Economy On A Recession Watch

Posted By Darren Winters on Jan 20, 2022

Economy On A Recession Watch

Bond King Jeffrey Gundlach has got the economy on a recession watch while the inflation fire burns.

The Fed’s mandatory inflation target of 2% and transitory inflation view, touted by Fed Chair Powell only a few months ago, is now assigned to the fairy tale books for adults. 

The easy part of the Greatest monetary easing experiment in the history of finance is over

The first stage of the Fed’s monetary policy, which was to halt a financial meltdown and economic depression, was successful. But the Fed policy to create currency and buy assets, known as quantitative easing, to support a spiraling 30 trillion US dollar public deficit, which sent M2 to the moon, was the easy part. Think about it. Pressing the green money creation button to support bubble asset prices and a ballooning public deficit is child’s play. 

But now comes the more challenging second part of the monetary experiment as inflation leaves the launchpad.

The situation is dicey, as market watchers are on recession watch

Economy On A Recession Watch

Here is the problem, with core US inflation at 7%, treasury investors are demanding higher yields. 

So the US 10 year treasury note current yielding 1.79% will no longer cut it. In short, the US 10 year treasury yield needs to go higher. 

So investors will continue to unload US 10 year treasury note with a current yield of 1.79%. The logic is simple; why invest in an asset that no longer protects wealth against inflation.

We believe the net capital flow in US 10 year treasuries could continue to be negative, with core inflation at 7% and yields at 1.79% at the time of writing this piece.

But as demand for US 10 year treasury note falls, its corresponding yield rises, bearing in mind the treasury price and its yield have an inverse correlation. 

The US 10 year treasury note is watched closely since it is the yardstick used by banks and other financial services providing loans to set interest rates.

Rising treasury yields increase the cost of servicing debt, which is a headwind on the economy. 

What is interesting is that the market, bond investors, are forcing interest rates up to a time when some of the biggest bond investors have got the economy on recession watch.

The recent volatility in stocks can be attributed to the rising US 10 year treasury yield, which steepened in the second half of January.

Unprofitable companies which are highly leveraged are likely to be worse impacted by rising borrowing costs, particularly when the economy is on recession watch.

Perhaps this explains the rotation of capital from growth to value companies, which are profitable and pay investors dividends.

With the Fed claiming that putting out inflation fire is a number one priority, how will the economy cope with the rising cost of servicing debt when many have the economy on recession watch

“Inflationary pressure is building,” Gundlach said. “If we look at the economy … It’s undeniable that it’s been supported by quantitative easing and the Fed’s balance sheet expansion. And since that’s going away, it is just not plausible to think that we don’t have more headwinds in 2022 for risk assets and, ultimately, for the economy. The signals from the bond market are starting to look a little bit like a pre-recessionary period,” Said Gundlach. 

The world’s largest economy is on recession watch as US consumer confidence and the yield curve data are flagging a potential slowdown

“We are going to be more on recession watch than we’ve been for the past two years,” he said. 

The US economy is consumer-based, and household consumption could get tripled fisted due to declining real wages, falling consumer confidence, and increasing borrowing costs.

Will the Fed overplay tightening and thereby trigger a deep recession?

Perhaps the above is not an unreasonable question, bearing in mind easing policy was overplayed, which caused inflation to overshoot by a huge margin its 2% inflation mandate. 

You do not need to have a Nobel laureate in economics to figure out that in a Just In Time economic system locking down the global economy will cause supply bottlenecks. Moreover, creating a massive sum of the currency means more money chasing fewer goods, which equals a core inflation rate well north of 7%. 

We do not believe that the Fed implemented a monetary easing policy and was completely oblivious to this soaring inflation that it would cause.

Here is the zinger of the piece; 

With the economy on recession watch, the Fed could be deliberately financially engineered inflation in the economy

The central bank’s most lucrative client is the US federal government, which is a giant cash cow. The Fed milks almost half a trillion dollars of interest payments levied on a public deficit soon approaching 30 trillion US dollars.

So why would the Fed starve its cash cow to death with higher interest payments when it can keep suckling on the federal government (the nation’s) money teat. 

Inflation helps the government pay off the debt

So if core inflation continues at 7% for seven years then nearly half the public debt will be inflated away. 

While the economy is on recession watch and everyone thinks the Fed wants to fight inflation, perhaps it is the other way around. The Fed wants persistent inflation

If that contrarian view turns out to be correct, then maybe the reflation trade, growth stocks have been oversold in the first few weeks of January.

Time will tell whether the Fed is genuine about fighting inflation as many market watchers have the world’s largest economy on recession watch.

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