I have been saying repeatedly over the last several years that the Federal Reserve would very quickly return to a loose monetary policy at the slightest sign of recession.
When this long – and largely artificial – boom comes to an end, we will initially see interest rates go down. We will likely see price deflation. At the very least, we will see significant asset deflation.
The asset deflation will happen hardest in stocks this time around. That is where the unsustainable boom has been the most. I think real estate will also go down in many areas, but I don’t expect prices to fall as much as they did in the last decade.
Commodities, in general, are likely to go down, just as they do in most recessions. Gold is a little more unpredictable, but there may be a temporary downturn as the dollar temporarily strengthens. This may be short-lived because the Fed will adopt a loose monetary policy.
I fully expect another round of so-called quantitative easing (QE). This will be QE4. QE3 ended in late 2014. The Fed is currently in a deflationary mode, but that is going to end very soon. The Fed never exactly got around to reducing its balance sheet to anywhere near what it was in 2008.
You don’t hear Fed officials speak a whole lot about the yield curve, but I am certain that they watch it closely. James Bullard, who is considered a dove (meaning he tends to favor a looser monetary policy), has mentioned the yield curve. Last year, he said that the Fed should not challenge the yield curve, meaning that he thought the Fed should stop hiking its target interest rate.
The yield curve inversion has gotten worse. The 20-year yield actually briefly dropped below the 3-month yield. The 30-year yield is still above the 3-month, but not by a whole lot. The 10-year yield is currently well below the 3-month yield.
The bond market is smarter than the stock market. Of course, markets aren’t people. They aren’t really smart or stupid. But the people who invest in the bond market tend to be more correct than the people who invest in the stock market. This is a generalization, but it has continually proven true, at least in the short run.
Now, I do think buying a 30-year bond at a 2.5% interest rate is crazy, unless you plan to sell it well before maturity. I am not confident that inflation will be low 20 to 30 years from now, let alone 10 years.
In the short run, the bond market is smart. The inverted yield curve is the closest thing we can get to an accurate recession indicator. It is really just a matter of how much time it will take to shake out. It is typical for a recession to start about a year after the yield curve inverts.
It Didn’t Take Much
With the further inversion of the yield curve, and with a few hard days for stocks, the Fed indicated that it is willing to accommodate as necessary. Stock investors loved this indication by the Fed, even though everyone should have known it anyway. Now, people are expecting an actual cut in the Fed’s target interest rate. Because of this, stocks boomed on the announcement that really wasn’t that much of an announcement.
This is the Fed’s put. Investors expect the Fed to step in any time things get rough. And they’re probably right.
The only problem is (from their perspective), the Fed can’t control everything. Just because the Fed announces an interest rate cut, or even a new round of monetary inflation, it doesn’t mean it can save the stock market. The Fed could go crazy and announce, let’s say, $250 billion per month in new money, but this would only make things worse in the long run. It may or may not prolong the boom, but it would certainly prolong the agony. If the Fed got aggressive enough, it would eventually risk destroying the dollar as the world’s reserve currency.
I don’t expect the Fed to start QE4 until we are actually in a recession. For now, I think they will just lower the target range for the federal funds rate.
It is important to know that the Fed started lowering its target rate prior to the fall of 2008. It actually started prior to the official start of the recession in December 2007. It obviously didn’t matter. It couldn’t stop the bust, and it won’t be able to stop it this time either.
If anything, the Fed’s actions to loosen monetary policy should concern investors. We are told the economy is booming and that unemployment is historically low. Yet, the Fed is talking about lowering rates that are already low by historical standards. Yes, the Fed is definitely watching the yield curve. But whatever they do, it will be too little and too late to stop the bust.
The Fed is already blaming the tariffs imposed by Trump. I think the tariffs are bad, but they will not be the cause of the bust.
The only way to stop the bust would have been to never start the unsustainable boom in the first place. There shouldn’t have been QE1, QE2, and QE3. Growth would have seemed slower up to this point, but the growth would have been real and sustainable.
Instead, we are facing a recession ahead. My bet is on 2020 at this point. I want to take a few short positions (betting on stocks going lower), but I am not quite ready yet. I think it is a little early. We may see one final run up in stocks before the full bear market hits.
The biggest threat to the average American is unemployment. If you can keep your income during the recession, you may actually benefit. Things should get cheaper, at least for a little while.
I do think stocks are going to get hit the hardest. The boom in stocks is really irrational. The revenues and profits are not there now to back up the prices, and they certainly won’t be there once the next recession becomes evident. I think we could easily see stocks go down 50%, but it wouldn’t surprise me if it is much worse than that.
Some people’s dreams will be shattered. I think you should mostly be out of stocks now, but I especially can’t understand people who are supposedly close to retirement who are heavy in stocks.
There will be some pain ahead. It will also be a time of opportunity for those with some cash on the sidelines.