Recession odds have climbed considerably since Jerome Powell’s testimony before Congress and the latest Federal Open Market Committee meeting. However, the recent failures of Silicon Valley Bank (SVB) and Credit Suisse as higher interest rates impact regional bank liquidity also added to the risks.
This isn’t the first time we’ve warned in an article that the aggressive rate hiking campaign would either cause a recession or “break something”:
You get the idea. We’ve been warning of the risk for quite some time. However, the financial markets continue to ignore the warnings.
The Fed remains abundantly clear that it still sees inflation as a “persistent and pernicious” economic threat that must be defeated. As we noted previously, the problem is that in an economy dependent on debt for economic growth, higher rates eventually lead to an “event” as borrowing costs and payments increase.
As debt service increases, it diverts money from consumption, which fuels economic growth. Such is why consumer delinquencies are now rising because of the massive amount of consumer credit at substantially higher rates. Notice that when the Fed begins cutting rates, delinquencies decline sharply. This is because the Fed has “broken something” economically, and debt is discharged through foreclosures, bankruptcies, and loan modifications.
Ringing Alarm Bells
While the percentage of delinquent consumer loans isn’t problematic, the sharply rising trend is. Further, Heather Long of The Washington Post noted: “Many households are also behind on their utility bills: 20.5 million homes had overdue balances in January, according to the National Energy Assistance Directors Association.”Per the article, the bottom 60 percent of earners contribute about 40 percent of gross domestic product growth. People delinquent on loans are likely getting financially squeezed because of falling real wages and will be forced to reduce their consumption. If the unemployment rate rises, the problem will worsen. The article ends as follows: “The flares are going off. If the economy does fall into a recession, it will only get more perilous for those at the bottom.”
This is why the deep yield curve inversions are ringing alarm bells.
The current inversion of the 10-year interest rate and the two-year interest rate is now at the deepest level since Paul Volcker was engineering hikes that broke the back of double-digit inflation at the cost of two back-to-back recessions.
However, there’s a significant difference between now and the 1970s, which is the dependency on debt. As shown, household net worth has far outstripped gains in disposable income. Such was a function of a continuous decline in borrowing costs and massive increases in leverage.
Not surprisingly, as repeated throughout history, sharp spikes in net worth as a percentage of disposable incomes are a function of asset bubbles or other economic or financial distortions. Unfortunately, the result is always the same, as such distortions revert during the recessionary onset.
Of course, such is the function of recessions. While often villanized by the media and demonized by politicians, recessions are a “good thing,” economically speaking. Such is because, if allowed to complete its full cycle, it removes the excesses built up in the system from the preceding expansion. This “reset” enables the economy to grow organically in the future.
The problem today is that the Federal Reserve has repeatedly cut short the “recessionary cleansing” needed to reset the economy to a healthier status.
Mr. Powell Meets Rock
Mr. Powell and the Federal Reserve are caught between the proverbial “rock and a hard place.” In this case, the “rock” is the Fed continuing to fight inflation by hiking interest rates and slowing economic growth. However, the “hard place” is that each rate hike further increases the strain on consumers and, as seen with SVB, the financial system.If SVB was the warning shot of more bank failures, the Federal Reserve will have to pivot on monetary policy to bail out more banks. However, such won’t be bullish for investors, as the bailouts would occur during a deepening recession and falling earnings. This isn’t the environment you want to own overvalued instruments based on falling earning estimates.
Furthermore, if the Fed abandons its inflation fight and begins to bail out the economy, it will cause a resurgence of inflation. Such will either immediately put the Fed back into a rate hiking campaign, causing another crisis, or they'll have to let inflation ravage the economy.
Critically, the Fed had never faced needing to provide liquidity to the financial system when inflation was high. Since 2008, inflation has been “well contained,” allowing the Fed to lower rates and provide “quantitative easing” to stabilize markets and financial systems. That isn’t the case today.
There seem to be no good choices for the Fed as the inflation-fighting credibility Powell has earned in the markets comes with a cost.
“The issue is the tighter you keep borrowing conditions for the private sector, the higher you keep mortgage rates, the higher you keep corporate borrowing rates, the higher the chances you’re going to freeze these credit markets and basically sleepwalk into an accident or, in general, accelerate a recession later on,” said Alfonso Peccatiello, CEO and founder of The Macro Compass.
Peccatiello is correct, and the contraction in nominal M2 is ringing alarm bells. Such was a point Thorsten Polleit of The Mises Institute recently noted.
“What is happening is that the Fed is pulling central bank money out of the system. It does this in two ways. The first is not reinvesting the payments it receives into its bond portfolio,” he said.
“The second is by resorting to reverse repo operations, in which it offers ‘eligible counterparties’ (those few privileged to do business with the Fed) the ability to park their cash with the Fed overnight and pay them an interest rate close to the federal funds rate.”
As shown, contractions in nominal M2 have coincided with financial and market-related events in the past. Such is because the Fed is draining liquidity out of the financial system, which is ultimately deflationary. The reason that the drain is deflationary is that economic growth is slowing. As Thorsten said: “The Fed has announced that it intends not only to raise interest rates further but also to reduce its balance sheet and sponge up central bank money.”
This, in turn, implies a real risk that the Fed will overtighten, causing a recession.
SVB is likely the casualty of the coming economic battle.
