With Highest Debt Since WWII, Where Can We Possibly Go When Recession Hits?
As the Fed looks to stave off recession with rate cuts, a soft landing seems nearly impossible to pull off.
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The Fed has a dual mandate, one which matches the strength of the labor market versus the inflation in the economy. Neither have warranted the Fed to cut rates, even though every single business owner and consumer is screaming for them to do so.
All throughout 2023, a recession was expected, but one never came thanks to endless U.S. fiscal spending and lax monetary policy during COVID-19. Given the Treasury’s constant liquidity injection and game playing with the bond market, there has been a serious disconnect between the S&P 500 and the broader U.S. economy.
The S&P 500 has become one large technology index with seven names representing more than 30% of its value and dictating its direction. If one were to just look at the index, one would think U.S. is in a solid recovery phase, but if one drills down to all of the remaining 493 members, one can see just how bad things are.
Since July 2023, we have seen the U.S. consumer weaken and small- to medium-sized businesses lay off thousands during every conference call from Q423 onwards. The system has been flashing red since Q123 and we have already seen debacles from U.S. regional banks to Credit Suisse, then the U.S. bond curve. This year, it was the yen carry trade. When a system is built on so much leverage and free debt, it is impossible to know which domino falls next, but they are falling, one by one.
The U.S. national debt is on a one-way upward trend and most suggest that if it was not a problem over the past 15 years, it shouldn't matter now. At some point, the system has an overload. Today, we have not even entered a recession and yet we have the highest debt since post World War II. Where can we possibly go next time there is one?
The equity market mantra has been "the Fed will cut," so the put is alive and well. We have long opined that the cut is not as important as is the timing of the cut. The Fed is already six to 12 months too late. Due to the lagged effects, when indicators start moving the other way, it is not about the absolute direction but about the speed of that direction, i.e., the second derivative of the change. Unemployment rate has ticked up by 0.7% and, judging by the latest revision of down 818,000 jobs all of last year through March 2024, we have already triggered the Sahm rule in excess of 0.5%. This has always confirmed a recession. The question is not whether the Fed will cut, but by how much.
Bond markets have been calling bluff on the Fed for months as they are pricing in about 100 BPS of rate cuts this year, whereby the Fed has alluded to just one 25 BPS cut possibly in September. Their justification is that the economy is robust, the labor market solid and inflation moving their way but still above their target. Also, if they were to cut too much, the yen could face another squeeze, killing Japanese assets.
Either the bond market is too pessimistic or the equity too optimistic, but it does not add up. Looking back historically, we know equities are always the last to react and it pays one well to listen to bond and forex markets, as they are the more sophisticated brethren.
The Fed has never been able to call a recession until it smacks them right in the face. So, their statements need to be taken with a pinch of salt. After all, it was also the Fed that kept saying "inflation is transitory!"
As the old adage goes, when the Fed panics, the markets panic more. All eyes are on Jackson Hole and the Fed’s dot plot — not that that has ever been right.
At the time of publication, Bengali had no positions in any securities mentioned.
