Here’s Where the Next Crisis Starts

After markets got their hopes up yesterday after rumors that a partial trade deal was imminent, today those hopes were dashed.

President Trump said this morning that he hasn’t agreed to dial back tariffs on China after all. So the next round of tariffs will go into effect Dec. 15 in the absence of a breakthrough.

Markets were down today on the news, although not dramatically so.

But the trade war is definitely having an impact on growth.

The latest survey of manufacturers in the midwest gave its weakest reading in four years last month. It was also the second lowest in a decade. Overall, U.S. manufacturing contracted for the third consecutive month in October.

What about the broader economy?

The Devil Is in the Details

Last week, two major economic figures were released for the U.S. One was third-quarter GDP, which came in at an increase of 1.9%. That figure actually beat expectations of 1.6%.

But the devil is always in the details.

That’s still less than the second-quarter growth of 2% and an indication of a slowing-down trend for U.S. economic growth. And once again, the business investment spending component declined over the quarter.

Meanwhile, the manufacturing industry is having its worst year since the financial crisis on the back of trade wars and a slowing global economy.

So the economic data are still slowing down

Plus, as I’ve been reminding my readers, it was the consumer spending component that beat expectations again and contributed to much of that growth.

If the U.S. consumer gets tapped out, that key pillar of support for the economy would collapse. And that’s entirely possible.

Total outstanding consumer debt exceeded $4 trillion for the first time this year, and credit card rates are rising.

Auto loan delinquencies are also increasing and student debt is a crisis in the making. Corporate debt is another crisis in the making, which I’ll get to in a minute. As you’ll see, that’s the likely cause of the next crisis.

So don’t be surprised if the consumer taps out before too long.

But I said there were two key economic figures recently released. The second was the October unemployment report. And they paint a somewhat brighter picture.


U.S. payroll figures for October beat expectations, with 128,000 jobs being added after a consensus estimate of 75,000.

The unemployment rate did uptick by a tenth of a percent to 3.6%. That figure nonetheless remains close to a half-century low.

So the Fed can see a more or less healthy economy — if it wants to.

Unemployment is at a five-decade low, the economy has been growing (although slowing down) and the U.S. consumer is still active (although also slowing down).

Added together, all these factors were enough to substantiate the Fed’s indication that it will leave rates on hold for the rest of the year after its “insurance” rate cut at the end of October. It’s already lowered interest rates by 75 basis points this year.

But that is certainly no guarantee more rates aren’t coming.

If the U.S. or global economic growth picture deteriorates more quickly, that could easily press the Fed to cut rates further.

Meanwhile, the Fed is using its ability to inject liquidity into the money markets as a form of QE-lite to support the financial system.

That means more “dark money” is coming from the Fed.

But the problem is that the Fed is now caught in a “Catch-22.”

The Corporate Debt Bomb

As one article put it, the Fed “is stuck between an apparently booming economy and a financial crisis that might be right around the corner.”

If the Fed keeps rates this low, it means more financial asset bubbles can inflate. But if the Fed doesn’t lower rates, the corporate sector is most at risk.

During the last crisis, too much housing debt that was repackaged in nefarious ways by Wall Street tanked the markets and the economy. Now the ticking time bomb is too much corporate debt, also being repackaged by Wall Street.

Corporate debt is really what you need to watch.

Corporate debt is out of control, fueled as it’s been by all the cheap credit courtesy of the Fed.

U.S. nonfinancial corporate debt is now about $15 trillion dollars, or more than half of GDP. That’s an increase of more than 50% over its previous peak in 2008.

And it’s not like all this debt went to productive purposes like R&D or expanding business. It was mainly used to finance stock buybacks and acquisitions.

They may be good for shareholders (not to mention corporate executives who have gotten larger bonuses), but they don’t add to the economy.

All U.S. companies combined are burdened by a record $15.5 trillion of debt, or about two-thirds of GDP.  If interest rates were to rise, that debt could default and lead to a repeat of 2008.

Meanwhile, companies that fattened up on all this cheap debt over the past decade will be facing a major test as $4 trillion of bonds come due over the next five years, according to Oxford Economics.

The New Subprime Mortgages

Compounding the problem is that $660 billion of leveraged debt is in the form of collateralized loan obligations (CLOs) that have been sold to investors and financial institutions. CLOs are used to package lots of high-risk debt to be sold to investors eager for yield in this yield-starved environment.

If that reminds you of the collateralized debt obligations (CDOs) that were behind the subprime housing crisis, you’re right. Only in this case they’re packing not mortgage debt, but corporate loans.

A meaningful rise in defaults would produce severe losses. And we could be seeing a massive wave of defaults, which could spread like wildfire and produce a crisis.

It’s a dark money Catch-22 of the Fed’s own making, and it’s basically been going on for more than a decade now.

The Fed is aware of all this. A debt crisis is its major concern and it will behave accordingly. As always, watch what it does, not just what it says.

The ongoing bailout of the repo market shows us that the Fed will keep dark money going for as long as possible and in whatever amounts are needed. But it’s only deepening the Catch-22.


Nomi Prins
for The Daily Reckoning

The Daily Reckoning