Originally sent to VIXCONTANGO subscribers on June 13th, 2019
The St. Louis Fed came out with some devastating research on the relationship between yields and recessions earlier this year. This is a topic that hasn’t been explored as much but right now has become relevant since the yield curve has inverted and the clock to the recession has started ticking. While policy makers will publicly try to drum up optimism and try to stop the self-reinforcing pessimism that can exacerbate recessions, the overarching question for them right now is not WHETHER there will be a recession but HOW LONG and HOW BAD the recession will be. We are after all in the longest expansion in history and therefore historical precedent postulates another recession should be just around the corner. While the exact timing of a recession is important for traders, policy makers have a different problem in mind. They need to fight the recession and for them the question of timing is less important. What is more important is do they have enough tools to fight what is coming. And before they can figure out if they are armed appropriately, they need to size up the problem. How big and how long will be the next recession?
The researchers at the St. Louis Fed have discovered that the REAL 10-year Treasury Yield at the time of inversion (inversion defined as the 10-Year Treasury Yield is less than the 3-Month Treasury Yield) correlates with the longevity and size of the recession that follow. The lower the real interest rate (which is TNX – CPI) at time of inversion, the longer and bigger the recession that follows. By “bigger” recession understand bigger loss of employment, higher unemployment rate. The Fed research doesn’t try to explain why this relationship holds and why it is happening but they are there to tell us that it exists and that the Fed is aware of it.
Here is the bad news. The real interest rate at the current inversion is the LOWEST in history. We are 0.35% real interest rate. TNX is 2.15%, CPI is 1.8%. 2.1%-1.8% = 0.35%. This means that the next recession will be both longer and more severe than anything we have seen over the past 40-50 years. It sounds like the next recession will make the Financial Crisis look like a walk in the park! It will be even worse the recession of the late 70s which is the worst recession experienced by any American alive today. On the charts above, I have plotted what type of recession we can expect based on the Fed data presented.
The upcoming recession will be about 45-50 months (4 years) long and unemployment rate will go up about 5.5%-6% from current levels (to roughly 10%). So this is what the FED is grappling with right now. How to confront a 4 year long recession and 10% unemployment rate!
Are 5 rate cuts (one 50 bps cut each) going to be enough to forestall this? I doubt it. Rates need to go down 500 bps to forestall a recession. There will definitely going to be some balance sheet expansion (which is bullish for gold and pushes potential targets past 2000), but I don’t think the FED will shoot its QE bullets early on in the recession. I think the FED will do yield-control first (because it is likely to cost them less than outright QE) and then QE will be the final bazooka. Let’s hope that sequence works. I think QE will fail to resurrect markets and then after that FED has to come up with something else. But that is a topic for another day. For now though, know that the FED is getting ready to combat a 4 year long recession and 10% unemployment rate and that is why Clarida has been sounding so despondent lately.