Tornado in Nebraska
“They that sow the wind shall reap the whirlwind.” (Book of Hosea 8:7)
The famous biblical saying from the Old Testament quoted above suggests that in life, there are generally consequences for our actions. Although this was originally an ancient religious concept, it has application as a practical matter for all of us in our everyday 21 st century lives. It also serves as a metaphor for what is happening (and may happen) in our modern economics and politics. Indeed, we have “sown the wind” with our profligacy and love of debt, and I think this means that we will eventually, and perhaps soon, “reap the whirlwind.” Our economic and monetary policy mistakes over the last several decades, and our debilitating lack of political honesty about our out-of-control welfare state and its costs, will come back on us to inflict great harm, almost like a biblical-scale whirlwind destroying everything in its path. By that I mean that we are facing (in the next few years) what is potentially another very damaging and massive failure of economic policies and national politics in response to a series of imminent threats.
These threats are coming at us from every direction, viz: 1) high risk of a substantial global recession (Kevin Wilson, 2017a; Kevin Wilson, 2018a); 2) substantial risk of a potentially serious global currency crisis (Chris Puplava, 2019; William Watts, 2019); 3) a likely very high probability of a sudden explosion of the global corporate debt bubble (Kevin Wilson, 2019a); 4) a real potential for a global financial crisis brought on by Brexit and perhaps the left-over banking problems in Europe (John M. Mason, 2019; Mark J. Grant, 2019); 5) unknown levels of systemic risk associated with a probable severe economic decline in China for the first time in several decades (Kevin Wilson, 2017b); and 6) a real chance that our nascent trade war with China could transform into a serious long-term power struggle, otherwise known as a cold war (Shareholders Unite, 2019; Charles Edel & Hal Brands, 2019).
The presumed failure of new experimental economic policies and standard politics, here means specifically that the fiscal and monetary systems will once again apparently inadvertently punish the Middle Class in many countries in order to facilitate more deficit spending in support of burgeoning welfare states as they descend into a recession (cf. Kevin Wilson, 2017c; Kevin Wilson, 2019b). The version of the welfare state now employed in the US punishes work and savings while it rewards sloth and indebtedness. The Middle Class has been and will apparently continue to be squeezed at every turn (Kevin Wilson, 2019c). Meanwhile the so-called “1%” will ultimately see their wealth once again differentially (and “inadvertently”) boosted in the aftermath of the coming recession by the Fed’s counter-productive policies in fighting deflation and trying to artificially boost demand.
This time around will likely mark the third major inadvertent betrayal of the Middle Class at the hands of economists and politicians (from both parties) in just the last 40 years. The first apparently inadvertent betrayal by economists and politicians was the Great Inflation of 1965-1982 (cf. Kevin Wilson, 2018b; Robert J. Samuelson, 2010; The Great Inflation and Its Aftermath; Random House, New York, 316p). This was a completely unnecessary large-scale experiment (ominously labeled “the New Economics”) with the theories of monetary and fiscal policy that cost the Middle Class dearly for decades and achieved virtually nothing beyond very high inflation rates and a declining standard of living. It was undertaken for laudable reasons, but the underlying theory (i.e., Keynesian manipulation of demand) was based on woefully incorrect theoretical models about how employment and inflation work, and spectacularly wrong empirical methods driven by reliance on the notorious Phillips Curve. An unmeasurable parameter (i.e., Potential Output) was the principle guide to policy, just as another unmeasurable parameter (the Natural Rate of Interest) drives policy now. Unfortunately, in spite of years of gross prediction failure, the Potential Output parameter was stubbornly clung to by the Fed from around 1965 until 1982. In consequence, monetary policy was far too loose and inflation soared as a result.
The second inadvertent betrayal by economists and politicians was the Great Financial Crisis of 2008-2009 and its aftermath (i.e., what might be called “the Great Fizzle”). This involved: 1) the abject failure to protect the financial system by nearly all federal regulators (except for the FDIC) in the lead-up to the crisis; 2) massive and generally unpunished frauds in the housing markets and within the real estate sector of the bond markets; 3) over-reliance on flawed value-at-risk (“VAR”) models on Wall Street; 4) massive investment banking, mortgage, and insurance sector failures and subsequent (unprecedented) bailouts of often unworthy (i.e., insolvent) corporations with taxpayer money; 5) active Federal Reserve support of gigantic credit and asset bubbles whose size guaranteed an eventual implosion that would nearly cause a global depression; and 6) lasting damage to the wealth and well-being of the Middle Class and the elderly caused by both the recession and the ultra-low interest rates imposed by the Fed (cf. Kevin Wilson, 2017d; Kevin Wilson, 2018c; Kevin Wilson, 2018d; Kevin Wilson, 2018e; Kevin Wilson, 2019d). We arguably have still not fully recovered from the Great Financial Crisis (Chart 1), yet here we go again, plunging (Charts 2-4) towards yet another bubble collapse and all its attendant negative impacts.
Chart 1: The Output Gap Still Hasn’t Closed After 11 Years
Chart 2: Real Per Capita Demand for Capital Goods Has Apparently Permanently Declined
Chart 3: Sharp Decline in Housing Permits and Starts (To 1991 Recession Levels) in Period Since 2006
Chart 4: Global CAPEX Is Plummeting
Defining Economic Policy Failure
If readers will grant me a starting premise that the Great Inflation of 1965-1982 and the Great Financial Crisis of 2008-2009 (whose impacts continue today) are both examples of policy failure, then I submit that we are on the verge of another. We are apparently heading into a serious recession without having fully recovered from the last one (Charts 1-3 above; Charts 5-6 below). We are also burdened with nearly the greatest amount of debt ever, and we are already printing the biggest federal deficits ever (nearly $1 trillion), outside of wartime or recession. Add in another probable $1 trillion/year of deficit spending due to a 2019-2020 recession, and we face the biggest federal deficits and largest Treasury financing needs ever. This means that whatever efficacy there is to Federal Reserve monetary stimulus during recessions, we will perhaps experience less impact from it now than in many decades. This is in part because of the debt overhang, and in part because the Fed never completed their return to ”normal” rates, so they can only provide 2.50% of monetary easing to the Zero Bound. However, in 2001-2002 the Fed dropped rates by 4.75%, and in 2007-2009 the Fed dropped rates by 5.25% (Kevin Wilson, 2019d; Op. cit.). By the way, this is the first time the Fed has been stopped out of their plans to normalize rates since the 1930s (David Rosenberg, August 9, 2019).
Chart 5: Global Yield Curve Inversion Predicts Global Recession
Chart 6: Odds of a US Recession Are Spiking
By the end of September, the Fed will presumably already have used up some 0.50% of that total of 2.50% of potential easing. Another way to analyze the relative effectiveness of the Fed’s potential maximum rate drop is to look at it on a real, effective rate basis. Adjusted for inflation of about 1.80%, the total drop in the Real Effective Fed Funds Rate from its recent peak to the Zero Bound would only come to a maximum of 4.30%, taking the Real Effective “FFR” to -1.8%. In contrast, the total Real Effective Fed Funds Rate drop in 2008 was about 7.50% and it produced a trough Real Effective “FFR” of about -3.75% (Chart 7). In 2002 the trough Real Effective “FFR” was only about -2.00% after a drop of about 5.00%, but that was a far different economy than what we have at present. So even if rate cuts were deemed effective, which I doubt, they would be smaller than what was seen in previous recessions. Yields on the 10-Yr. Treasury can also be expected to drop by the average amount at least, which would be about 2.26% from the peak (which was at 3.26%), taking the 10-yr. all the way down to a yield of 1.00% or so. In the event of a serious recession, we can expect the Fed to get a little panicky because: 1) their efforts will seem a bit inadequate in terms of total stimulus provided by the rate drop, as discussed above; and 2) they will feel like they are “pushing on string,” i.e., their efforts will appear to have little effect because of the existing output gap (Chart 8) and the enormous federal, state, municipal, and corporate debt overhang.
Chart 7: Real Effective “FFR” Drops During Recessions
Chart 8: The Output Gap Still Hasn’t Closed After 11 Years
In Baseball, It’s “Three Strikes and You’re Out” - Not So in Economics
Assuming that my perception of an impending global recession that will strongly impact the US is correct, how will the fiscal and monetary authorities respond? They certainly will not let their previous failures prevent them from trying out new manipulations and experiments, because they are technocrats who see the world as deterministic (Philosophy Terms, 2019), and their role as one in which logical things are done by experts to produce a predictable, benign and logical result. However, as I’ve stated before, there is absolutely no accountability in economics, with the exclusion of national level politicians (Kevin Wilson, 2018c; 2018d; Op. cit.). Federal Reserve Board appointees cannot really be removed from office, so they will have little fear of dismissal for incompetence or lethargy. Most will have lucrative consulting careers ahead of them when they depart the Fed, regardless of what happened on their watch. Indeed, there is no “three strikes and you’re out” rule for Fed governors or Fed bank presidents.
Famed author and analyst Nassim Nicholas Taleb has severely criticized the economics profession as “fake,” because economists have no skin in the game and are paid merely to speculate on what might happen (Wikiquote, 2019). However, I’m sure that in spite of these observed economist behaviors, the Fed will still be a little wary of stoking the flames of populism any further than they already have. They are already held in low repute by many voters, and politicians like Donald Trump have been highly critical of central bankers in recent years. So the Fed may want to move forward cautiously, meaning they might stay far behind the curve for quite a while yet, and act so as to avoid popular anger at “bailouts for the rich.” Meanwhile, the economic situation will likely deteriorate and many will urge the Fed to “do something;” indeed, many Fed governors have acted on the basis of “doing something” in the past (Kevin Wilson, 2019d; Op. cit.). We’ve already discussed the idea that the “FFR” will be dropped to the Zero Bound as a first response to a declining economy, and that process is already clearly underway. What happens once the Zero Bound is reached is what worries me. There are several unconventional policy options available, some of which were tried out in the recovery from the Great Financial Crisis (e.g., “ZIRP,” “QE,” and “Operation Twist”), and a couple which have not yet been tried out, at least in recent decades.
Which of these will be employed is a difficult call in some ways, but we can certainly narrow down the possibilities. Ben Bernanke, that ever-popular Fed ex-Chairman and "savior of capitalism” (but nevertheless deeply flawed academic economist; cf. Kevin Wilson, 2019a; Op. cit.) has already laid out what might happen. He mentioned the Fed would first be taking rates to the Zero Bound, but he would then employ negative rates before resorting to “QE” again (Ben Bernanke, 2016). He seems to think that negative rates would provide significant monetary stimulus. That is a curious thing to believe, given the massive failure of the Bank of Japan or the European Central Bank to achieve any kind of traction no matter how negative they actually take rates (Brian Blackstone, 2019;Simon Constable, 2019). Indeed, the policy appears to have backfired and actually contributed to economic decline (Chart 9), and even some Fed researchers have criticized “NIRP” (Jens H. E. Christensen & Mark M. Spiegel, 2019).
Chart 9: Failure of Negative Rates to Gain Traction
Former Fed Chairman and “Maestro” Alan Greenspan has opined that, “ There is no barrier for US Treasury yields going below zero." He went on to say, "Zero has no meaning, besides being a certain level," according to Fortune Magazine (Erik Sherman, 2019). “NIRP” can be very damaging to banking sector income statements and balance sheets as net interest margins are deeply cut. Therefore “NIRP” poses some systemic risk problems, although it does have the cheering result that currencies tend to be gradually devalued under such a policy. That certainly appears to be the case for Europe, where “NIRP” is everywhere (Chart 10) and the Euro is declining relative to the US dollar (Chart 11). The Fed will be under pressure from President Trump to keep lowering rates, although it’s not clear whether he would favor “NIRP.” Still, the above noted pronouncements from former Fed chairmen like Bernanke and Greenspan are probably an indication that the Fed will seriously consider adopting “NIRP” before it undertakes another politically risky round of “QE” that would antagonize the populists. For what it’s worth, my opinion is that since so many other countries have already undertaken “NIRP” as a last-ditch defense, the Fed will too.
Chart 10: Soaring Amount of Negative Debt, Much of It in Europe
Chart 11: Decline of the Euro As “NIRP” Takes Hold
Adding to the uncertainty is the fact that everything becomes unpredictable and strange when banks must pay borrowers to take out loans, and bondholders must pay for the privilege of lending money to corporate debtors or the federal government. Not to mention the probable disaster that would ensue when some $3 trillion of short-term funding provided by the money markets completely dries up, according to analyst Peter Boockvar (quoted by Alex Harris, 2019). But even if disaster in the short run is somehow avoided, it would be hard to avoid it in the long run. At some point markets would rebel at seeing negative-yielding 10-yr. or 30-yr. bonds thrust at them in auctions, and we would observe bond auction failures in the US just like the one that happened last week in Germany. Eventually the central banking authority (in our case the Fed) would be forced by circumstances into massive debt monetization via “QE,” to avoid dumping unwanted bonds on the market. There is already talk also of issuing 50-yr. or 100-yr. Treasury bonds, which would be a disaster for those already holding 20-yr. to 30-yr. federal debt.
Under the Japanese version of unconventional policy known as Quantitative & Qualitative Easing (“QQE;” Chart 12) in which nearly half of all government bonds and even very large amounts of stocks have been bought by the “BOJ,” gross mutilation of capitalist principles has been countenanced just to keep the game going (John Greenwood, 2017). The ultimate outcome of such a path must eventually be the destruction of the markets (Chris Anstey, 2018) and presumably also the currency (cf. Chart 13), although the latter does not appear to be happening yet in Japan. Some economists believe that debt monetization will be completely benign in the long term (Maxime Menuet et al., 2016).
Chart 13: Weimar Republic’s Demise Under Debt Monetization
However, others point out that sustained debt monetization like that long practiced by Japan, and more recently by Europe, is ultimately inflationary in a big way (Michael Klein & Kenneth Kuttner, 2019), and therefore economically destructive. There appears to be very little practical difference between debt monetization as currently practiced in Japan and Europe, and Modern Monetary Theory (“MMT”); the result will likely be about the same. But many in recent years have been discussing just such an aggressive policy (either “MMT” or old-fashioned debt monetization) as the preferred choice going forward (cf. Pater Tenebrarum, 2011; Michael Klein & Kenneth Kuttner, 2019; Op. cit.). This bodes ill for those who will be forced to live under such a regime. As I have written elsewhere (Kevin Wilson, 2019d; Op. cit.), the choices are stark given our proclivity for enormous deficit spending, and the Fed really doesn’t have the tools to do its assigned task anymore.
If "NIRP," "QE," and low-level debt monetization are tried sequentially and yet the economy still struggles, then we may even resort to the "helicopter money" once speculated upon by Milton Friedman, and later by Ben Bernanke. This would involve a massive fiscal spending program fully financed by the Fed, and it would have a tendency to be inflationary. This was tried on a limited basis in Japan during the Great Depression, with no serious damage done; it was also done in the US on a massive scale during World War II, and again, inflation was kept under control (Kevin Wilson, 2016). Results were pretty fair, but the key constraint is that it can only be applied one time if runaway inflation is to be avoided. Any attempt to resort to serial helicopter drops would end in disaster.
A quick look at the federal deficit should also give us pause as to whether any effective fiscal stimulus is likely to be forthcoming in the impending recession (Chart 14). It would appear that the fiscal authorities’ hands are tied this time around, because any fiscal stimulus would naturally have to be completely monetized under a mega-QE regime. This would likely have populists screaming like they did after 2008, and it might make bond investors go crazy as the Fed would openly manipulate the yield curve, again as they did in 2008-2013 (Chart 15). Budget fights and fights over the federal debt ceiling might possibly result as well. If Congress and the President stop bickering and join together on a crisis-driven fiscal stimulus package once the recession fully kicks in, it will not be a good thing; rather, it will be another disaster, just like it was under President Obama. This will be in part because the money will be spent on Congressional hobby horses and boondoggles, and part because the multiplier for almost everything except infrastructure spending is actually negative. Not to mention that consumers will suspect future tax increases under Ricardian Equivalence, so they will increasingly hold back on spending, the more panicky Congress and the President become.
Chart 14: “CBO’s” Projected Huge Deficits, Which Ignore Recessions
Chart 15: US 10-Yr. Yields Under “QE” Actions
The financial implications for investors if the Fed undertakes “NIRP” might be considerable (Gautam Dhingra & Christopher J. Olson, 2019). Investors in that case would do well to avoid bank stocks (e.g., SPDR S&P Regional Banking ETF [KRE]; Financial Select Sector SPDR Fund [XLF]). Investors would also do well to avoid low-rated debtor companies (e.g., many companies in the i–Shares Russell 2000 ETF [IWM] or the i-Shares Micro-Cap ETF [IWC]), which will continue to survive as zombies but will also avoid changing what’s wrong with them because of perpetual easy financing. Long Treasuries (Wasatch-Hoisington US Treasury Fund [WHOSX]; i-Shares 20+ Yr. Treasury Bond ETF [TLT]) will do well as the recession develops, but this will likely be a trade, not a buy and hold position. Bond holders will want to keep an eye out for extreme futures market positioning as a contrary indicator. Also important would be any marked change in direction for the 5-Yr. TIPS break-even amount. After the 10-Year US Treasury passes the test of decreasing to a new low (below 1.32%) and as it nears a (prospective) yield of 0.50% to 1.00%; or alternatively whenever the Federal Reserve re-institutes “QE” policy; or under yet another alternative the impending bear market for stocks bottoms out (whichever of these comes first), I would expect very high risk of a bond selloff. Depending on circumstances it is possible this hypothetical selloff could even be a pretty big one.
Right now, i t makes sense with all the uncertainty, deflationary trends, and negative real rates to invest some money in a gold fund like SPDR Gold Shares (GLD), but only as a short-term hedging trade, not a buy-and-hold position. The I-Shares Gold Trust (IAU) is an alternative ETF that may be safer for those who want to hold it for a somewhat longer period of time. But the safest form of gold in the event of a true financial apocalypse is physical gold. For those discounting a possible near-term recession and bear market, some liquid alternatives like the Otter Creek Prof. Mngd. Long/Short Portfolio (OTCRX) could be held to protect assets in the event of a much sharper market draw-down associated with deteriorating economic data.
Disclosure: I am/we are long OTCRX, IAU, GLD, WHOSX, TLT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Disclaimer: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks or other securities mentioned or recommended. This post is illustrative and educational and is not a specific recommendation or an offer of products or services. Past performance is not an indicator of future performance.