While it may be impossible to predict the exact timing of a recession, most experts still think we will not experience an economic downturn until sometime in 2020. Yet, historical data suggests that after the Federal Reserve starts cutting interest rates that a recession is a foregone conclusion. Even though the Fed claims their July rate cut was a mid-cycle cut and there is nothing to worry about, the probabilities that our economy will enter a recession after the second rate cut are extremely high.
In last week’s update and in my Friday video, I showed historic evidence that recessions start due to the Fed easing monetary policy after a long economic expansion. While the notion that the Fed causes recessions may sound strange, history shows otherwise. When charting several asset classes against the Federal Funds Rate, it becomes clear that the Fed is responsible for kicking off recessions.
Now that the Fed has kicked off the latest easing cycle by lowering the Federal Funds rate by a quarter percent, investors who understand the relationship between the Fed’s easing cycles and recessions are aware that the next recession my start in the next ninety days. Over the next ninety days, our economy is going to feel the effects from the U.S. Treasury borrowing a large amount of money and the monetary lags from eighteen months ago, which are going to tighten financial conditions.
The economic data over the second quarter showed signs that the recent slowdown was stabilizing, but that will soon change. The U.S. Treasury drained over $300 billion from its savings accounts as the government ran short of money over the past three months. When the Treasury pulls money from its savings accounts, it feels like a jolt of stimulus to the economy since the money held in their savings is not counted towards the broad money supply.
Now that the budget has been passed and the debt ceiling has been suspended, the Treasury is going to refill their savings accounts by approximately $350 billion. Over the next three months, the Treasury is going to borrow an additional $350 billion above their normal borrowing, which will pull $350 billion out of the broad money supply. Draining money out of the economy will feel no different than the Fed raising interest rates by one-and-a-half percent or reducing their balance sheet, except the size of the drain will be large compared to the tightening the economy has felt over the past two years.
While the exact motivation behind the Fed’s decision to lower interest rates is unknown, to soften the blow from the Treasury’s plan to pull an additional $350 billion from the economy, the Fed will need to substantially cut rates. Each time the Fed cuts the Federal Funds Rate by a quarter percent, it has the effect of increasing the money supply by approximately $60 billion. To balance off $350 billion of additional borrowing, the Fed would need to cut six more times in the next three months.
The Fed will not be able to cut that many times in the near term since their next two meetings are not until the middle of September and the end of October. When the Fed does cut, they rarely cut more than half-a-percent, but next time they may cut even more. When money is drained from the economy, it leads to lower interest rates, even though many believe otherwise.
Money is further drained from the economy when the Treasury is borrowing large amounts of money, as rising government debts lead to lower interest rates. Lower interest rates, in a debt-based economy such as ours, lead to tighter financial conditions. When financial conditions tighten too much, our economy enters a recession.
To ease monetary policy, the Fed must buy short-term Treasuries from the banks. The “Smart Money” buys bonds ahead of and during a Fed easing cycle since the Fed must buy bonds, and large quantities of them, to lower the Federal Funds Rate. In addition to the Fed buying Treasuries, the large commercial banks are continuing to buy huge quantities of Treasuries.
Large commercial banks buy government bonds to take advantage of tighter financial conditions and due to regulatory requirements. The new Basel III rule requires large commercial banks to increase their capital adequacy ratio, and this can be achieved by purchasing government bonds. Rather than hoard cash to increase their capital adequacy ratio, large commercial banks prefer to buy U.S. Treasuries since they have the potential to make a profit from selling their Treasury bonds in the future.
During recessions, there is a huge demand for cash, and the banks will need to meet that demand. At the same time, investors who have been chasing the stock market will turn to the bond market after losing money when stock prices fall, and the banks will happily sell their Treasury bonds to meet demand. The large commercial banks will profit on the sale of their Treasury bonds since bond prices rise when interest rates fall, and interest rates fall during recessions as financial conditions tighten.
Foreigners should also increase their purchase of U.S. Treasury bonds as the Fed lowers interest rates. When interest rates are high, foreign investors must pay a high price to hedge their purchase of U.S. Treasury bonds due to currency fluctuations. As interest rates fall, the cost of currency hedges also falls. Since U.S. Treasuries are yielding a premium over other foreign government bonds, lower interest rates should cause foreign investors to buy large quantities of U.S. Treasury bonds.
Investors are also hoping for further rate cuts as they are convinced that lower interest rates will lead to higher stock prices, even though they will not. The Federal Funds futures, which attempts to predict future interest rate decisions by the Fed, is indicating a strong demand for another rate cut. Since rate cuts cause the Fed to buy more bonds, financial conditions will further tighten should the Fed cut at one or both of their next two meetings.
It is likely the Fed will cut rates at their September, October, and December meetings, since ten-year Treasury yields are already predicting tighter financial conditions. Ten-year Treasury yields have already fallen to where they were during the Presidential elections in 2016, despite claims by analysts and experts that yields were going to skyrocket. Based on the relationship between ten-year Treasury yields and the manufacturing sector, ten-year yields are now predicting a contraction in our manufacturing sector which should start in the next month or two.
Lower Treasury yields also predict lower oil prices due to the tight relationship between five-year Treasury yields and crude oil prices. Oil companies hire large numbers of employees and inject large amounts of money into our economy when financial conditions are loose. When crude oil prices fall due to tighter financial conditions, exploration and production are reduced, which leads to layoffs, as evident by rising unemployment claims in Texas.
In the next three months, financial conditions are going to rapidly tighten and should continue to tighten through the end of the year. The Fed will likely rapidly ease monetary policy as the global economy continues to contract and our domestic economy begins to contract. Monies will continue to flow into bonds and investors look to take advantage of the Fed’s easing cycle, which will lead to even tighter financial conditions.
Ten-year Treasury yields are also a leading indicator for the future direction of stock prices since stock prices usually follow Treasury yields. Currently, the gap between the broad equity indices and ten-year Treasury yields is at its largest gap in history, which suggests that stock prices are headed back to their 2016 levels where ten-year Treasury yields are currently.
Unfortunately, most investors are not expecting stock prices to fall, since financial professionals are indicating that rate cuts are bullish. Just like with prior cycles, most investment professionals have not been in the industry long enough to understand how lowering interest rates after a long economic cycle leads to a recession. After all, the average financial professional has a little over eight years of experience in the industry, meaning they do not know how to manage money through a recession.
When stock prices start to fall to catch down to ten-year Treasury yields, consumer confidence will fall, as consumer confidence has a seventy-five percent correlation with stock prices. When consumers are confident, they spend more money, which suggests retail sales are soon to fall and unemployment claims are soon to rise.
Looking back at prior rate cut cycles, it is easy to identify why the economy enters a recession shortly after the Fed’s second rate cute. While stock prices can rally following the first and second rate cut, they too will succumb to tighter financial conditions indicated by falling Treasury yields. When factoring the $350 billion drain on the economy over the next three months, it is hard to see how this economic expansion can continue.
For investors who are holding highly liquid U.S. Treasury bonds, opportunity comes when investors are panicking to sell. Given that eighty percent of the stock market is now traded by computers through algorithmic programs or passive investment strategies, stock prices can fall faster than most realize.
History shows that when the Fed starts cutting the Federal Funds Rate at the end of a long expansion that U.S. Treasury yields fall, and Treasury bond prices rise. As yields fall, financial conditions tighten as evident by a falling M2 Money Supply. Stock prices fall along with crude oil, and volatility skyrockets when the Fed enters an easing cycle.
The next three to six months should be interesting and present an excellent opportunity to buy high-quality assets at a discounted price for those who are holding highly liquid investments.
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Weekly Economic Update 8/9/19 (08/09/19 – 30 min)