Conditions for Economic Recession | October 18, 2023
This report argues that the pre-conditions for a major economic collapse are currently present across a variety of metrics and markets.
Humans are bad at assessing risk.
In this report I’ll be outlining some of the current economic risks and present the case for the risk of an economic recession and large pullback in major equity indexes (as well as crypto) being considerably higher than most are estimating.
Let’s first explore the statement “Humans are bad at assessing risk.”
People underestimate risk when it is a risk to them but they overestimate it when it is a risk to other people. How many smokers argue they can smoke ‘in the right way’ and it is other smokers, heavier smokers, who are at risk? How many drivers argue they can drive safely and it is the more reckless drivers who put themselves and others in danger?
Humans are bad at assessing risk that compounds over time. When two or more risks interact, the potential collective effect can be greater than the sum of its parts. For example, people with 1 or more co-morbidities are at a much higher risk of dying due to covid than people with 0 co-morbidities. Being an old, obese, and a smoker is considerably riskier health-wise than any single one of those things by themselves.
Recency bias is the tendency to overemphasize the importance of recent experiences or the latest information we possess when estimating future events. For example, an employee’s recent actions are more heavily weighted in a performance review than their actions at the beginning of the review period.
Complacency stems from continually doing the same things and getting seeing the same results over a long period of time, overweighting the effects of our own actions. For example, you could have invested consistently in the S&P 500 from 1988 to 2000, seen extraordinary returns, and experienced no significant draw downs. Why change your behavior of the last 12 years that has led to so much success? Complacency blinds us from the fact that markets are independent forces that move independently of our individual actions.
While humans often underestimate the likelihood of a bad scenario playing out, we are also bad at predicting the magnitude of bad scenarios. Often time the failure to hedge for a black swan event can be far more costly than expected in both time and money.
Losses in money equate are accompanied by losses in time. While a 50%+ drawdown can back breaking, the real back breaker is finding your investments in the same spot they were 12.5 years earlier.
Sure the average return for the S&P 500 is 7% per year, but if you started investing in 1996, your average return after 12.5 years is 9% (minus inflation!).
While you’ll often hear “time in the market is better than timing the market” there a still massive sample sizes of time where virtually no progress was made.
In this example, employing a simple strategy of removing market exposure in the worst historically performing months (February and September) would have avoided cumulative losses of ~24% and ~19% respectively.
Dave Ramsey is often criticized for his conservative approach towards investing and affinity towards debt minimization, especially in bull markets when risky investments are paying off. However, his take on risk and debt is worth understanding. Essentially it boils down the to idea that even small amounts of risk, when extrapolated over a long enough period of time, eventually compounds into large setbacks or losses.
In other words, if you bet the farm on every opportunity, you’ll eventually lose everything even if the chance of failure is small.
All of this simply to say, humans are bad at managing risk, bad at predicting negative outcomes, and generally under estimate the severity of those negative outcomes.
Current Evidence for a Large Drawdown in Equity Indexes
The inverted yield curve is one of the most reliable recession indicators, but most do not understand the underlying mechanics behind it. If you already understand how bonds work, you can skip below - if not here’s a quick refresher:
U.S. Treasury bonds, often referred to as "Treasuries" or "T-bonds," are debt securities issued by the United States Department of the Treasury to finance government spending and operations. They are considered one of the safest investments in the world because they are backed by the “full faith and credit of the U.S. government”. Treasury bonds have a fixed interest rate, a face value, and a maturity date. Here's how they work and their relationship with yield and bond prices:
- Face Value: When you buy a Treasury bond, you are essentially lending money to the U.S. government. The bond has a face value, also known as the par value or principal amount, which is the amount the government promises to pay back to the bondholder at maturity. For example, a $1,000 face value Treasury bond will pay back $1,000 when it matures.
- Maturity Date: Treasury bonds have a predetermined maturity date, typically ranging from 10 to 30 years from the date of issue. This means that the bondholder will receive the face value of the bond upon maturity, regardless of the price they paid for it when they bought it.
- Interest Rate (Yield): Treasury bonds pay periodic interest to bondholders, typically semiannually. The interest rate is fixed at the time of issuance and is known as the "coupon rate." For example, a 10-year Treasury bond with a 2% coupon rate will pay $20 in interest every six months on a $1,000 face value bond.
Now, let's discuss the relationship between yield and bond price:
- Bond Price and Yield Inversely Related: The price of a Treasury bond in the secondary market is not fixed; it can fluctuate. The bond's price is influenced by various factors, including changes in market interest rates. When market interest rates rise above the bond's fixed coupon rate, existing bonds with lower coupon rates become less attractive to investors. As a result, the prices of these bonds drop in order to make their yields more competitive with current market rates.
- Interest Rate Risk: This inverse relationship between bond prices and interest rates creates interest rate risk for bondholders. If you buy a Treasury bond and market interest rates rise, the bond's price will fall, and you may experience a capital loss if you decide to sell the bond before maturity.
- Yield to Maturity (YTM): The yield to maturity is the total return an investor can expect to receive if they hold the bond until it matures. It takes into account the bond's current market price, the face value, and the remaining time to maturity. As the bond's price falls due to rising interest rates, its YTM will increase because the fixed coupon payments represent a higher yield relative to the lower purchase price.
- Inverse Relationship in Action: To illustrate this relationship, consider a scenario where a 10-year Treasury bond with a 2% coupon rate is issued, but market interest rates rise to 3%. As a result, newly issued bonds are paying 3% interest. Investors in the secondary market will demand a discount on the 2% coupon bond to make its yield competitive. This discount results in a lower bond price.
In summary, there is an inverse relationship between Treasury bond prices and yields. When market interest rates rise, bond prices fall, and when market interest rates fall, bond prices rise. Bondholders need to be aware of this relationship, as it affects the potential gains or losses associated with their bond investments.
Normally, a long term bonds will give a higher yields than short term bonds. Logically this makes sense as you would expect to receive more yield for taking on the risk of locking up your money for a longer period of time.
The relationship between long-term and short-term bonds can be seen by taking the 10 year yield (long-term) minus the 2 year (short-term). This is called the yield curve.
Below is the yield curve (top) and S&P 500 (bottom orange). We originally published this chart idea last November at the local bottom of the S&P 500 because we felt the stock market would rally into the yield curve inversion like it always does.
Historically we see the top for the S&P 500 come in after the yield curve has bottomed out and/or re-inverted, which is then usually followed by a large recession.
We are currently seeing that the yield curve has very likely bottomed out, but has not quite re-inverted. Let’s break down the mechanics of why we see a large crash in risk assets when the yield curve re-inverts…
Right now the yield curve is inverted because the Federal Reserve has been hiking rates for the past year, effectively increasing yields on short-term bonds. For reference, 3 month bonds will track to the Fed Funds rate fairly tightly.
Because the market has largely expected the Fed to continue hiking rates through the past year, the yield curve has inverted and caused a large crash in bond prices across the board, particularly in long-term bonds. All the 10 year notes that were originated in at a <1% yield have drastically dropped in price due to the higher rates available now, remember bond prices and yields have an inverse relationship.
Bonds have continually dropped in price because the Fed has insinuated that they are going to continue to raise interest rates in order to curb inflation. The fed raises rates to battle inflation as higher rates make it more expensive to borrow money and run on debt. This makes it more difficult for consumers and businesses to finance purchases, ultimately reducing demand. As demand drops, prices drop, inflation drops.
Below is the historic relationship between long-term bonds (denoted by TLT, a long-term bond ETF) and the Fed Funds rate:
Look at what happened to long term bond prices (TLT) when the Fed started hiking rates^.
Now look at what happened to TLT when the fed started cutting rates:
Large pumps in the prices of bonds as the fed Funds rate drops^.
Now let’s add in the S&P 500:
We see Fed pivots (rate cuts) are followed by large drawdowns in the S&P 500 and large decreases in the 10y yield (bond prices go up).
Now what causes this?
The Federal Funds Rate (FFR) and Treasury yields are closely related, and changes in the FFR can influence Treasury yields in various ways. The FFR is the interest rate at which depository institutions (such as banks) lend reserve balances to other depository institutions overnight. The Federal Reserve sets the FFR as a tool to influence monetary policy and control the money supply.
Here's how changes in the FFR can affect Treasury yields:
- Direct Impact on Short-Term Yields: The FFR primarily affects short-term interest rates. When the Federal Reserve raises the FFR (a tightening monetary policy move), it becomes more expensive for banks to borrow money, and they pass on these higher costs to consumers and businesses through higher interest rates on loans and deposits. As short-term interest rates rise, yields on short-term Treasury securities, such as Treasury bills (T-bills), also tend to rise in response.
- Indirect Impact on Long-Term Yields: Changes in the FFR can also influence longer-term Treasury yields, such as those on Treasury notes (T-notes) and Treasury bonds (T-bonds), although the relationship is not as direct. This influence occurs through several channels:
a. Expectations: When the Federal Reserve changes the FFR, it sends signals to financial markets about its stance on future monetary policy. If the Fed raises rates, it may signal that it intends to control inflation or cool down an overheating economy. As a result, investors may revise their expectations for future inflation and economic growth. If they expect slower economic growth and lower inflation, they may buy more long-term Treasury securities, driving up their prices and reducing their yields.
b. Portfolio Rebalancing: When short-term rates rise, investors may shift their investments from short-term securities to longer-term ones to seek better returns. This increased demand for longer-term Treasuries can push up their prices and lower their yields.
c. Yield Curve Shape: Changes in the FFR can influence the shape of the yield curve. When the Fed raises the FFR, it tends to flatten the yield curve (i.e., the difference between short-term and long-term yields narrows). Conversely, when the Fed lowers rates, it may steepen the yield curve. These changes in the yield curve shape can affect investor behavior and investment strategies.
It's important to note that the relationship between the FFR and Treasury yields is not fixed or one-to-one. Other factors, such as economic data, inflation expectations, geopolitical events, and global interest rates, also play a role in determining Treasury yields. Additionally, the impact of FFR changes on Treasury yields may vary depending on the overall economic and market conditions at the time.
As the Fed tightens monetary policy by hiking rates to fight inflation the economy weakens across many metrics. Demand goes down, consumer spending goes down, the cost to finance a house or car goes up. Essentially it just becomes harder and more expensive to run a business and times get tighter for individuals. Unemployment usually rises, which is the accelerant in all recessions/market crashes.
Stocks (equities) therefore see instability and weakness as we usually see decreases in company revenues as consumer demand drops.
Then when inflation finally drops and the economy is already in a weakened state, the Fed has to start loosening (cutting rates) to re-inflate the economy and avoid a complete meltdown.
Except when it comes to equities, the act of pausing rate hikes, then eventually cutting rates is the final kill shot to equities.
Remember, while the Fed has been cutting rates, yields have been rising and bond prices dropping. When the Fed finally decides to cut rates they are essentially making high yielding bonds more scarce, as bond yields largely follow the fed funds rate:
For example, if the Fed starts cutting the Fed Funds rate from 5.5%, they are essentially saying, you’ll no longer get 5.5% yields on bonds, causing many to buy bonds to lock in the high rates.
EXCEPT the bond market is a free market and like any free market, it is based on supply and demand. This relationship of bond yields largely following the Fed Funds rate back down only works if there is enough demand for bonds to push prices up and yields down.
Right now, the US government is, as usual, spending recklessly in addition to financing two wars (Russia/Ukraine & Israel/Gaza). The financing of these wars entails increasing the rate of US Treasury issuance, or in other words, flooding the market with US Treasury supply.
Supply and demand… If supply goes up, price goes down. This could mean that high yields may be sticky, and the typical rotation we see back into treasuries could be underwhelming. EXCEPT, the US government is anticipating this lack in demand and has announced that the US government itself will be buying back treasuries.
The Treasury department on Wednesday said it would repurchase US government debt next year for the first time in decades, in an effort to boost liquidity in the $23tn government bond market. The programme would allow the Treasury to buy back older bonds, which are typically harder to trade, from primary dealers — banks that act as market makers for the Federal Reserve — and help improve functioning in some corners of the market. The buybacks are expected to help with cash management, allowing the department to issue more consistent levels of shorter-dated debt. This would be the Treasury’s first buyback programme since the early 2000s, and comes after liquidity — the ability to easily buy and sell an asset at prevailing market prices — deteriorated late last year to its worst levels since March 2020.
— Financial Times
This buyback program is effectively a bank bailout at the expense of US taxpayers.
Who owns most of these bonds that are now worth significantly less than they were 2 years ago? Banks do. This has been one of the primary reasons for several banks collapsing in the past year.
Current losses on US Treasuries are at a staggering $1.6T.
No, you are not alone. It is indeed mind-boggling. To sum it up:
The Fed is raising rates to fight inflation and it is killing treasury values. Instead of cutting back on treasury supply to help bonds recover what does the US gov do? The opposite. The US gov spends more, issues more debt, finances proxy wars, flooding the market with treasuries, only to print more money to buy them back (which is inflationary).
Sound like a death spiral? That’s because it is.
The market seems to be catching onto this and is already potentially front-running the traditional risk-off rate-cut trade of longing long-term treasuries with Gold, another high performing risk-off asset.
Gold is the other risk-off asset that periodically sees positive price performance in the wake of the Fed cutting rates and equities falling.
Now that we understand the underlying dynamics between rates, treasuries, equities, and gold, it becomes somewhat clear that the conditions are present for a large crash in equities, a rally in gold, and a potential rally in treasuries. Of course, markets are constantly changing and there is no guarantee a crash ever comes - but the entire point is to recognize that the risk of a crash is significantly higher than usual due to the present market conditions.
Now let’s examine a variety of other data points and metrics that also indicate a potential market crash.
Unemployment is a risk asset crash accelerant. Stock indexes like the S&P 500, Nasdaq, QQQ, and Dow Jones all benefit from the “infinite bid”. The infinite bid is derived from the portion of the paychecks of the working class that gets largely allocated directly to equity indexes via investment advisors and pension funds without them ever seeing or touching it.
So long as people have paychecks, there is a constant flow of capital (demand) propping up these indexes.
When unemployment rises, this flow of capital is disrupted, which usually results in a market pullback.
Note the strong correlation between accelerating unemployment and stock market crashes:
While unemployment numbers are currently low, any sudden rises from here should be taken seriously. The next unemployment rate numbers are released on November 1st and in the past 2 weeks there have been many headlines of major companies laying of workers.
While tech been layoffs have been declining through the year, October is seeing an uptick with major layoffs at LinkedIn and Qualcomm.
Permanent job losses are currently rising, which is a major cause for concern:
Pay very close attention to the labor market, as an increase in unemployment could be what pushes equity markets over the ledge.
War & Oil
We already briefly discussed the strain war is putting on the US treasury market via increased debt issuance (flooding the market with treasuries).
The locations of the two wars the US is currently financing put strain on the oil market.
Russia produces 10% of the world’s oil. Ukraine also produces a decent amount of oil compared to many other countries.
The Israel/Gaza conflict is bordered by some of the largest oil producing countries in the world including Saudi Arabia, Iraq, Iran, Kuwait, Qatar, Egypt and Syria.
Continued turmoil in these areas coupled with US involvement could strain oil markets.
Oil prices are a leading indicator of inflation, which is the whole reason the Fed has been increasing interest rates.
Rising crude oil prices lead to higher prices in most goods and services. It also puts strain on businesses and individuals who heavily rely on oil for transportation.
Crude oil prices spiked to $130/barrel last year and the Biden administration drained the US Strategic Petroleum Reserve to combat high oil prices, leaving it at record lows while oil prices remain elevated around the $85 - $95 per barrel range:
The need to refill this reserve may lead to further oil demand and higher prices.
On the other hand, US oil production is finally starting to ramp back up, which may have the opposite effect:
Additional conflicts may break out which could further strain US markets and resources, the most likely of which is China invading Taiwan with China being yet another large oil producer and Taiwan being a major chip producer.
Consumer Debt & Delinquencies
Recessions are often marked by rises in consumer debt and delinquencies. As people lose their jobs and prices get more expensive (inflation rises) it becomes harder and harder to support one’s lifestyle.
The concerning part about many of the following charts is that we are seeing a large spike in delinquent debt despite low unemployment rates.
We’re seeing a fairly concerning uptick in credit card debt that is delinquent:
We’re also seeing a rise in delinquencies in auto loans:
And lastly, a small increase in delinquencies in the housing market.
The car market is already showing signs of weakness. As mentioned above, delinquencies are increasing.
The used car market is already starting to roll over:
An additional strain on the auto industry is the 34,000 union members working at Ford, General Motors (GM.N) and Chrysler parent Stellantis (STLAM.MI) who are out on strike. Ford has furloughed 2,480 other workers, citing impacts of the strike.
This places strain on both the workers at the consumer level as well as car manufacturers.
The luxury watch market has already seen a massive pullback, showing people are already cutting back on unnecessary expenditures.
The crypto market has a few catalysts both to the upside and downside:
Upside catalysts include a spot BTC ETF approval and the 2024 BTC halving.
A spot BTC ETF approval would be bullish as it would likely lead to large capital inflows from the traditional finance world. One potential headwind accompanying a spot ETF approval is int he case of the Grayscale GBTC Trust conversion. If it gets approval to convert to an ETF, there is over 643,572 BTC that becomes liquid and available to sell.
The Bitcoin halving is bullish because it reduces supply side flows of BTC, reducing sell pressure from miners. It should be noted that the effects of the halving are diminished each cycle, as the supply reduction is diminished by 50%.
BTC block rewards moving from 25 BTC per block to 12.5 BTC per block is a reduction of 12.5 BTC, which is much more significant than the 12.5 → 6.25 BTC reduction, which is more significant than the coming 6.25 → 3.125 BTC reduction in 2024.
Downside catalysts include the potential crash in equities outlined above, Bitcoin miners being pressed for revenue, potential for the US gov BTC overhead, Mt Gox overhead, and FTX overhead.
A crash in equities would only negatively affect the speculative crypto markets, though in all reality a crash in equities would very likely be preceded by a crash in crypto.
Bitcoin miners are currently approaching a 50% reduction in revenue due to the 2024 Bitcoin halving
Expect Bitcoin miner capitulation (BTC selling) from many miners in the months directly following the halving. In order for miners to maintain their current level of revenue, BTC will have to double in price from where it’s at currently. If a traditional financial crash is occurring simultaneously in the background, this will be a tall order.
Other overhead for Bitcoin supply includes the Mt Gox distribution which is expected occur sporadically over the next year as well as the US government which has expressed its intent to sell some its BTC, of which it currently holds and estimated 194,188.
According to documents filed on March 31st, 2023 the US government intends to sell roughly 41,000 BTC by the end of the year.