The Next Financial Crisis

Is the market giving us a glimpse of the next financial crisis?

In a recent post we advised that the #Federal Reserve should proceed cautiously in their program to raise interest rates lest they provoke another financial crisis.

We have not been the only voice to express such a concern about a potential financial crisis.

“If the economy turns out to be weaker than it appears, then the Fed’s moves could prove dire for both Wall Street and Main Street.”

“If there are real pockets of weakness in the economy, then the Fed doesn’t need to tighten four more times. “Maybe business has already begun to cool. Maybe they’re well on their way to taming inflation. The point here is that we don’t know.”

Instead of trying to overshoot inflation with lockstep rate hikes, the Fed should take a more measured approach to avoid another financial crisis.

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Alas, apparently the Fed does not read this blog. They have announced a plan to proceed even more vigorously with rate hikes.

“Interest rates are still acommodative, but we’re gradually moving to a place where they will be neutral,” he added. “We may go past neutral, but we’re a long way from neutral at this point, probably.”

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The Fed Is Optimistic

Chairman Powell’s cavalier attitude toward interest rate hikes is based on his very optimistic view of where the U.S. economy is right now.

The U.S. is experiencing “a remarkably positive set of economic circumstances, and we’re working hard to try to sustain the expansion and keep unemployment low and keep inflation right on target,” he said Wednesday. “There’s really no reason to think that this cycle can’t continue for quite some time.”

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Maybe Chairman Powell is correct. But there are many who disagree.

Economist John Williams says the recent rate hikes mean the “Fed is killing off the economy.”

Williams says, “I heard President Trump make some comments to that effect, and he’s right.”

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In his post-announcement press conference, Powell cited a strong economy, low unemployment, solid growth, etc. He said that “It’s a particularly bright moment” for the economy.

Barring significant developments, the Fed may raise rates again in December and perhaps three times next year.

Meanwhile, the Commerce Department announced this morning that second quarter U.S. GDP expanded at a 4.2% annualized rate.  This confirmed the earlier estimate.

In 2009, almost every economic forecaster and commentator was talking about “green shoots.” In 2010, then-Secretary of the Treasury Tim Geithner forecast the “recovery summer.” In 2017, the global monetary elites were praising the arrival (at last) of “synchronized global growth.”

None of this wishful thinking panned out. The green shoots turned brown.  The recovery summer never came.  The synchronized global growth was over almost as soon as it began.

I’ve said repeatedly that the Fed is tightening into weakness. But it’s more than the rate hikes. The Fed is also winding down its balance sheet.  Furthermore, the pace is scheduled to accelerate next year.

Bearing in mind that monetary policy works with a 12–18-month lag, this extraordinary tightening policy in a weak economy is almost certainly a recipe for a recession.

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Inflation is reemerging

There is a general agreement that after ten years of very aggressive monetary expansion, and in light of recent hints of rising inflation, an increase in interest rates is appropriate. However, there is little agreement on the appropriate level of interest rates. Nevertheless, the Federal Reserve revealed in the September meeting that they see the economy as strong enough to justify continuing their policy of pushing interest rates higher.

“With regard to the outlook for monetary policy beyond this meeting, participants generally anticipated that further gradual increases in the target range for the federal funds rate would most likely be consistent with a sustained economic expansion, strong labor market conditions, and inflation near 2 percent over the medium term.”

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The dangers of excessive Fed interest rate hikes are many.  One sector that is especially vulnerable to business downturns is real estate.

The U.S. economy is growing at a healthy pace, the labor market is its tightest in years and consumer confidence hasn’t been this high since 2000. But one warning sign of trouble could be flashing in the housing market, according to forecaster Lakshman Achuthan.

“Our leading home price index has made a downturn that it hasn’t made in a long time.” “The last time it was this weak … was in 2009 coming out of the last recession, and this leading index in 2006 really did call the housing bust.”

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Furthermore, in September sales of previously owned homes in the U.S. fell for the sixth consecutive month.

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Global Liquidity Is Eroding Fast… But Nothing Is Breaking Yet

All of our measures of liquidity have continued to weaken over the last two months. This applies to public sector liquidity, which has now declined to ~3% (vs 16%+ growth in ‘16 and ‘17)…

Our concern remains one of accumulation of policy failures, as CBs and investors understate the degree of linkages between asset classes. For example as 30Y mortgages touch 4.7%, there are already signs of tightening. Similarly rising short-term rates are bound to impact car loans & credit cards.  In addition, more vulnerable EMs could infect stronger EMs, causing a more robust contraction at the time when OECD leading indicators are already easing.

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Bubbles Do Burst

And of course the perennial looming calamity is pensions, both public and private pensions.

“Now our entire pension system, public and private, is dependent on the current bubbles in stocks, real estate, junk bonds and other risk assets never popping.

But a funny thing eventually happens to financial bubbles: they all pop. And when the current bubbles pop, they will gut pension reserves, projections and promises.

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Furthermore, we should keep in mind that the consequences of credit contraction are felt both in the U.S. and abroad. Part of the poor performance of the stock markets is not doubt related to ongoing trade disputes. However, a good deal of the slump in stock markets is caused by credit contraction and resulting decline in economic growth discussed above.

The Shanghai Composite Index plunged 2.9 percent Tuesday, sending negative ripples through world markets. China stocks are now down 12 percent in October and 26 percent over the last 12 months.

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What The Smart Money Is Doing

Many prominent money managers have already begun to adopt defensive investment strategies in anticipation of the next financial crisis.

The Swedish Wallenberg family’s holding company Investor AB, which owns stakes in about a fifth of the companies listed on the country’s benchmark large-cap index, is preparing for a potential weakening of the global economy.

The Stockholm-based company is making sure the holdings in its 372 billion-krona ($42 billion) portfolio, which includes wireless-network equipment maker Ericsson AB and appliances manufacturer Electrolux AB, are agile and flexible enough to handle a changed outlook after leading indicators started pointing to a softer demand environment. The company recently also sold a 500 million-euro ($577 million) 12-year bond to increase its financial headroom.

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