Note: This post was first published on Patreon on 24 May 2018
This is my first post on Patreon. And I think it’s fitting I led off with a piece on the next recession. After all, the reason I started on Patreon in the first place was because I believed the next recession was coming — and that this would likely mean another financial crisis.
So, I want to make the case for thinking about the next recession now. And I lot of this goes back to what I wrote last November about now being the most dangerous period in the business cycle. Here’s the basic framing:
Animal spirits are a natural part of capitalist societies as people seek and make profit. Later, animal spirits take them to extremes and they recoil when those extremes end in losses. In the United States, even without a central bank, this was true.
The central bank is conceived as a buffer against the depressions that result from boom bust cycle that animal spirits create. The bank’s basic role is to prevent those depressions from becoming severe. In more recent times, the central bank is seen as needing to act to prevent those depressions from occurring in the first place.
But, of course, the record for the Federal Reserve suggests that, while the central bank may have prevented depressions in the last three-quarter centuries, its policies have caused recessions. So when the central bank begins to raise rates, that’s when to start thinking about a recession.
Look at the following chart:
Notice that every recession is preceded by a rising fed funds rate, the rate the Federal Reserve uses for its main policy lever. And that’s because the Fed has always been leaning against the excesses of animal spirits at the latter end of business cycles – so much so that it tips the economy into recession.
Now, one could make the argument that correlation doesn’t imply causation. And that would suggest that rising Fed Funds rates don’t actually ’cause’ a recession; they are merely a marker or hallmark of the pre-recession economic environment. I don’t have a quarrel with that argument right now, if only because I am not interested in assigning causation. I am looking to figure out what the pre-conditions of recession are, and what they aren’t. And rising fed funds rates is one of them.
Going back to animal spirits for a second, let’s look at how the Fed described the economic conditions in mid 1988 when it started a rate hike campaign thirty years ago this month that ended in recession. Here’s the policy statement. What I want to highlight is the basic premise for rate action:
“The information reviewed at this meeting suggested continuing strength in the economic expansion, supported by strong sales in both domestic and export markets, and relatively high utilization levels of labor and capital resources. In this setting, consumer and producer prices have risen more rapidly recently. In addition, labor costs increased substantially in the first quarter.”
Translation: the Fed felt the economy was running so hot that it needed to raise rates. And it continued to do so until May 1989. Recession came more than a year later. And by then, the Fed was cutting rates.
Compare what the Fed was saying then to what the Fed has said in its
Translation: the Fed feels the economy is running so well that it needs to raise rates as a way of normalizing policy. And it has indicated it will continue to do so for the foreseeable future. The question is whether the moderation in the pace of hikes and the tepid nature of the economy will prevent recession from occurring.
So, in both cases, though the nuances and the pace of growth and inflation differ, the economy was doing so well that the Fed felt it necessary to raise rates. And in the historical case thirty years ago, eventually that pace of growth did a full reversal, ending in recession.
Now, by definition, a recession is a period when we see durable declines in real GDP, real income growth, employment, industrial production, and wholesale and retail sales. So the question is this: what makes these factors decline durably and how can we spot the signs in advance? This is the holy grail of macro forecasting.
So the modern day Jay Powell Fed’s question of whether it can slow walk hikes enough to prevent recession boils down to whether it can see the signs of recession well enough in advance.
As a markets guy, a former credit guy, I see this world through the prism of credit markets.
And so I attempt to match up what is happening in that world in terms of credit growth, in terms of default rates, in terms of credit spreads, with what’s happening in the real economy.
More than anything, I am looking at rate of change figures because my basic premise is that levels matter much less than rates of change. And by that I mean that the economy is a large system that carries with it a lot momentum. It is hard to turn. And that is true whether the economy is growing at 3% or 7%.
But if it gets hit by a large enough shock and it is vulnerable enough, a recession will happen. You need both the vulnerability and the shock. What kinds of shock? A big rate of change decline across a number of key metrics: credit growth, employment growth, industrial production. And you need to see spikes in negatives like jobless claims, defaults and bankruptcies and credit spreads.
Right now, we’re not there yet. But the signs of distress have begun, particularly in credit markets. Credit growth has actually been stalled since 2015. And credit spreads are now increasing, leading to a rout in US corporate bonds and US emerging market bonds. Higher interest rates in the US and in EM have also led to a rout in EM currencies and EM equities.
As yet, signs of distress in the real economy have been muted.
Going forward I intend to enumerate what I am seeing in all of these markets and keep you up-to-date on where we are as we await the next recession. I believe it is coming within the next two years.
Thank you for your contributions. I look forward to writing a lot more.
P.S. – Please feel free to comment below on your view and what specifically you want to see me address in future posts. I’m not sure if and when I will put this on Credit Writedowns publicly. But if I do, your comments will be helpful.
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