Has a recession already started in the US? Russ Winter has made some recent posts in his blog showing evidence to the effect that it has. I have my doubts, but it’s a mostly matter of timing, and also relevance.
A recession doesn’t rule out a rising stock market. In fact, history is replete with examples of recessions being bullish. That’s because the Fed and other central banks around the world respond to weakening economies by pumping up the volume of liquidity that they inject into the system. Considering that the Fed has already been growing the System Open Market Account (SOMA) at a base rate of 5% for years, and that M2 is growing at 5%, any additional pumping on top of that could be hyper bullish for stock prices.
In the late stages of a boom/bubble, central bankers would normally be tightening credit, and that would normally result in a bear market in stocks. Our friendly central bankers would then reverse course as soon as economic growth went negative. Credit demand in the real economy would have weakened by then, and as the recession worsened, the stock market would begin to rally.
That wasn’t because the market was “all knowing” and was “discounting” the future. It was because there was a flood of excess liquidity that had to go somewhere. Some of it went into stocks and their prices rose. A few people began to have more money to spend as a result, and other people began to feel more positive because the market had begun rising. The economy soon followed because businessmen began to find renewed confidence to invest in production.
That was in the good old days before the Fed had outlawed recessions, and got in the business of stimulating bubbles through endless liquidity pumping at the first sign of any economic or financial weakening. So we ended up with rolling bubbles, mostly in the stock market, but expanding to other, more esoteric, forms of financial assets.
The most recent bubble was the US housing bubble. This one was the bubble to end all bubbles. Unlike past bubbles where speculators needed to be drawn in to participate in something they normally would not have participated in, in this bubble, anyone who owned a home, and a whole bunch who didn’t and never should have, were participants. Otherwise sane people began treating their homes as if they were ATM’s from which “cash” could be “withdrawn.” Only they weren’t withdrawals. They were loans. And now those loans have to be paid back. And a whole lot of folks, unfortunately, can’t pay the loans back.
The result is and will continue to be debt destruction– a massive wave of liquidation, write-down, and write-off that is only now just beginning. That there will be a recession as a result seems certain.
My feeling at this point is that 4% retail sales growth, while a clear deceleration from past levels, is not yet recessionary. It remains a hair above government reported CPI growth. There’s no question that vast swaths of the US population, and vast regions of the US, are already suffering their own personal recessions. As the housing collapse worsens, these forces of recession will eventually tip the balance in the nationwide data to the downside, regardless of how well the top 10% continues to do. The top tier simply will no longer be able to grow their spending enough to overcome the drag of the multitude who are forced to stop spending.
The Fed has continued to grow the SOMA at 5% even when there was no recession. That’s 2-3% above reported GDP growth. M2 money supply is also growing at 5%. What’s going on? The Fed is pushing money growth, but the economy isn’t keeping up. That’s stagflation folks.
So what is the Fed going to do for an encore as the housing crisis worsens, and the pace of mortgage debt liquidation increases. Those forces should begin to impact money growth negatively. The Fed’s response will be to pump even more, growing the SOMA even faster.
This is not the good old days when the Fed first tightened credit, then came the recession, then the loosening, and concurrently the stock market rally. In today’s bizarro world of endless Fed liquidity, the Fed never tightened, and recession is coming anyway as the inevitable result of the collapse of this housing bubble that suckered just about everyone.
So the Fed will now begin pumping from a high base growth rate. Credit conditions will tighten in spite of the Fed because of the reverse bubble mechanics now at work in the massive mortgage markets. The $1.5 trillion in the retained portfolios of Fannie and Freddie, nearly twice the size of the Fed’s $800 billion SOMA, will begin to shrink, and will continue to do so as wave upon wave of foreclosures hits the market. Whether the Fed and FCBs can pump enough to offset that shrinkage remains to be seen.
One thing seems certain. They will attempt to force liquidity into the system. They do that by the mechanism of open market operations via the Fed’s 22 primary dealers. Those dealers then put that liquidity to work in whatever markets they deem most likely to profit from. Will they buy bonds? Will they simply buy short term money market instruments? Will they buy futures, options, other derivatives? Or will they buy stocks? They certainly aren’t going to lend it out to build more housing, or retail stores, or office buildings. Factories? Fuhgeddaboudit.
There’s simply no way to know where they will put that cash. But they will be buying something. As the economy weakens, and there’s no demand for capital to expand production and economic activity, liquidity will be pumped directly into the trading floors of Wall Street and Chicago.
The Weimar scenario may well rear its ugly head as a result.
Or will the destruction of mortgage assets result in a debt collapse that outpaces the inflationary impulses of the central bankers and the Pigmen on Wall Street?
There’s no way to know. But it does seem that the new central banking paradigm–let’s call it the Greenspan paradigm–of no recession and endless liquidity has left us in a very bad place, one from which there would seem to be no way out without enormous pain. The decision to never recess, to have permanent rolling bubbles, may have left us on the brink of permanent rolling recessions.
As for how the stock market reacts to the horror show, as always, I suggest that we follow the money, and let the charts be our roadmap.
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Great commentary!
When the tech bubble unwound, we had a recession and a bear. Billions were wiped out of the stock market. I’ll bet the Fed was pumping all the way down at the same time they lowered interest rates. Would it not be unreasonable to expect the same thing as the housing bubble unwinds (recession and bear)?
Even when the Fed lowers rates and sucks in the last remaining borrowers, it will be draining blood from a stone. The consumer should be finished after the next round of rate cuts if not already tapped-out now. So the big question from your article really is where is all the money from Fed pumping going to go? I agree we need to wait and see, but I’ll be watching for a bond bubble as money looks for safety. Could we be following the Japanese down the road to 0% interest rates?
What is the Weimer scenario?
> Has a recession already started in the US?
Absolutely, and it started last year: all you need to do is to use a more realistic GDP deflator, and the answer becomes obvious. With understated inflation in the GDP deflator, you are overestimating growth.
I’m glad you know what the deflator should be. Care to share your secret and the facts and logic behind it?
Declarative statements are not evidence. I like facts and logic so that I can evaluate the validity of a conclusion.
Of course, even if we are in recession already, what difference does it make? Does it mean I should short the market or go long?
Nice work, Lee. The Weimar vs Japan debate will continue for some time. Until we can quantify the mortgage fallout, there’s no way to know if it will unseat any Fed liquidity pumps. Judging on the political reactions of late (Congress, Ohio, etc) it sure looks like they’re headed down both roads simultaneously. Still, I don’t see why we can’t have hyper-inflation and a bear market.
These 22 primary dealers, do they have to borrow from Fed or could they decide not to?
They are under no obligation to borrow as far as I know. I would assume not all of them bid every day. The Fed holds a meeting with them every morning to find out how much financing they need “to carry their securities inventories.” That’s the basis for how much the Fed offers in terms of repo and permanent money.
So if they’re all flush, the Fed does no repos that day.
> I’m glad you know what the deflator should be. Care to share your secret?
John Williams at Shadow Government Statistics follows every statistic change and footnote in the government’s numbers for inflation, and has recreated M3. You can subscribe to get the data, he may have free items on his web site also. It is very math-heavy, and you will get all the math you could want. For example, he can give you current inflation expressed as it was calculated before all the formula changes and hedonic adjustments. The interesting thing is that in the government CPI reports, nothing is truly hidden (except maybe the intent) – for everything they do, there are footnotes which explain the changes in methodology.
Rhetorical question: At a high level, do you agree that inflation is underreported?
If so, then its a no-brainer that if inflation is underreported, then the GDP deflator is too low (regardless of the exact number), which makes the stated growth rate an overestimated work of fiction. People and politicians like nice big growth numbers.
If you dont agree that inflation is underreported, then you assert that methodologies such as replacements in the inflation indexes are acceptable, where an old lady who cant afford steak anymore switches to hamburger becuase its cheaper and the index doesnt reflect any change in prices. (I dont buy it, but you’re welcome to your opinion). The rejiggerings of CPI are ongoing.
Shorting is hard because with money growth of at least 8-10%, the market can fall in value by that much in one year, and yet in nominal terms, appear to remain flat.
> … I have my doubts
This is the only reason I posted, no flames were intended. I wouldnt be here if I didnt think the guys at WSE were doing a good job and knew what was going on.
I agree that the CPI is probably understated and that hedonic adjustments are a joke. Whether that translates into the US already being in recession is questionable. I also doubt that it matters, since the market responds to liquidity changes before the economy does.
If a person is going to trade successfully, whether short or long, then he or she has to forget about the fundamentals entirely and focus on the charts. Believing that the economy is bad while the market is going up only prevents the trader from taking the proper actions at the right time.