Multiple Risks Are Converging at Once
Since the end of QE and the “taper” in October 2014, the Fed has been trying to “normalize” their balance sheet and interest rates. The balance sheet needed to be reduced from $4.5 trillion to about $2.5 trillion through “quantitative tightening” or QT, which is tantamount to burning money.
Interest rates needed to be raised to around 4% in stages of 0.25%. The purpose of QT and rate hikes was so that the Fed would have the capacity to lower rates and increase the balance sheet (“QE4”) again to fight a new recession.
The rate hikes started in December 2015 (the “liftoff”) and the balance sheet reductions started in October 2017. Both started slowly but have gained momentum. Rates are now up to 2.5% and the balance sheet is just below $4 trillion.
The Fed’s problem was that actual rate hikes were about 1% per year and the balance sheet reduction at $600 billion per year had the effect of another 1% of rate hikes. Would the Fed be able to achieve its goals of 4% rates and a $2.5 trillion balance sheet without causing the recession they were preparing to fight?
It turns out the answer is no. In late December, Fed chair Powell announced the Fed would be “patient” on rate hikes. That means no more rate hikes until further notice. Now, the Fed has also apparently thrown in the towel on balance sheet normalization.
When QT began, Janet Yellen said it would “run on background” and would not be an instrument of policy. Ooops. Now the Fed is ending it so it clearly is an instrument of policy.
Right now, my models are saying that Powell’s verbal ease is too little too late. Damage to U.S. growth prospects has already been done by the Fed’s tightening since December 2015 and the Fed’s QT policy that started in October 2017.
The 2009–2018 recovery has already been the weakest recovery in U.S. history despite a few good quarters here and there. And there’s little reason to expect it to pick up from here. In fact, growth is slowing.
GDP expanded 3.4% in the third quarter of 2018, which looks good on paper. But the trend is pointing down. Q2 growth was 4.2%. This trend tends to confirm the view that 2018 growth was a “Trump bump” from the tax cuts that will not be repeated. And Q4 GDP, which has been delayed due to the government shutdown, will probably be lower than Q3.
Some of the major banks have downgraded their Q4 GDP forecasts after yesterday’s poor retail sales report.
Goldman Sachs, for example, previously projected fourth-quarter GDP to expand at 2.5%. Now it’s down to 2.0%. Its projections for the rest of the year are no better. JPMorgan also revised down its previous Q4 forecast from a previous 2.6% to 2.0%. And Barclays lowered its Q4 forecast from 2.8% to 2.1%.
Even the Atlanta branch of the Federal Reserve, which is known for perpetually overestimating GDP, has cut its Q4 forecast by almost half. A little over a week ago its reading was 2.7%. But after yesterday’s retail sales report, its latest forecast comes it at just 1.5%.
We also have other signs the economy is slowing down. A report this week revealed a record seven million Americans are now at least 90 days behind in their car loan payments. There is also a student loan crisis unfolding.
Total student loans today at $1.6 trillion are larger than the amount of junk mortgages in late 2007 of about $1.0 trillion. Default rates on student loans are already higher than mortgage default rates in 2007. This time the loan losses are falling not on the banks and hedge funds but on the Treasury itself because of government guarantees.
Not only are student loan defaults soaring, but household debt has hit another all-time high. Student loans and household debt are just the tip of the debt iceberg that also includes junk bonds corporate debt and even sovereign debt, all at or near record highs around the world.
But it’s not just the U.S.
China and Europe are both slowing at the same time. China’s problems are well-known. And while the causes may vary, growth in all of the major economies in the EU and the U.K. is either slowing or has already turned negative. Markets see the global slowdown (despite Fed ease) and are preparing for a recession at best and a possible market crash at worst.
Still, why has growth slowed down at all?
The answer has to do with debt, Fed policy, political developments, as well as currency wars and trade wars. Specifically, the U.S. and China, the world’s two largest economies, are discovering the limits of debt-fueled growth.
According to the Institute of International Finance (IIF), it required a record $8 trillion of freshly created debt to create just $1.3 trillion of global GDP. The trend is clear. The massive debts intended to achieve growth are piling on every day. Meanwhile, many of the debts taken on since 2009 are still on the books.
The U.S. debt-to-GDP ratio is now 106%, the highest since the end of the Second World War. The Chinese debt-to-GDP ratio is a more reasonable 48%, but that figure is misleading because it does not include the debts and guarantees of provinces, state-owned enterprises, banks, wealth management products and numerous other entities that the government in Beijing is directly or indirectly obligated to support.
When that additional debt is taken into account, the real debt-to-GDP ratio is over 250%, about the same as Japan’s.
Debt-to-GDP ratios below 60% are considered sustainable; ratios between 60% and 90% are considered unsustainable and need to be reversed; and ratios in excess of 90% are in the red zone and will produce negative growth along with default through nonpayment, inflation or other forms of debt repudiation.
The world’s three largest economies — the U.S., China and Japan — are all now deep in the red zone.
What is striking is the speed with which synchronized global growth has turned to synchronized slowing. Indications are that this slowing is far from over. While growth can create a positive feedback loop, slowing can do the same.
Warnings of economic collapse are no longer confined to the fringes of economic analysis but are now coming from major financial institutions and prominent economists, academics and wealth managers. Leading financial elites have been warning of coming collapses and dangers.
These warnings range from the IMF’s Christine Lagarde, Bridgewater’s Ray Dalio, the Bank for International Settlements (known as the “central banker’s central bank”), Paul Tudor Jones and many other highly regarded sources.
Coming back to the U.S., the Fed may have avoided a recession for now, but they have left themselves far short of what they’ll need to fight the next recession when it comes. That could lead to another lost decade. The U.S. looks more like Japan with each passing day.
Investors can profit from this with a combination of long-volatility strategies, safe-haven assets, gold and cash.
for The Daily Reckoning