Blundering Into Recession

June 12 is just three weeks away.

That’s when the Federal Open Market Committee, FOMC, the Fed’s interest rate policy arm, will in all likelihood raise interest rates another 0.25%, the seventh such rate increase since the “liftoff” in interest rates in December 2015.

The market is currently putting the odds of a rate hike at 95%.

This is the most aggressive tempo of rate hikes of any major central bank and puts U.S. policy rates significantly higher than those in the U.K., Japan or eurozone.

The issue for investors is whether the Fed is raising rates too aggressively considering the strength of the U.S. economy. Higher rates imply a stronger dollar, imported deflation and head winds to growth.

If the U.S. economy is on a firm footing, then the rate hikes may be appropriate, even necessary to head off inflation.

But if the U.S. economy is vulnerable, then the Fed’s actions could trigger a recession and stock market sell-off unless the Fed reverses course quickly.

My view is that the latter is more likely.

The Fed is tightening into weakness and will reverse course by pausing rate hikes later this year.

When that happens, important trends in stocks, bonds, currencies and gold will be thrown into reverse.

Outwardly, the Fed is sanguine about the prospects for monetary normalization. Both Janet Yellen and new Fed chair Jay Powell have said that interest rate hikes will be steady and gradual.

In practice, this means four rate hikes per year, 0.25% each, every March, June, September and December, with occasional pauses prompted by strong signs of disinflation, disorderly markets or diminution in job creation.

Lately job creation has been strong. And inflation has picked up. But it’s been spotty. The Fed still faces head winds in achieving its inflation goal.

The Fed is targeting a 2% annual inflation rate as measured by an index called PCE core year over year, reported monthly (with a one-month lag) by the Commerce Department.

That inflation index has not cooperated with the Fed’s wishes, and despite recent gains, hasn’t been able to hold consistently above 2%.

This has been a persistent trend and should be troubling to the Fed as it contemplates its next policy move at the FOMC meeting on June 12-13.

I’ve warned repeatedly that the Fed is tightening into weakness. The Atlanta Fed is projecting a 4.1% growth rate for the second quarter. But it’s known for its rosy projections that are almost always revised downwards once the data come in,

It had to lower its estimate of first quarter growth from over 5% to 1.8%. You can pretty much bet they’ll have to significantly reduce this projection as well.

The economy has been trapped in this low-growth cycle for years. The current economic recovery shows none of the 3% to 4% growth that previous recoveries have shown.

Meanwhile, the Fed is plowing ahead with its policy of quantitative tightening (QT), or cutting into its balance sheet.

Balance sheet normalization is even more on autopilot than rate hikes. Now, the Fed will not dump its securities holdings. Instead, it refrains from rolling over maturing securities. When the Treasury pays the Fed upon the maturity of a Treasury note, the money simply disappears.

This is the opposite of money printing — it’s money destruction. Instead of QE, we now have QT, or quantitative tightening. It’s like the Fed is burning money.

The Fed has been transparent about the rate at which they will run off their balance sheet this way, although transparency should not lead investors to complacency.

The Fed wants you to think that QT will not have any impact. Fed leadership speaks in code and has a word for this which you’ll hear called “background.” The Fed wants this to run on background.

Think of running on background like someone using a computer to access email while downloading something on background.

This is complete nonsense.

Contradictions coming from the Fed’s happy talk wants us to believe that QT is not a contractionary policy, but it is.

They’ve spent eight years saying that quantitative easing was stimulative. Now they want the public to believe that a change to quantitative tightening is not going to slow the economy.

They continue to push that conditions are sustainable when printing money, but when they make money disappear, it will not have any impact. This approach falls down on its face — and it will have a major impact.

My estimate is that every $500 billion of quantitative tightening could be equivalent to one .25 basis point rate hike. Some estimates are even higher, as much 2.0% per year. That’s not “background” noise. It’s rock music blaring in your ears.

For an economy addicted to cheap money, this is like going cold turkey.

The decision by the Fed to not purchase new bonds will therefore be just as detrimental to the growth of the economy as raising interest rates.

Meanwhile, retail sales, real incomes, auto sales and even labor force participation are all declining or showing weakness. Every important economic indicator shows that the U.S. economy can’t generate the growth the Fed would like.

When you add in QT, we may very well be in a recession very soon.

Then the Fed will have to cut rates yet again. Then it’s back to QE. You could call that QE4 or QE1 part 2. Regardless, years of massive intervention has essentially trapped the Fed in a state of perpetual manipulation. More will follow.

But what about the stock market?

Despite February’s correction, the stock market remains overpriced for the combination of higher rates and slower growth.

The one thing to know about bubbles is they last longer than you think and they pop when you least expect it. Under such conditions, it’s usually when the last guy throws in the towel that the bubble pops. February’s correction took some air out of the bubble, but the dynamic still applies. It just extended the timeline a bit.

But is this thing ready to pop for real?

Absolutely, and QT could be just the thing to do it. I would say the market is fundamentally set up for a fall. When you throw in the fact that the Fed continues to have no idea what they’re doing and has taken a dangerous course, I expect a very severe stock market correction coming sooner than later.

The Fed is going to find out the hard way that raising rates and reducing the balance sheet will slow the economy. I believe that will ultimately lead to another flip-flop and the Fed will once again loosen.

When the market sees that the Fed has decided to flip from tightening to an easing policy, look for increased volatility — and more corrections.

Regards,

Jim Rickards
for The Daily Reckoning