Five factors pointing towards US recession

Money Supply

M1 is falling almost as fast as it during the Great Depression

The Yield Curve

The last time the yield curve (the gap between the 10-year bond yield and the "cash rate"/Fed Funds rate) was this negative was before the deep 1974 recession and the deep and long 1980-1983 recession.

The Fed Funds rate

The Fed Funds rate has risen as much as it did during the '74 and '80-'83 recessions.

Credit tightening

Banks' willingness to lend is collapsing, and banks are tightening credit standards.  This is not yet at levels seen in the GFC, but the data are quarterly, so we don't know what's happened in the most recent three months.

Commodity Prices

I wrote the piece I linked to above a year ago.  

The lag between a sharp rise in commodity prices and the subsequent economic downturn is quite long --- 24 months, though it has been as short as 12 months.  

All 5 Factors

If we combine all these indicators into one index, we get the chart below.  As an "average" of five indicators, it isn't as severe as some of its components.  On the other hand, it has not yet bottomed.

What seems clear enough is that there is likely to be a US recession.  How long and how deep it gets depends on whether there is a banking crisis, whether the Fed raises rates further, and whether the post-Covid rebound in services continues.  I'll keep you posted.

Note that where the 5 factor index appears to coincide with recessions, 
that's because it has been plotted with a 12-month lag.

US real M1 falling fastest in 100 years

 US real M1, i.e., M1 deflated by the CPI, is falling faster than at any time in the last 100 years.   The post WW2 decline in the inflation-adjusted time series was because war-time price controls were lifted and published inflation jumped to 20%, before falling back.  In fact, it went negative---businesses had in fact raised prices too enthusiastically, which I suspect is happening again.

The Fed instituted a policy of "quantitative easing" during the Covid crash, which caused a big jump in money supply.  Since it became concerned about inflation, it has reversed this policy, and this has reduced money supply.  There was also a change in definition of money supply, but I have adjusted my data to reflect this.

If you argue that quantitative easing expanded the economy, leading to low unemployment, high growth and surging inflation, you must accept that "quantitative tightening" will lead to the reverse outcomes. There is no sign that real M1 has started to rise.  If anything, its absolute decline is accelerating.

I think this is a major blunder on the part of the Fed, and will lead to a sharp decline in economic activity.  The lags are long, but we should be starting to feel the effects of this singular plunge in real money supply from now on.

A debt crunch is looming

 From Bloomberg

Just when it seemed the US regional banking strains were starting to ease, First Republic Bank has leaped back into headlines, reigniting concerns of rising pain in the lending system.

Banks increased emergency borrowing from the Federal Reserve for the second week in a row in a sign of the ongoing stress in the system. Last week, the New York Fed reported that financial conditions in its region had deteriorated sharply.

The trouble is rekindling concern that a credit crunch is underway. And it further complicates the plan for next week’s Fed policy meeting, where officials have to figure out how to balance the risks of tighter borrowing conditions against stubbornly high inflation.

Below are six charts that help explain why and how borrowing is getting harder in vast parts of the economy:

Lending Contraction

“Lending from U.S. banks is poised to contract over the next few quarters,” Amanda Lynam, head of macro credit research at BlackRock Financial Management wrote in a note on Thursday. Headwinds to profitability including higher deposit costs have seen bank spreads underperform relative to non-financials, she wrote.

Money Supply

The blow to credit availability comes as the money supply shrinks, a sign that the spike in interest rates by the Fed is causing money to exit the banking system, shrinking the availability of loans. That could slow the economy, with monetarist economists suggesting it could herald a crash and deflation.The Dallas Fed and the San Francisco Fed last week reported pressure on funding in their geographic regions, with projects being canceled and nonperforming loans expected to increase.

[See my piece about money supply, here]

Consumer Headwinds

Banks that posted quarterly results this month said they boosted provisions on bad consumer loans to levels not seen since the early days of the pandemic. For example, Capital One Financial Corp. increased its provision for credit card losses by more than 300% to $2.26 billion compared with a year earlier. The firms have generally said the rising provisions are just consumers returning to pre-pandemic norms.

Office Woes

Capital One also set aside more money to cover souring office loans, as vacancies rise and many workers choose to work from home. Morgan Stanley has previously estimated that office property valuations could fall as much as 40% from peak to trough, increasing the risk of defaults.

Another emerging source of stress in credit is the leveraged loan market as corporate borrowers with floating-rate debt struggle to keep pace with higher borrowing costs.

Higher Defaults

The amount of loans trading at distressed prices, defined as below 80% of face value, has jumped 26% to about $127 billion since the end of February, according to data compiled by Bloomberg. That compares with a 10% increase for bonds to about $488 billion.

“We believe the loan market, which has historically had a lower default rate than the high yield bond market, will record a higher rate during this cycle,” Armen Panossian and Danielle Poli, managing directors at Oaktree Capital Management LP, wrote in a memo last week. “This is due to the covenant-lite nature of most loans and the rising prevalence of loan-only capital structures.”

Credit Chatter

Company executives worldwide, meanwhile, are talking about credit on conference calls at the highest rate since the pandemic hit, according to data compiled by Bloomberg News. Some mentions include Evercore Inc.’s Chief Executive Officer John Weinberg noting an increase in restructuring and liability management business and Peabody Energy Corp. investor relations vice president Karla Kimrey saying the company has positioned itself to avoid uncertain credit markets.

Just how deep will the US recession be?

Readers of this blog will know that I have worried about this issue for many months now.  

Here are two more charts which strongly suggest that a deep recession is possible.   They show data back to 1970.

The first chart shows the 12-month change (absolute, not percentage) in the Fed Funds rate.   The Fed Funds rate is the rate the Federal Reserve Bank charges for overnight borrowings by banks from the Federal Reserve system.  It is the bellwether which sets the level of interest rates in the market.   In the chart, I have plotted it upside down, because when interest rates rise, the economy slows, and when they fall, the economy accelerates.  I have also moved it forward, that is, I have plotted it with an 18-month lag, because it takes a long time for the change in rates to take effect.  

The QCI is a monthly coinciding index (i.e., it coincides with the business cycle), which closely tracks real GDP.

Notice how close the relationship between the change in rates and economic activity is, except for the GFC (2008/2009), where the downturn was materially worsened by the half-witted orgy of ill-advised mortgage lending by the banks in the years prior to the Fed raising rates.  The inevitable hangover took down the banking system and everything else with it.

The other apparent break in the relationship was caused by the Covid Crash of early 2020.  This also caused the spike in the QCI in early 2021 via the year-on-year calculation.

The rise in rates (shown in the chart as a fall, because, remember, it's inverted) is consistent with the deep recessions of 1973-1975 and 1980-1982.  The only good news is that this indicator (the inverted change in Fed Funds) is bottoming---provided the Fed doesn't raise the Fed Funds rate from now on.

Click on chart to see clearer image

The second chart shows the rate of change in real (i.e., after allowing for inflation) money supply.  The data for both M1 and M2 appear to have been distorted in early 2020 by a definitional/regulatory change by the Fed affecting the classification of chequing and savings accounts.   It's partly this change which may have caused the spike in the year-on-year rate in 2020/21.  But the spike was prolly also caused by the Fed flooding the system with liquidity.  However, this distortion is now passed.

Real money supply is falling faster than it has done at any time in the last 63 years (1960-1970 not shown in the chart).   It's falling faster than it did before the 1973–1975 and 1980–1982 recessions, and they were, before the GFC, the deepest recessions the USA has experienced since the Great Depression.  The implication is that the US is likely to experience a recession as deep as those two.  In other words, not a "soft landing".    See this interesting analysis from Reuters.

Click on chart to see clearer image.
Note: money supply charts not plotted with a lag.

So I remain sure that the US will experience a recession this year, with a peak-to-trough fall in real GDP of 3-5%, and a rise in the unemployment rate of 5-6%.

What could prevent these outcomes?   Well, Covid has distorted many indicators, and many economic relationships.  So time-honoured linkages and drivers may no longer work.  I think that, though possible, this is very doubtful.  

Of the Big 8, the US, Europe, the UK, Brazil and Russia are themselves likely to go into recession or are already in one this year.  China is rebounding, and India is still growing strongly.  On balance, the rest of the world won't save the US.  In the past, it usually went the other way---US recessions transmitted themselves to the rest of the world.   (The China rebound will likely reduce the depth of Australia's recession, though our Reserve Bank has also raised rates by too much.) 

During the 1973-1975 recession, the S&P500 fell by 44% peak to trough.  During the 1980-1982 recession, it rose at first before falling by 20%.   During the GFC, it fell by 57%.  However, the banks are much better capitalised now than they were when the GFC began, and the kind of financial crisis we experienced then is less likely (but by no means impossible) today.  So far this cycle, the S&P500 is down just 14%.  The risks, surely, are on the downside.