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Is the Fed Setting the Stage for Another Crisis?

Is the Fed Setting the Stage for Another Crisis?

With the narrative of a “soft landing” gaining traction, the possibility of another crisis event in the economy looms. The question on everyone’s mind: will the Fed be the trigger for this crisis? While it remains uncertain, the risks are mounting as lagging economic data compromises the Fed’s “higher for longer” policy.

To get a better understanding of the situation, let’s examine the Fed’s history of monetary actions. In a previous article, “Investors Push Risk Bets,” I discussed the notion of the “instability of stability.” This concept assumes rational behavior from all market participants and the avoidance of destructive actions. The Fed heavily relies on this assumption, considering the unprecedented monetary policy program it has implemented over the past 13 years. However, they now face the challenge of navigating the risks that have accumulated in the system.

Historically, when the Fed raises interest rates and yield curves invert, it often leads to a crisis event. The fallacy lies in believing that a “soft landing” scenario, like the one in 1995, will spare us from a recession. While the economy did not experience a recession that year, crisis events did occur along the way. Additionally, the yield curve did not invert in 1995 but did so in 1998, precluding a recession approximately 24 months later.

The chart below illustrates the relationship between yield curve inversions and recession or crisis events. Inversions typically occur 10-24 months before a recession, as the lag effect of higher borrowing costs takes hold.

The Fed Versus The 10yr-2yr Spread

To fully understand the potential for a crisis event in the near future, we must consider the collision of events currently taking place. The U.S. is now in its most highly leveraged economic era, with a total measurable leverage of $97 trillion as of Q2 of 2023. This means that it takes $4.36 in debt for every $1 of economic growth. The level of debt has nearly doubled since 2008, and the economy has also grown significantly during this period. As a result, the collision of significant debt-financed activity with restrictive financial conditions is likely to lead to weaker economic growth.

Total System Leverage

As financial conditions tighten, weaker growth tendencies often precede recessions and crisis events. The fact that previous crises occurred at substantially lower levels of overall leverage should be cause for concern.

Financial Conditions (Inverted) Vs. GDP

By examining the annual rate of change in total system leverage versus changes in interest rates, we can anticipate a crisis event occurring around 36 months after rates start to rise. Since rates began increasing in 2021, we can expect the next crisis event to occur in late 2024.

Total System Leverage (Ann % Chg, 36-Mth Lag) Vs, Rates

Yield curve inversions play a crucial role in confirming the timing of the next recession or crisis event. While the media tends to proclaim a recession when yield curves invert, the lag effect means that the actual recession has yet to take hold. As we can see in the graph below, the lag effect of yield curve inversions preceding a recession is significant.

The Lag Effect (Yield Curve Inversion To Recession)

Considering the massive amount of stimulus injected into the economy and the still-high levels of money supply relative to the economy, the next recession will likely resemble the episode in 2006. Just because the collision of higher borrowing costs, reduced money supply, and slowing economic growth hasn’t immediately caused a crisis or recession doesn’t mean it won’t.

A Policy Mistake with Enormous Risks

In a previous article, “Rising Interest Rates Matter,” we explored how an increase in interest rates, a tightening of monetary policy by the Fed, or a faltering economic recovery could lead to a crisis event. In the short term, the economy and markets can defy the laws of financial gravity as rates rise, thanks to momentum. However, rising rates act as a brake on economic activity in a highly leveraged economy, leading to negative impacts such as increased debt servicing requirements and reduced productive investment.

  • Rates increase debt servicing requirements, reducing future productive investment.
  • Housing slows as people buy payments, not houses.
  • Higher borrowing costs lead to lower profit margins.
  • The massive derivatives and credit markets are negatively impacted.
  • Variable rate interest payments on credit cards and home equity lines of credit increase.
  • Rising defaults on debt service will negatively impact banks.
  • Many corporate share buyback plans and dividend payments were financed with cheap debt.
  • Corporate capital expenditures are reliant on low borrowing costs.
  • The deficit/GDP ratio will soar as borrowing costs rise sharply.

A crucial factor to consider is the justification for high equity valuations during the past decade: low interest rates. With inflation on the rise, shrinking profit margins, and higher interest rates, valuations have become a significant concern.

Rising Interest Rates Lead to Valuation Reversals

In the words of Mohamed El-Erian, investors should anticipate a shift from a relative valuation market mindset to an absolute valuation one. When such a shift occurs, the return of capital becomes more important than the return on capital. The question remains: when will the next crisis event occur?

While we can’t predict its exact timing, it’s only a matter of time until the Fed’s “higher for longer” policy prompts someone to push the “big red button.”