Major Economic Upheaval Ahead

Major Economic Upheaval Ahead. By Shanmuganathan Nagasundaram, Chief Investment Officer at Plus43 Capital.

The 75 basis hike by the US Federal Reserve on June 15th was quite extraordinary for a number of reasons:

  • The 2022 Q1 US GDP was negative at -1.4% …
  • The US Stock markets [are] in a bear market (defined as a correction > 20%) …
  • The US Bond markets had possibly the worst 6 month period in the last 40 years.
  • The Cryptos which had a total M.Cap of more than $3T have lost more than 2/3rd of its market capitalization in the last 6 months.
  • The current US housing bubble, which is much larger than the 2008 bubble (median house prices relative to median income is nearly 33% higher than that of 2008), has started correcting with six consecutive monthly declines for the Housing Market Index.
  • The US Consumer Confidence sank to a low of 50.2 – a level not seen since 1980 when the US Fed Funds rate was at 20%.

Under any one of the above conditions, the Fed would have normally dropped rates. … For sure, this hike of 75bps is going to worsen the market conditions in equities, bonds and real estate. If ever there was a lingering hope of the US Economy escaping a recession, this hike effectively vanquishes that.

Extraordinary to raise interest rates under these conditions — which tells you a major change is upon us. Inflation of the CPI has arrived, as long foreseen.

Is the 75 bps raise the right move by the Fed? Directionally Yes. In terms of the quantum, this 75bps increase is pretty much the equivalent of applying a band-aid for a bullet wound. Even much higher increases – 200 or for that matter even 500 bps would leave real interest rates deeply in the negative territory. There is virtually zero probability that this 75bps hike would even moderately reduce the inflation numbers though this hike is big enough to guarantee the onset of the Minsky moment i.e. setting off an Inflationary Depression. …

Of course, the media as well as the public at large believe that inflation will moderate over the next few years. How a 10%+ consumer price inflation will decrease with a 1.5% or even a 5% interest rate is beyond any economic logic. … The 10-year treasury which is at 3.2% today (was around 0.6% in June 2020 and 1.4% in June 2021) is still absurdly low and my guess is we will cross 6% in about a year’s time. …

QE and QT (quantitative easing and tightening — increasing and reducing the rate at which new money is created):

Was QE the correct response to the 2008 Great Recession? I would have to point out at this juncture that not only has the results have been pronounced on the above with a near unanimous thumbs-up, but Bernanke & Co have taken the victory lap as well. A bit premature, as the world now is beginning to recognize.

It is but imperative to point out that the success of QE is contingent upon the successful execution of QT. The massive expansion of the Balance Sheet from less than $1T before 2008 to nearly $9T today is hardly the sign of a stabilizing economy despite other macro-indicators such as GDP growth, stock market returns etc. IF AND ONLY IF the balance sheet can be rolled back meaningfully without cratering the economy can QE be defined a success.

This creation of artificial money and credit has the same impact as that of a drug overdose on individuals i.e. a temporary high with an apparent sense of stability. It is only when the drug is stopped, do the withdrawal symptoms surface and that is exactly the scenario with QE as well.

The US Fed has previously twice attempted QT and on both occasions, had to roll-back in short order due to adverse market reactions. Given the set of extremely negative indicators we are starting with today (as specified in the introduction), the chances of QT being done for any meaningful period of time is indeed remote.

Infinity here we come, because politicians always choose inflation over depression:

The best case for QT would be about a 0.5T reduction in the Fed Balance Sheet to about $8.5T before QT is replaced with QE to infinity. …

In all probability, the Q2 GDP will be negative and this in combination with the bursting of the housing bubble will put the US Fed and the US Government in a difficult spot. Do they fight the pervasive inflation with rate hikes and QT OR do they support the faltering economy with rate cuts and QE?

My guess, and this would sound really absurd today, is that they would do a combination of rate hikes and QE. The explanation would be that the rate hikes would temper the inflation and QE would support the economy. Not unexpectedly, the actual result would be the opposite — QE would accelerate the inflation to double-digits and the rate hikes would deepen the recession into a depression.

Running out of rope.