Economy in a Stranglehold

A cautious view about the current financial and economic environment would be entirely warranted, due in part to the brute force use of interest rate policy by the Fed and ECB during the last year to combat inflation. The primary purpose of today’s interest rate shock is to slow economic growth, through something called the ‘monetary policy transmission mechanism’, to reduce general price pressures. It’s a blunt tool that often creates unintended consequences, and we don’t believe this time will be different.

Notwithstanding, the popular mood today is arguably bullish. The predominant case among bulls seems to be that the labor market and GDP remain relatively strong; the financial crisis is behind us (the failures of SVB, Credit Suisse and others occurred in March); the equity rally of 2023 will broaden from a small handful of mega tech companies to the rest of the market; stocks are actually attractively priced (Bank of America recently suggested that excluding the ‘Magnificent 7’ mega-cap tech stocks, the rest of the S&P 500 is trading near 15x earnings); and the Fed pausing its rate hiking campaign, soon if not already, should set stocks free to the upside.

This is seemingly a compelling case. Indeed, Alan Greenspan surprised many by terminating his aggressive rate hikes of 1994 in early 1995, marking the beginning of a historic period for financial markets over the next 5 years. No one knows the future, of course, and perhaps we’re witnessing the beginning of another historic bull run. But what makes today different is that Greenspan stopped raising rates well before the Treasury curve inverted; and the inverted yield curve today strongly suggests to us that serious macro risks exist and the Fed has overdone it. Greenspan’s deft maneuvering in 1995 earned him the title of ‘the Maestro’.

To be specific, when Greenspan signaled an end to his rate hiking cycle in early 1995, the spread between the 10-year Treasury and 3-month T-bill was positive – more than 100 basis points; today it is negative at more than -115 basis points. The difference is equivalent to a major rate cutting cycle of at least eight quarter point reductions.

As we see it, the interest rate shock of 2022-2023 along with high inflation and a general absence of new incentives for risk-taking have created a long list of serious economic and financial problems, such as consumer, corporate and commercial real estate distress, tighter lending conditions, property market distress and a manufacturing recession in China, and general economic malaise in Europe.

The combination of these variables and the current macroeconomic policy trajectory don’t bode well for the future. We believe that signals of impending recession are all around us and most probably occurring first in Europe at large; while at the same time serious financial risks are accumulating ever so slowly.