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And Here Comes the Recession

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NEW YORK – March 28, 2019

Investing in the US economy for a long time becomes unprofitable, as evidenced by the fact that the rates on three-month Treasury bonds have reached higher than those for ten-year bonds. This is usually the forerunner to a recession in the US economy, which affects the entire global market and all countries of the world.

Honestly, it should not have come as a surprise. After the Federal Reserve pivoted early January and utterly capitulated in early March, everyone should have deduced that something was seriously wrong with the US economy. Bond markets have already signaled this for a while.

The rates on long-term US bonds are falling against the background of increased investor demand. If in December two increases were planned in 2019, now not one is expected. The end of the monetary tightening cycle came as a surprise, making safe assets, like ten-year US government bonds, much more attractive to investors.

And Here Comes the Recession

As a result, the rates on ten-year bonds fell so much that they became lower than three-month ones. And according to the Federal Reserve Bank of San Francisco, this is a sure sign of the upcoming recession. Over the past 50 years, almost every time this has happened, markets have started to fall. But we wrote about it in detail here and here.

And Here Comes the Recession

The last time the US economy was in recession was from December 2007 to June 2009. During this time, the US GDP fell by 4.3%. Housing prices in America fell by almost 30%, and the S & P 500 index by 57%. This has affected the entire global economy.

Now the American economy is growing steadily. In 2018, the GDP grew by 2.9% against 2.2% a year earlier. President Trump believes that the American economy would have grown by 4% if the Fed had not raised rates and was not engaged in normalizing its balance sheet.

However, despite all the formal indicators and Trump’s assurances, there are very few optimists left on the market. Most economists, including Fed experts, are confident that a recession is imminent. The only question is timing.

According to GnS Economics experts, who have been warned about the coming recession and crisis for two years and whose forecasts for many indicators turned out to be 100% true, the global recession will start in Q4 2019 (Q1 2020 in the US). However, with the ever-steepening yield curve, it appears that the recession may even arrive earlier. The thing is, in the last 10 years we have not been living in a normal business cycle. This is because of the constant flood of stimulus, most notably from the major central banks and China.

But, the Fed rate-rising cycle is over, the global economy is slowing, and its driver (China) is likely to be maxed-out. 

Judge for yourself: To date, asset markets have been supported by global central banks.

The main locomotive of the world economy was China. In 2009, China started a cycle of fiscal and monetary stimulus, the scale of which has never been seen before. This is clearly visible from the diverging trajectories of real GDP and debt.

And Here Comes the Recession

As a result, China has become so indebted that continuing such massive stimulus programs would eventually crash its economy. This is something that the ruling communist party is most likely determined to avoid.  Also, because the effect of stimulus wanes over time, which has been seen from falling productivity in China since approximately 2011, there comes a point where continuing it just adds debt (and risks) without spurring the economy.

According to GnS Economics, China has either reached this point, or is at least in close proximity to it.

In this regard, China is unlikely to remain the main driver of the global economy in the future.

As Tuomas Malinen, the CEO of GnS Economics and an Adjunct Professor of Economics at the University of Helsinki, notes, according to recent academic research, beliefs are crucial in determining the turning points in the business cycle. When some piece of news, such as signals of an approaching recession, spooks investors and households, they start to restrict consumption and investments, and the cycle turns. In this process, real economic and financial factors, naturally, matter.

The unfortunate fact is that the global economy never really recovered from the last steep downturn. As mentioned above, the expansion has been achieved by stimulus, with the latest iteration of the tax cuts enacted by the Trump Administration. The growth in the US has been achieved principally through ballooning corporate and government debt.

When financial conditions start to tighten, due to, for example, bank and capital market losses from a slowing global economy, they will make it harder for corporations and households to rollover debt. They start to cut back their spending and the cycle turns. With high levels of debt, like now, this occurs even after only relatively modest tightening.

This is already visible in the US credit cycle. Since 1976, the annual impulse of bank credit has never fallen for two consecutive years without a recession. In 2018, the credit impulse recovered, somewhat, but still fell for the second year in a row despite a very large fiscal stimulus.

And Here Comes the Recession

The annual credit impulse of bank credit (annual change in bank credit normalized with nominal GDP) in the US economy. Source: GnS Economics, Fed St. Louis

The inverted yield curve and credit impulse signal that the onset of the recession is close. The only thing missing is for it to start to influence perceptions which may occur, basically, at any time. This is what happened, for example, in 1929.

On March 20, the Fed made the widely unexpected decision to keep interest rates unchanged, and also stated that there were no longer plans for a rate increase in 2019. Moreover, it spoke about the reduction rate and the imminent termination of the process of the sale of the portfolio, accumulated on the Fed balance sheet after the 2008 crisis.

It means that central bankers acknowledge the asset bubble they have created and fear its demise. At the same time, they understand that  if it happens, they have no reasonable means of stimulation.

Another important factor is the "zombification" of the economy. We discussed this problem in detail here.

The fact is that continuous stimulus has ”zombified” the economy, which has resulted in stagnated productivity growth. This implies that many corporations will not be able to continue operating when the economy falters and/or rates rise. The foundations of the economy have been compromised. The asset market has become the economy.

Do you remember how the US housing bubble collapsed with catastrophic consequences in 2006-2008?

Then the massive stimulus enacted by central banks was aimed at reinvigorating the global debt cycle, which has fluctuated through the different regions of the world since the 1970’s. Central banks have succeeded in this endeavor.

Today, in conditions of upcoming recession in the US and in the global economy, central bankers have only one solution left: direct debt monetization. The economy is likely to again be “flooded with money” (in the sense of newly printed dollars). Unfortunately this treatment is not effective anymore  and is unlikely to be effective in the future.  For today we have exhausted the current set of “solutions.” There are no more bubbles to inflate, except the real economy itself.

The continuation of quantitative easing is fatal to the economy. In the end, the policy of central banks would eventually destroy not just the purchasing power of money, but the corporate sector and the trust of citizens in the system.

However, nothing can be changed. Crisis is inevitable. We need to be prepared for the worst, because such policies are just a small step away from the current QE-programs.

All that remains for us is to observe the last breath of a vicious model of economic management created by central banks.

Author: USA Really