A Brief History of the Rumbling Recession
Is the US heading for recession? If so, what will trigger it?
Unlike previous ones, this article will be a short one. This story is told in 10 short points, and a few more charts:
1. Monetary and fiscal panic-stimulus in 2020 led to the highest CPI inflation in 40 years.
2. The Fed panicked again and hiked interest rates (the opposite of stimulus) too far, causing the bond market to crash.
3. The bond market saw this policy error and growth concerns amid the fierce hiking pace, caused a deeply inverted yield-curve — the deepest inversion since the 1980’s. {My next article will dive deeply (pun intended) into yield-curve inversion and why this happens before recessions}
4. Banks began struggling due to this deep curve-inversion because their business model is to borrow short at low rates and to lend long at higher rates. If short rates are higher than long rates (yield curve is inverted) then they have negative profit margins. So, they manufactured their own positive yield curve by paying only a fraction of money-market rates on the client-deposits they held, in order to fund their lending activities.
5. Furthermore, banks incurred massive unrealized losses on their treasury portfolios because of the carnage in the bond market mentioned above. When depositors withdraw their funds, banks have to sell treasuries to raise the cash needed to honor the withdrawals, thereby realizing those unrealized losses. One caveat though — banks should hedge their interest rate risk, which some did, but some didn’t.
6. Seeing the smoke rising in the distance from the smoldering financial fire, unsecured depositors at SVB (Silicone Valley Bank) started shifting their funds to safer havens such as money-market funds and US T-bills (Short term bonds) which have no default risk and pay much higher interest than bank deposits. This turned into the second largest bank-run in history.
7. Deposit flight and realized losses due to redemptions rendered many banks insolvent. Some banks failed and the rest got saved by the Fed, through special liquidity injections (de-facto money printing).
8. The whole banking sector is now tightening their lending criteria and banks are leveling down their lending books to balance their assets and liabilities. {If liabilities (deposits) shrink, their assets (loans) will have to be reduced as well}.
9. This leads to credit contraction, which further tightens financial conditions and increases the risk of recession. Add to this, the 40% of commercial real estate (CRE) mortgages (on office blocks with no tenants) that will come up for refinancing before 2025 at rates, multiples higher than their issue rates, and a credit crisis could be thrown into the mix.
10. Leading indicators have been pointing to recession for months now, and early signs of economic contraction is now starting to show up in the co-incident and lagging data as well.
The Conference Board Leading Economic Index is signaling for a recession to occur within the next few quarters.
US ISM Manufacturing PMI is now firmly in recessionary territory (below 50).
The year-on-year change in new jobless claims are slowly ticking upwards.
Despite the above observations, the Fed is still holding firm that they will raise rates by another 25 basis points and then keep them there until the end of 2023. The market does not believe them — and that includes me. See the chart below:
Counter Argument
So how could my base case turn out to be wrong?
1. If the labour force participation rate and productivity increase to put downward pressure on inflation without having to kill demand by choking the economy with tight financial conditions, and
2. If real wage growth can flip positive as inflation comes down, so that the consumer can stay healthy, and
3. If the Fed starts basing its policy decisions on leading indicators, rather than lagging ones, and
4. If the fiscal and monetary authorities stop over-reacting on both easing and tightening, so that the bull-whip can be stabilized,
Then a recession can be avoided.
I would however, not hold my breath while waiting for this to happen.
One undeniable anchor of strength, one glimmer of hope, is the health of the aggregate consumer’s balance sheet. Leverage is far below trend and there is capacity for households to take on credit — if only the banks had capacity to extend it…
Conclusion
I think that the banking crisis is not over yet, largely due to the Fed’s over-tightening and being late to adjust their policies again. I expect equity markets to have another down-leg (Not necessarily new lows) , but as soon as the Fed finally wakes up to reality, they will probably over-react once again by sudden and forceful stimulus, which will put (pun intended) in a bottom for all risk assets. The Fed-put will then be back. Bitcoin and gold has already sniffed this out.
I’m looking forward to your comments — especially to those with opposing views.
Good luck out there.
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Disclaimer
The views expressed in this article are the views of Johan Kirsten and are subject to change at any time based on market and other conditions. This is not financial or investment advice, nor a solicitation for investment funds and should not be construed as such. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities.
