Palisade Research - Thu, Nov 15, 2018

The Fed's Tightening Is Going To Tip Us Into A Recession Soon Enough

image of businessman standing on uneven blocks piled sky high

My core thesis is pretty simple.

The Fed's 'healthy economy' rate hikes are going to tip the fragile world economy into the next recession. . .

This is what we call the Fed's Paradox.

I've written that once the Fed hiked enough for 'real' rates (i.e. after inflation adjusted) to rise - that's when the pain will start.

And right now - 'The Street' expects that the Fed's going to hike rates for the fourth time this year come December.

This will put the Fed-Funds Rate (aka FFR - which is the overnight lending rate of banks) at 2.5%. . .

And because of all this Fed hiking and tightening - we're seeing a whole flood of problems. The most important being:

- The dollar shortage (more here). . .

- Global corporate earnings souring (more here). . .

- Chinese onshore bond defaults soaring to a record (more here). . .

Remember the Emerging Market chaos this year that was brought on because of a strong dollar and rising short-term rates?

This was also a symptom of the Fed's tightening.

I don't need to go back and highlight every single thing the Fed's caused. I've written about all these issues carefully and often.

But now it's time to really worry that 'critical mass' (aka tipping point) has been reached as bank lending is set to dry up.

Let me explain. . .

A very important 'leading-indicator' I look at is the spread (difference) between short-term rates and long-term rates.

"A leading indicator is any economic factor that changes before the rest of the economy begins to go in a particular direction. Leading indicators help market observers and policymakers predict significant changes in the economy."

Most commonly, it's the two-year bond against the ten-year bond.

This is called the 2 n' 10 Rule.

I've written before in detail about this powerful rule and what it indicates (you can read here).

But in summary: the closer the spread between these two gets to zero - the flatter the yield curve is. And once the spread goes negative - the yield curve inverts.

And just so you know - an inverted yield curve (when the spread is negative) has preceded the last nine straight recessions.

So what's the spread between the 2-and-10-year at today?

It's at 0.25% - aka 25 bips. . .

Why does this matter?

Because as the yield curve flattens - and later inverts - it typically strains commercial bank lending.

And without new lending, there's no way for households or businesses to borrow and spend or refinance. Which greatly reduces economic growth.

This is why the 2 n' 10 Rule is a great way for understanding where the state of institutional and bank lending is - and will be going. . .

line chart of yield curves emphasizing 5-year periods from 1990

As the above graph shows - before the last three recessions, the yield curve inverted. And bank lending was much tighter.

Thus - today - as the Fed continues raising short-term rates while long-term rates barely budge - we're going to see bank lending and credit dry up - which is already starting to happen. . .

Many U.S. banks saw weaker business loan demand in the third quarter of this year.

This has the Fed worried - especially because they reportedly asked these banks what they would do if there's a "moderate inversion of the yield curve" over the next year.

Most of the Banks claimed that they would find this inversion scenario as a "less favorable" economic outlook. And that they would expect the quality of their loan portfolios to crumble.

But most importantly - they would find it less profitable to lend. And that their risk tolerance would would decline.

This is their way of saying they will tighten credit.

"Significant shares of banks indicated that they would tighten their standards or price terms across every major loan category if the yield curve were to invert."

And this tightening of bank lending would effectively grind the economy to a halt.

Imagine if the already greatly indebted U.S. businesses and households urgently needed new loans to pay off older loans (in need of refinancing).

They won't be able to if banks tighten their lending standards and restrict credit.

There's already a massive amount of low-rated bonds outstanding (Triple-B) that are a hair-away from being downgraded.

And these firms only had access to easy capital in the first place because of the Fed's post-2008 ZIRP (zero interest rate policy).

area chart shows growing investment grade debt with rising risky debt down to safer debt, since 1998

But now that the Fed's tightening - they're basically stuck.

They don't have the credit-rating required to get cheap financing once banks tighten.

And without access to easy loans or the ability to refinance - these firms will have to sell off assets and raise dollars just to pay the interest on their debt - or risk defaulting.

And - like a chain of bonds going off one by one - this would trigger asset prices to plummet.

If asset prices start falling - that would be a whole other can of worms. But putting it simply - Wall Street would be in deep trouble.

So again - this is the Fed's Paradox. . .

By them tightening into a 'healthy economy' they will effectively kick off the next recession. One way or another. And push us into a 'sickly economy'.

We always see some sort of financial crisis every-time the Fed hikes enough so that 'real' rates rise.

Don't believe it? Just look for yourself. . .

line chart shows Fed interest rate tightening cycles since 1915, and major market events which followed publishes interesting contributor articles in addition to its own content. We have not verified any of the above details.

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