds without impacting the markets. The banks buy bonds ahead of a recession since they know in advance who they are going to sell their bonds to.
There is a great deal of debate among investment professionals of how many rate cuts it takes before stock prices collapse. The consensus view is it takes two cuts, and therefore anyone who owns stocks should keep buying stocks until the second rate cut. It is not the number of rate cuts that matter, but how long it takes the Fed to cut after Treasury yields peak.
When the Fed starts cutting rates in the months immediately following a peak in Treasury yields, stock prices can and have rallied for several more months. When the Fed starts cutting rates well after Treasury yields peaked, then stock prices tend to fall shortly after the first rate cut. The reason has nothing to do with the number of rate cuts, but how much of a lead time the banks and the “Smart Money” have to accumulate Treasury bonds.
The more lead time the banks and the “Smart Money” have to buy Treasury bonds, the sooner stock prices start to fall after the first rate cut. With a current lead time of nearly ten months, with the longest lead time being fourteen months, the Fed is going to trigger a massive bond rally at a point when there is not much liquidity in the markets and after the banks have bought a huge amount of bonds.
In my weekly videos, I regularly cover the technical price levels of Treasury yields, which show they are about to break out to the downside. Treasury yields have been trading sideways for the past couple months in anticipation of a Fed rate cut. When the rate cut happens, the Fed will buy Treasury bonds from the banks, who will take the cash and buy more Treasury bonds at the next U.S. Treasury bond auction.
The banks will continue to profit on their bonds until the public starts selling stocks and the Fed ramps up their bond purchases. When analyzing the economic cycles, it is easy to see how every expansion and every recession since the inception of the Federal Reserve has to do with the Federal Reserve raising and lowering interest rates. While investors will likely buy stocks on the news of the next rate cut, you now know the next recession, along with the ensuing rally in Treasury bonds, is just a few of months away.
While my view regarding rate cuts may be unconventional, one day after I wrote this piece, I read the following in an article about rate cuts: “Since the 1950s, the Fed has embarked on 19 easing cycles, including the unconventional easing measures adopted during the course of this economic recovery, according to Deutsche Bank’s Binky Chadha. However of these, 9 or almost half, saw the economy eventually slip into recession; not only that, but the latest three rate cut resulted in a recession within 3 months of the first cut.”
My view on the relationship between cutting the Federal Funds rate and recessions began when I compared 1- and 3-year Treasury yields to the Federal Funds rate to confirm their relationship to the Federal Funds rate in advance of a potential trade following the July 31st FOMC meeting. As I suspected, my view was confirmed, making it an easy decision to purchase short-term Treasury bonds after the Fed cuts rates.
While many investors believe long-term rates can and will rise despite the Fed cutting rates, they are wrong. I also compared both 10- and 30-year yields and found they follow the Federal Funds rate lower one hundred percent of the time. I didn’t stop there.
In addition to the entire Treasury yield curve following the Federal Funds rate lower, stock prices also follow the Federal Funds rate lower after the first or second cut. As expected, volatility also rises following rate cuts, which will be interesting since a huge portion of the equity market is short volatility as they believe volatility will stay perpetually low.
Crude oil prices also fall when the Federal Funds rate fall due to their relationship with 5-year Treasury yields, which validates my view that crude oil prices are headed much lower. This also validates the chart of oil and gas producing stocks, which shows they are going to be very cheap.
The growth rate of the broad M2 Money Supply also follows the Federal Funds rate lower, which confirms that lower interest rates lead to tighter financial conditions, along with lower Treasury bond yields. Now you know that recessions do start shortly after the first or second rate cut and how to invest your money when they start cutting.
How Low Will Oil Stocks Go? (07/29/19 – 10 min)
The Real Reason the Fed Cut Rates (07/31/19 – 16 min)
How Rate Cuts Cause Recessions