Sven Sees Recession On The Horizon

February 6, 2017

Sven Sees Recession On The Horizon

  • An analysis of employment, interest rates, currency, and inflation suggests a recession is inevitable in the next few years.
  • The FED can’t change economic laws nor protect us from ourselves. On the contrary, the FED will lead us into a recession in order to prevent a future depression.

Introduction

The FED didn’t raise rates last Wednesday but they are still on track to raise rates two to three times in 2017. The FED’s goal is to “foster maximum employment and price stability” through economic activity expanding at a moderate pace and inflation rising to, and stabilizing at 2%.

What we know is that inflation has been slowly rising and will reach 2% relatively soon. The labor market is strong and yields have been increasing in the expectation of higher interest rates.

A concept that always eludes economists, consequently also members of the FED, is stability. By looking at a model, an economist is trained to think that the economy can be controlled. But history shows that a stable scenario is never the case. In today’s article, I’ll forecast what lies ahead of us by looking at how the last two economic cycles developed.

What Happened The Last Two Times Rates Were Rising?

I’ll analyze only what happened in the last 20 years as before that, the world was different with less global trade and competitiveness.

There have been two periods with increasing interest rates in the last 20 years. A two-year period that started in 1999, and another two-year period that started in 2004.

Both rate increases lead the economy into a recession three years after significant rate increases had started.


Figure 1: Federal funds rate from 1997 with recessions shaded. Source: FRED.

Therefore, if the FED raises rates according to their plan and the economy really gets going, we are three years away from a recession. The main question now is: Can the FED keep things stable and prevent a recession?

One of the indicators the FED is carefully watching is unemployment which is close to the natural rate of unemployment. The natural rate of unemployment is a level that occurs when the labor market is in equilibrium and inflation is stable.

Unfortunately, in the past it wasn’t possible to keep the economy at full employment for longer as inflation would soon take over forcing the FED to hike rates and lead the economy into a recession.


Figure 2: Federal funds rate and unemployment rate. Source: FRED.

Further declines in the unemployment rate have lead to inflation as there is more competition for labor. The red arrows in the next figure show how inflation and unemployment usually move in opposite directions.


Figure 3: Inflation and unemployment trends. Source: FRED.

At some point, corporations see their margins decline as labor costs increase. Increased interest rates further add fuel to the fire as debt servicing costs increase. In such an environment, projects that seemed profitable when interest rates and labor costs were lower become unprofitable forcing corporations to tighten.

Before discussing the implications of tightening, let’s first see how higher rates and strong employment impact currencies.

The Currency Environment

With full employment, the FED is forced to raise rates in order to prevent an economy from overheating because an overheated economy could lead to hyperinflation followed by a depression. Higher rates also enable monetary easing in the future in order to soften the blow when the economy eventually starts contracting.

President Trump is trying to devaluate the dollar with rhetoric, but the fact is that yields and interest rates are in an upward trend.


Figure 4: 10-year treasury yield. Source: FRED.

With other safe currencies like the Yen, Euro, or the Franc having zero or subzero interest rates, it’s inevitable for the dollar to appreciate as interest rates and yields increase. A higher dollar makes the economy less competitive and could be the trigger for a reversal in the employment trend.

Are We Running Into A Recession?

What’s very important to understand is that the economy isn’t an elusive concept. It’s a machine that is made from millions of parts. Those parts are me, you, our neighbors, your financial advisor, my favorite bartender, etc.

What we all have in common is that we are human and we behave like humans. Human behavior doesn’t like changes and prefers satisfaction now rather than later. Therefore, we rush to buy cars, houses, and all other things we think we need as soon as we feel comfortable and positive about the future. Because the economy is growing, we like to assume the same trend will replicate into the future. We soon start living beyond our means, counting on the next salary increase, bonus or promotion to cover for the difference.


Figure 5: Change in personal saving rate is turning negative. Source: FRED.

At some point, a small percentage of companies will find it difficult to operate with consistently higher labor and debt servicing costs and will start to fire people.

At the first sign of the employment reversing, more tightening occurs as companies don’t like to invest in a contracting economy with less people employed. The next figure shows that a reversal in the employment trend is usually definitive.


Figure 6: Unemployment either goes up or down for longer periods of time. Source: FRED.

As we are close to the natural unemployment rate, the only option is a trend reversal. It’s unnatural for the unemployment rate to stay close to the natural rate for longer periods of time.

As soon as there is less hiring, a negative spiral is triggered. Less employment leads to lower demand for goods. At some point, unfortunately, our neighbor also gets fired, which means we are entering a recession. The FED then lowers rates and eventually a new cycle begins.

I wish I knew exactly when the next recession will arrive, but that’s impossible. The only thing we can do is to build our portfolios whilst keeping in mind that we are getting close to the peak of this economic cycle.