Let’s be very clear what yesterday’s full frontal capitulation by the Fed means: It’s coming. The next recession that is. It’s just a matter of the how and the when. Now mind you the Fed will never, ever overtly tell you a recession is coming. They can’t. Their underlying primary mission is to keep confidence up. A Fed predicting a recession would cause all kinds of havoc in capital markets and almost certainly bring about a recession. So they won’t tell you, but their actions speak loud and clear.
First understand what the capitulation means: It means that all their 2018 statements of optimism and predictions of raising rates in 2019 and previous insistences on a balance sheet roll-off being on”autopilot” were all wrong. Reality and markets rolled over them. They didn’t see the slowdown coming and only after markets dropped 20% in December did they change their policy stance and have now cemented a dovish stance for years to come.
Yesterday’s capitulation was so complete and even more dovish than markets had expected. How scared is the Fed? How scared should markets be? What are they seeing that forces them to not only halt the balance sheet roll-off, but to only project a token rate hike for 2020 in effect ending the rate hike cycle?
To visualize the extent of the capitulation look where the Fed’s “normalization” process will now end in September:
A pitiful end to a process that was falsely advertised as “normalization”. And it’s a global problem.
Every major central bank on the planet is now carrying enormous balance sheets. All have turned fully dovish, none will reduce their balance sheets. 10 years after the financial crisis no central banks will have normalized and can’t. The ECB is still running negative rates with no end in sight.
Let’s call a spade a spade: Normalization would crash capital markets globally. The world is destined to never see a true normalization and central banks will be forced to remain accommodative in the face of slowing growth. The promise of organic growth following what was supposed to be temporary central bank intervention was simply a pipe dream. The Fed tried and failed. Markets and the economy have forced their hand and now the US Fed is trapped and is forced to be the dovish for years to come. Intervention and accommodation have become permanent. Globally.
Growth peaked in 2018 as a result of the temporary sugar rush following the US tax cuts.
And note the glaring gap in public narratives even in the US. This is the Fed’s latest economic forecast:
GDP growth below 2% and below 4% unemployment forever and ever amen. Who can believe it 10 years into an economic expansion financed by ever more debt?
Not I, especially if you consider that the administration’s federal budget is entirely dependent on 3% GDP growth in perpetuity. After all they project trillion dollar deficits with 3% growth. Excuse me, but I have a question: What’s the deficit with less than 2% GDP growth as opposed to 3% GDP growth? What’s the deficit with a recession coming? A lot higher than 1 trillion dollars I venture to guess which means funding requirements will explode higher beyond even the current absurdity of already running trillion deficits at the end of a long business cycle.
Markets are increasingly pricing in rate cuts in 2020 following the Fed decision. Why? Well, because that’s what usually happens next when the Fed ends its rate hike cycle.
Let’s dissect this chart:
During the past 2 market bubbles the Fed ended its rate hike cycle in June of 2000 and August of 2006 respectively as unemployment was at a cyclical low. In 2000 the unemployment rate was below 4% as it is now. In 2006 unemployment settled in the 4.5% range. In both cases a recession soon followed as the business cycle turned. In 2000 the recession ensued a mere 9 months following the end of the rate hike cycle and the Fed was forced to cut rates a mere 6 months following the rate hike pause as markets were dropping to new lows.
In 2006 markets proceeded to rally until November of 2007 and then the recession unfolded beginning in December of 2007.
They key question for everyone here is will we see a 2000 or 2007 repeat? Both have major implications for equity markets.
In 2006 markets rallied hard after the Fed ended its rate cycle. Markets proceeded to place a major topping pattern in 2007 and then the financial crisis unfolded.
Bulls will want to cling to this scenario as it suggests a recession is still 2 years away.
Two problems with this scenario: 1. Markets are already starting to price in a rate cut for January (47% probability as of yesterday). In the 2006 example the Fed did not cut rates until August 2007, 14 months after the pause and the recession began in December 2007, hence the lead time here is much shorter. And remember the Fed doesn’t cut by advanced schedule, it’s unfolding events forcing them to. The timing will be driven by markets and the economy. Everything in the Fed statement and the global macro data is suggesting that things have deteriorated much faster than anyone anticipated just 6 months ago. So a rate cut could also come sooner than anyone expects. 2. Markets are already engaged in a potential major topping pattern:
Just like they were in 2000.
In 2000 the Fed stopped the rate hike cycle in June of 2000, markets had already topped in March or 4 months before. In 2000 the market counter rally peaked in September 3 months following the rate hike pause printing lower highs. The Fed started cutting rates in December another 3 months later. The recession began in March of 2001, 4 months later.
Compare to now:
Markets peaked in September 2018 and the Fed for all intents and purposes stopped its rate hike cycle in December, 3 months after markets peaked. And here we are another 3 months later and markets are at risk of peaking here, engaged in a major topping pattern. So you see this script aligns much more closely to the 2000 scenario versus the 2007 scenario. This suggests a rate cut may come A LOT sooner than people anticipate.
What would force a rate cut? Simple. Worsening economic data, dropping markets and an inversion of the yield curve.
Yield curves have already flattened significantly and as history shows an inversion can happen suddenly following such periods of consolidation and a recession follows shortly. And what does the 30 year vs 5 year yield curve suggesting here in context of markets and cyclical low unemployment?
To my eye it suggests highly elevated inversion risk consistent with a business cycle coming to an end, the only question is the when and how.
Look, nobody has the all answers here, the world doesn’t follow a predetermined script, all I can point to are the technicals in context of macro events and the fact is the Fed is chasing and they know it. To go this dovish implies they know there’s more than just noise in the data. There’s a real concern that a recession may be unfolding and they’re trying their dearest to provide some runway here.
Fact is global growth, while claimed to be stabilizing, has yet to show any serious surprise to the upside. China trade deal, Brexit, all these supposed trigger events for growth are taking longer than expected and there are still no clear resolutions on the table. At this rate they may be too little too late to stop the cycle.
How will we know which scenario applies? The 2007 or 2000 scenario? New market highs would suggest there is time and room before the recession hits.
However if markets sell off over the next few weeks and months central banks may have lost control. They are already all dovish, they can’t surprise on the dovish side any longer. That carrot has been removed by yesterday’s Fed capitulation. All they have left is QE4 and rate cuts to come. And those will come at the point of either new market lows and/or deteriorating data. So, ironically, markets may decide the timing of the rate cut. If the 2000 script unfolds we may see rate cuts a lot sooner than anyone can anticipate. A ridiculous notion at this precise moment in time I know. But everyone talks tough after a 500 handle rally on the S&P 500.
Fedex this week suggested the slowdown is not over. The Fed yesterday suggested the same. Yesterday’s drop in financials following the Fed announcement suggested someone is paying attention. Will the rest of the market? The next few weeks will provide a lot more clarity as Q1 earnings and outlook adjustments come in.
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Author: Tyler Durden