Pressures Appearing in the US Economy

The Federal Reserve Bank’s index of financial conditions continues to soften, with the latest data showing the easiest conditions since November of 2021. 

Remember, it was in November of 2021 when Jerome Powell finally admitted that the inflation in the United States was not transitory after all.  Inflation at the time was over 6%, and prices were climbing in nearly every part of the economy. This was hardly one of Powell’s shining moments.   Given the looseness of current financial conditions and given the Fed’s obsessive focus on finding excuses to cut rates as soon as possible, one can easily conclude that there must be some be very ugly risks beneath the surface that aren’t showing up yet in the official economic data.

With the US government running massive fiscal deficits, it is easy to see why lower interest rates are in the long-term best interest of the economy.  Higher funding costs would progressively worsen the US debt situation and subsequently lead to a crowding out effect of private sector economic growth as the government struggles to attract sufficient investment flows to cover its huge funding requirements. This in turn would have an adverse effect on private investment, and ultimately lead to a sharp economic slowdown. 

We are already seeing some waning interest from investors to buy government debt, and higher interest rates would worsen that problem as the US is burdened with an ever-growing debt service issue. In fact, even holding rates at current levels for a sustained period could lead to some serious troubles. The challenge is that inflation is still running too hot in the US economy.  Given the unprecedented fiscal and monetary stimulus which the authorities piled into our economy, the residual inflationary pressures are hardly a surprise.

A number of sectors in the economy are already under pressure. Commercial real estate, for example, is really suffering, and those problems will only get worse over the next several years.  Record vacancy levels and tremendous refinancing needs will exacerbate a growing problem. There is also increasing weakness in the residential real estate market as higher mortgage rates are choking demand, leaving many sellers stuck with properties they can’t move.  Other areas in the  economy are also starting to show some strains.  Restaurants and retail sectors are two of the obvious ones, with waning demand.  Due to the fact that many parts of our economy are so highly connected and intertwined, when we finally get a downturn in the US economy, it will manifest quickly and be widespread.  

The reaction of the Fed to a sharp drop in economic output will be immediate, regardless of the levels of inflation at the time.  Aside from the inherent bias of the Fed to try to lessen the funding costs of the heavily indebted public and private sectors, the Fed has a significant fear about possible systemic risks in the banking sector.  As we have discussed previously, the banks are carrying staggeringly large amounts of unrealized losses in the form of “held-to-maturity” debt that is way underwater.  (The Fed is also carrying a large book of underwater securities, but that is a different topic for a different day.)  A sharp economic downturn could create a type of snowball effect, with bank lending getting choked off due to a softer economy, so lower rates would at least soften the blow on a marked-to-market basis.

The banking sector is a critical component in this scenario, as ultimately banks’ leveraged lending is the key to the creation of money in the economy.  If the banks are forced to pull back, then the wealth illusion in the US economy will start to erode quickly.  Remember, in a highly leveraged system, asset prices typically climb as the dollar’s buying power decreases.  This is the long-term effect of inflation playing out over time.  As long as rates stay low, and inflation stays moderate, this illusion can persist.  It is the government’s way of kicking the can down the road, delaying the truth of the economy for as long as possible, and staying in power. The value of assets such as homes, stocks, land, and other investments will grow steadily in nominal value as they weaken over time in real value.  

Higher interest rates will shatter this illusion, however, and suddenly the naked truth of the economy is revealed.  Economic growth can come to a standstill, and all the serious weaknesses in the system become quickly exposed.  With lower interest rates and modest inflation, wealthy investors enjoy the higher prices of homes, land, and other real assets.  The sad reality, however, is that these things become less and less affordable for most people.

Politicians rely heavily on this illusion.  They like to point to a rising stock market and higher home values as signs of their great prowess in facilitating economic success. For obvious reasons, they don’t like to point out the massive levels of government debt or the dramatically higher costs of college, health care, childcare, and food, as they steadfastly avoid reminding people of their troubles in order to try to stay in power.  

The Fed is well aware of this dynamic, and they play a key role in this scenario.  Therefore, with a heavily leveraged economy, the central banks will always err on the side of being too loose and too easy with monetary policy.  With lower rates, government borrowing, commercial mortgages, residential mortgages, funding for working capital, personal debt, and pretty much everything else seems more affordable.  As long as the rate of inflation isn’t shockingly high, the central bankers will make up some stupid story to try to mask the truth.

The current economy is almost a perfect case in point, as surveys show that more than half the country thinks we are in a recession.  In fact, more than half the country is in a recession.  Our economy is bifurcated right now, with the rich people flourishing due to higher rates – which yield higher cash flows on liquid savings – and a higher stock market – which gives them still further buying power and wealth.  It is the rest of the people who are choking on the higher costs, working multiple jobs to try to pay the bills.

Going forward, I expect the economic data to start to soften.  Unfortunately, I don’t expect the inflationary data to ease as quickly unless we get a very sharp economic downturn.  Therefore, there is a growing risk of stagflation rearing its very ugly head, as we can be very sure that the Fed will react to soft economic data aggressively, cutting rates despite otherwise easy financial conditions, while hoping that the softer economic data will lead to a drop in inflationary pressures.  The lower rates, however, could backfire on the Fed, leading to a resurgence in inflation without a strong, corresponding pickup in economic growth. 

This scenario is not unlike our experience in the 1970s. It would be very painful, and the Fed’s tools to address this mess are quite limited without triggering massive, widespread pain.  Is this my actual forecast?  I would say it is a growing risk, and I assign an increasing probability to it, but it is not quite my forecast right now.  I am leaning this way, but I am not fully committed to it yet.  The most likely scenario is that we continue to muddle along for a while, kicking the can down the road for a while longer, maintaining the illusion of wealth and success even as real economic growth continues to soften and sputter along.  

I believe that in either scenario, precious metals will continue to outperform as stores of value.  In the scenario in which we muddle along, stocks will continue to perform well until they finally start a long overdue vicious correction.  The boom in AI stocks has delayed the sharp sell-off for a while, but at some point, we need to shake out a lot of weak long positions.  

My downside target for this correction is quite aggressive, and for sure the authorities will try to delay this for as long as possible.  When it finally comes, and it will come, we need to gird ourselves for a move of surprising proportions.  How big?  Don’t be surprised if we get a sell-off of 30% to 40% from somewhat higher levels.  What could trigger the move?  A whole host of things could act as a trigger.  The key point is that nearly all of us will miss the move, or otherwise get hurt by it, but after the move is done, we will all marvel at how obvious it was.  In fact, in my favorite scenario, the move down will start after we get some good news.   A truly exhausted market will try to rally on good news, but the market strength won’t sustain itself, and sellers will start to enter the market.  The move down will start slowly, and many speculators will try buying dips since that strategy has worked for years.  The selling pressure, however, will be persistent, and finally it will overwhelm the short-term speculators who are trying to go long on weakness.  

In the currencies, the dollar is showing some real signs of weakness.  Dollar yen finally ran into selling around 157.50, and I have finally put on some more aggressive short-term plays to capture yen strength. For the most part, my focus on the yen is longer term, as the move I am anticipating there is very large, but it will take a while to play out.  I would expect some general dollar weakness, but the yen and Swiss franc should outperform. In my preferred scenario, the dollar will sell off generally as US rates finally start to head lower.  The only major currency that won’t have lower interest rates will be the Japanese yen, and this will add further fuel to the yen’s strengthening. Eventually, I see the dollar breaking down below 140.00 and re-testing the 127.50 level.  This will take quite a long time, but it should be powerful and persistent.  Playing for a move like this will require a lot of patience, and it is best to use option strategies to capture it.  

One of the strongest anecdotal reasons I like this trade so much is the fact that so many people believe that further yen weakness is a one-way, easy bet.  The trade is extremely crowded, and the Japanese authorities have in fact been very effective over long periods of time when they intervene in the market.  I am not sure why speculators feel that Japanese intervention is so ineffective.  When they intervened against the dollar in 2022, the dollar proceeded to drop almost 25 yen.  I could reference many similar efforts over the years, but the point is that there are different types of intervention.  Sometimes the authorities simply want to smooth out market conditions that are becoming hyper-volatile.  Other times they really want to reverse a move that is creating adverse effects on the economy.  The current situation is more of the latter.  Japanese investors have been reinvesting their overseas profits outside of Japan, and Japanese authorities want to reverse that trend.  If Japan is going to finally end its 34 years of dismal economic struggles, it will require massive domestic investment, and that means that a lot of off-shore holdings need to be brought back home.  Betting against Japan Inc. is not a great strategy over time. Japan Inc. is well capitalized, patient, clever, and highly disciplined.  

As we approach the elections here, it is reasonable to expect an increase in overall market volatility.  The Fed will be a bit stuck politically as it will want to look independent and unaffected by political pressures, but it is likely that by November the Fed will be feeling the need to cut rates.  This conundrum only occurs once every four years, and it will be very interesting to see how Powell and his colleagues handle the situation.

In general, we should anticipate a long cycle of highly increased levels of market volatility over the coming years.  It should be a fantastic trading environment, but not one for the faint of heart.  

In the meanwhile, wishing you all the best of luck.

Andy Krieger