A Long Shadow Creeps Over the Economy this Summer

July 15, 2019

9 min read

It’s time to turn around and see the darkness that the Fed sees looming over you. Earnings season is already extending signs of recession with the first corporate reports coming in far darker than expectations that were already twilight dim in FactSet’s estimations, which pegged earnings as likely to show a 2% contraction.

Even the Fed sees problems ahead. Jerome Powell’s speech to congress has been called “one of the most dovish Fed speeches ever!” While that quickened the heart of a sugar-hungry stock market, what does it really tell you about how soon or likely the Fed sees recession looming for the economy or sees trouble for the stock market? Why else would Father Fed suddenly become the “most dovish … ever?” Does the Fed become its “most dovish … ever” when the economy and the stock market are doing great?

Father Fed tried to explain the sudden change this way:

We’re learning that interest rates — that the neutral interest rate — is lower than we had thought and I think we’re learning that the natural rate of unemployment is lower than we thought,” [Powell] said. “So monetary policy hasn’t been as accommodative as we had thought.


Hmm, they’ve been doing this for a hundred years, and they’re just now figuring out where the neutral position is for the one control they use the most? And everyone reporting on Powell’s testimonies accepts that explanation without question???

One thing I’ve said for years on this blog is that, when the Fed finally arrived at the time when it tried to normalize monetary policy, it would discover it has created an economy and markets that have become utterly dependent on its continued largess and highly reactive against any tightening. The Fed is, in its own words, just now realizing that. It has created total dependency, and that’s what has pushed the “neutral rate” lower than the Fed has ever thought it would go.

Summer recession is overshadowing everything now

If you turn around to look at what the Fed is looking at, you’ll understand why the Fed suddenly flew like a frightened dove away from its own tightening agenda. The Fed’s cause of concern shows up in the lengthy shadows being cast ahead by big corporations as they manifest themselves before the public at the start of the reporting season. The following notes are the kinds of things Powell warned the nation about in hushed tones when he spoke about the troubles he is hearing from the Fed’s many corporate contacts. Now we can hear what the Fed has been hearing:

Yesterday BASF, the largest chemical company in the world, announced its earnings would fall well short of analyst estimates in the second quarter. Earnings season in the US begins imminently.

Zero Hedge

Bear in mind as you read this stuff, that analysts estimates were already horrible:

Fastenal’s Dismal Earnings Spell Pain For Q2 Earnings Season. One of the biggest walls of worry facing the market, now that both the US-China “ceasefire” and the Fed’s imminent rate cut are in the rearview mirror, is just how bad the coming earnings season will be. As a reminder, last week we showed using Factset data, that the number of companies issuing negative guidance had risen to the second highest on record…. Today’s dismal report by Fastenal suggest that the wall of worry can’t be high enough as the upcoming earnings season may be far worse than even the more pessimistic predictions.Fastenal, one of the first industrial companies to report earnings and as Barron’s puts it, a “valuable source of insights about the health of US manufacturing” … earned 36 cents a share, less than half the 74 cent estimate.… Profits are coming down. Fast.… Fastenal’s results follow news of a poor quarterly performance from MSC Industrial Direct (MSM), another distributor of parts and other gear for manufacturing. MSC’s results missed Wall Street’s expectations and management issued a sales forecast for the current quarter that was below what analysts were predicting.”

Zero Hedge

Freight rates have dipped year-over-year for six months straight while loads on the spot market … fell by 50.3% in June year-over-year. Truckers have also continued to warn of a “bloodbath” as they slash their profit expectations and companies file for bankruptcy.

Zero Hedge

A fifty-percent drop in one year? That’s massive. In economic terms, these reports about the reports are starting to read like a Halloween script.

According to investors surveyed by Absolute Strategy Research, as reported by the Financial Times, investors are “buckling up” for the economic downturn they believe is imminent. ASR’s findings, which are based on a survey of more than 200 institutions controlling a combined $4 trillion of assets, suggest that the bond rally is not a blip.

Zero Hedge

I’ve been saying for a couple of months now that the stock market may go up until the Fed’s rate cut becomes fact at the end of the month and that the market will get a little bounce from the cut … but not much. It may go up because it WANTS to, but I’ve also said consistently that the road to new records is going to be an increasingly difficult path for investors to trudge up this month as corporate reports start coming in, revealing all the signs of recession I’ve said would be showing up by summer.

Once we get past whatever market bump the Fed’s first rate cut may give, the stock market is going to be all about the bad earnings that will have been coming in and about Trump’s multi-faceted tariff wars. If earnings come in as badly as things are starting to show, markets may fall apart even before the Fed can cut rates.

At present, earnings look even worse than I’ve been saying they will be, and I’ve been stating the worst likelihoods that I find reported as being my most-likely scenario because of the combined impacts of Fed tightening and trade wars and, much more troubling, our whole flawed economic foundation that sits beneath this top-heavy market. It’s too early, though, to know if these early reports will prove representative of the whole. Right now, they are just foreshadowing what may come.

China syndrome still melting through the economy

On the trade-war front, things look worse again … already. Trump just accused China of not honoring its G-20 agreement to buy more products, and some advisors in the Trump administration are saying the US may need to put new tariffs on China over its continued purchases of oil from Iran. (Trump has not weighed in on that yet, but it would certainly intensify the trade conflict if the US does that; so Trump has to decide which he will weigh the heaviest, his Iran sanctions or a trade settlement with China.) Meanwhile China is continuing to say officially that its “core issues must be resolved.” It continues to stress that must happen in an environment of mutual respect, free of intimidation attempts.

There’s more. According to the Washington Post (bearing in mind that The Post is a Trump antagonist owned by Amazon’s Jeff Bezos),

The Trump administration is increasingly concerned about prospects for a trade deal with China, amid an unexpected reshuffling of the Chinese negotiating team and a lack of progress on core issues since the Group of 20 summit in Japan, according to U.S. officials and senior Republicans briefed on the discussions.

The Washington Post

The reshuffling by China, according to The Post, appears to be an effort by Xi to put a tougher negotiation team together. As I keep saying, China is in the trade war for the long game with Xi having no concern about re-election in 2020. I’ve also been pointing out repeatedly that the stock market has been living inside its own pipe dream by refusing to price in the reality that this trade monster is not going away soon.

The market is rising on a sugar high that may continue through the actual announcement of rate cuts, but there is no protein in that diet to sustain market performance, and the rate cut is fully priced in; so, it will be a short-lived high whenever the market’s eyes clear enough to finally see the darker reality that has already gathered all around it.

Restrained between stocks and bonds

Moreover, if the treasury experiences more horrible auctions like yesterday’s (the worst in years), which spiked bond yields up, bonds will become a magnet again to pull money out of stocks. In Thursday’s 30-year auction, foreign investors like China, who now have less trade with the US, have less need for US bonds and so they bought a lot fewer bonds. They may be trying to up the amperage in their trade wars with the US, or they may being sliding into their own budget shortfalls so they have no surpluses to invest any longer. Whatever their reasons, the flight of direct buyers is its own looming monstrosity given the US government’s rapidly growing, titan of debt that it now has to refinance routinely without Fed help. (Lack of Fed help will be a short-lived situation, as the Fed will be forced to return to monetizing the debt.) For now the US treasure is being forced to offer higher yields while attracting fewer bidders.

This problem could become exponentially worse when the debt ceiling is lifted so the US treasury has to rush out and buy bonds to pay back all the IOUs it has been writing to the Social Security Fund and Medicare while the treasury has been disallowed from adding any more debt. The US hit its ceiling in March. (Current bond issues are just rolling over existing debt.) New debt issuance will suddenly spike into what appeared today, at least, to be a badly deteriorating market for US debt. To the extent that debt suddenly hits the scene in shorter-term treasuries, the sudden flood could make it difficult for the Fed to do what it says it is going to do in lowering short-term interest rates.

(I’m now rethinking my own move into bonds, which was based on certainty the Fed will be lowering rates this summer, in light of the fact that trade troubles (and perhaps trade retaliation) have just started creating notable problems in the US treasury market. I’m not sure yet if this is a one-off or signs of more troubles to come. I was going to hold until just before the government is ready to vote on the debt ceiling, anticipating a spike in yields when the government suddenly throws a lot of debt on the market. If you’re going to buy bonds and hold them to maturity, higher yields are good news; but if you buy into bond funds, which one is pretty well forced to do with 401K retirement funds, rising yields after you buy in means many of the bonds in those funds that were purchased at lower interest rates are less desirable, so they have to be sold at lower prices in order to cash out people who want out of the fund.)

On the other hand, this is a stocks-and-bondage game where, if stocks crash quickly enough, money would typically slosh into bonds in search of a safe haven, flooding the bond market quickly with demand and pressing yields down. We are at a point I said long ago we would likely get to where it will be hard to tell which will crash first and worst, stocks or bonds.

Money could rock out of stocks and flow into bonds as a safe haven just in time to save the US treasury for awhile from its sudden loss of sovereign investors, or money may flow out of bond funds when the spending cap is lifted and the government floods the market with more bonds, crashing the value of existing bonds.

Cash is looking good again as a less rocky place to park and sit out the possible bloodbath. After years of a bull bond market engineered by central-bank free money soaking up all the government’s bonds and a lot of corporate bonds, the bond market is perilously perched, should government bond supply suddenly increase just as foreign demand suddenly drops due to trade wars.

Things are about to get a lot more complicated than “Fed cuts rates, stock and bond markets rise together.” Thursday provided a perfect example of how complicated the see-sawing tumult between stocks and bonds may become. The Dow screamed upward to a grand victory, setting a new record above the 27,000 mark (up 228 points to a strong 27,088) while the S&P 500 merely sat the day out on the bench (up only 6.8 points to remain stuck a mere fraction below its 3,000 stratosphere), and the Nasdaq Composite actually sat game out in the penalty box (sinking a modest 6 points to close below its last record).

A big part of the drive up in the Dow came from the rise in bond yields. Instead of drawing money out of stocks and into bonds, higher long-term yields boosted the value of financial stocks where the Dow is weighted more heavily than the other indices, taking the Dow to record heights! Yet, all indices initially sunk on news of the “ugly” treasury auction with the S&P and Nasdaq remaining out of the action for the day. The rise in long-term rates caused bank stocks to rise because banks make money borrowing on the short side and selling on the long side (in terms of loan duration). So, this improvement in the yield curve was seen as bringing relief to banks that have been increasingly operating in a compressed yield environment. Higher inflation on Thursday, which Powell also said the Fed was no longer anticipating, also sent long-term bond yields up because yields have to compensate for inflation over time.

As I say, it’s about to get complicated as money starts moving all over in search of yield and in flights to safety while investors figure out what to do under this rapidly changing Fed regime that is taking place in a much different economic environment than the last time the Fed was cutting rates. It’s taking place at the very summit of the stock market and very bottom of unemployment — highly peculiar places to be stimulating the economy with new rounds of rate cuts, to say the least! I think we’re all going to have some learning to do as we watch to see what that even looks like!

Something wicked this way comes

Just remember, both Janet Yellen and Ben Bernanke confessed that it is the Fed that murders economic expansions (their words, not mine), and the weapon they said the Fed uses is over-tightening the economy in their effort to suffocate inflation. (Exactly as I’ve said the Fed would do at the end of its recovery.) In that light, consider how the Fed has been talking about not raising interest rates any higher and now about lowering them while that entire time it has continued to rapidly tighten up its balance sheet like a rope around the economy’s neck without a word about that in any of its speeches.

Nice sleight of hand, huh? Turns out the monster creating all the shadows is the Fed, itself. There’s a twist you might not have seen coming. If you don’t believe me, just read the Fed’s own confessions linked to above.

Reprinted with author’s permission from The Great Recession Blog

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