Next Recession All On Fed, Not China Trade War

(Forbes) Bloomberg reported yesterday that economists are cutting their growth forecasts. A recession is coming. (Trump is history. Bloomberg is happy.)

And they're right, of course. A recession is coming. One day. A recession always comes. But the odds of it hitting the U.S. economy next year depends on what the Fed does with interest rates.

In fact, for the market, the pending recession has more to do with the Fed than the China trade war, now expected to go into high gear in September. Most pundits will blame the trade war, though even Fed chairman Jerome Powell said in his rate cutting speech to Congress two weeks ago that tariff stress is not yet showing up in the data.

Still, if the GDP revisions for the fourth quarter of 2018 are accurate, and growth fell to 1.1% year-on-year, then it is a no-brainer to say the economy is slowing more than expected. Nonfarm payrolls may even surprise to the downside in the coming months, something that actually can be linked to the trade war. Without any macro shifts, one must assume a recession is in sight. 

The yield curve is now inverted. The yield on a 10 year Treasury bond is 1.75% as of Thursday. The yield on 3-month Treasurys is 2.05%. If you're a lender, you are supposed to be lending long and borrowing short and if that is not the case, you're reducing your risk taking.

The Fed has to steepen that yield curve to change the recession math.

Meanwhile, gold is trading over $1,510 per ounce, and oil futures for the nearby September contract are trading at $52 and change. A year out, August 2020, the market is pricing oil under $51.

For supply side economic analysts like Vladimir Signorelli, founder of Bretton Woods Research, a way to gauge an oncoming recession is in the oil-to-gold ratio. "That's like our secret sauce," he says. It's currently 28 barrels of oil equals an ounce of oil. "We've run the numbers. You get to 48 barrels of oil per gold and you get zero interest rates," he says. At current oil prices, that would require gold over $2,200 an ounce. The last time we were that close was around 2012.

Zero rates puts the U.S. on par with Europe, where the European Central Bank's overnight lending rate has been at zero for three years. And where smarty-pants financial pundits are actually trying to convince savers that negative interest rates, and paying banks for allowing you to park money in a savings account, is somehow a good thing.

At the start of the year, Powell was talking about orchestrating a soft landing in the U.S. economy. Trump's regulatory rollbacks and the Republican tax cuts were bad for monetary policy. The economy was on fire. The job market was growing like gangbusters. Bad. 

Markets expected four rate hikes this year. Remember those days?

When you hear Powell talk about a soft landing, that's a euphemism for lowering growth. There's a part of the Fed that believes the U.S. GDP shouldn't grow over 2%. 

With Powell under siege by Trump, Fed doves like James Bullard and Charles Evans (perhaps joined by Christopher Waller) might convince voting members of the Fed Open Markets Committee (FOMC) to produce enough rate cuts to steepen the yield curve so risk-taking can recover and the U.S. avoids recession. 

This is more important than the China variable. 

"To be sure, the additional tariffs have increased downside risks for the U.S. and global economy," says BNP Paribas chief U.S. economist Daniel Ahn. "An additional 25 point rate cut from the Fed should be sufficient to offset an escalation even to the full 25% tariff rate on the remaining Chinese imports."

Trump said he would tack 10% tariffs on $300 billion worth of Chinese imports on Sept. 1. The tariff means all China goods shipped to the U.S. are now forced to pay higher port fees.

Since the FOMC meeting last week, the imposition of extra tariffs on China and the drop in the yuan, there has been a notable dislocation in the markets. Government bond yields are collapsing, especially in Europe where German bunds are hitting zero. Gold prices are rising. Stock markets are falling, though most of the recent sell-off can be linked to China. 

It has to be said that bond markets have long been sending a message of "secular stagnation" — low growth, recessionary economics and disinflation as demand softens. Bond markets did not take long to dismiss Powell’s description of the July 31 rate cut as merely a "mid-cycle adjustment". They want a bigger adjustment than 25 bips.

Curve inversion has been a consistent predictor of recessions over the past 60 years. 

PIMCO’s global economic advisor Joachim Fels said he also thinks a zero Fed funds rate is plausible. A 0% Federal funds rate would lead the market pushing Treasury yields to negative. A disaster for savers, but just another gambling chip for traders who push up negative yielding bond prices on the assumption that they will become even more negative in the not-so-distant future. They're making money on the bond price like it was a stock, and dumping them even quicker as there is no point holding a fixed income instrument that returns no income to anyone.

"Global government bonds that have negative yields now stand at a record $15 trillion and act as a gravitational black hole that drags positive yielding bonds lower," says Neil MacKinnon, an economist for VTB Capital in London.

Bretton Woods Research told clients this week that the Fed "must at least conduct two rate cuts by December" or its curtains for the economy. 

Trump's entire election prospects depend on a solid stock market, and GDP growth. Some political pundits have been itching for a recession, hoping to undermine Trump's already slim chances at victory in November 2020. 

"Without a steepening yield curve, it is hard to be bullish on the growth outlook and equities," Signorelli says.


More Articles