Here’s What I’m Worried About. And It’s Not a Recession
A rout in the hyper-inflated bond market can blow up everything at this point.
This is the transcript from my podcast last Sunday, THE WOLF STREET REPORT:
The locker room at my swim club has become the litmus test. When a complex topic, after years of being absent or ignored, suddenly crops up in conversation, and not just sporadically but all the time, it means that there is some kind of peaking going on. This suddenly hot topic now is a “coming recession.”
Just about everyone is talking about it. This means that fears of a recession or thoughts of a recession have now penetrated into the core of the previously recession-free zone: the swim-club locker room. It means that these recession fears might be peaking.
It makes sense. Recession-fear headlines are popping up everywhere. You cannot escape the drama. It’s not that there is a recession in the United States – far from it. It’s all about a coming recession.
And another term has penetrated into the musty locker room at my swim club, perhaps for the first time ever in its illustrious 100-plus-year history: “Inverted yield curve.”
People who didn’t care about it, who never cared about it, and who don’t know what it is, who don’t even really understand what a bond yield is, and who don’t really want to know what it is – in other words, perfectly sane people that have other things to worry about – are suddenly fretting about the inverted yield curve.
They’re fretting about it because everyone else is fretting about it. And every time the inverted yield curve comes up, recession talk is attached to it. But there’s a lot more to it than meets the eye.
In a survey released this week by the National Association of Realtors, 36% of active homebuyers – so people actively trying to buy a home – said they expect a recession starting next year, up from 30% a few months ago.
Active homebuyers are optimists. Or else they wouldn’t try to buy. They’re braving what in many markets are the most inflated home prices ever, and they’re ready to leverage up all the way to do so, and they’re ready to dive right in, but now they’re suddenly doing a lot of hand-wringing over a recession.
And they’re getting second thoughts about buying that home. 56% of these homebuyers said they would delay buying a home if the economy goes south.
Over the last 50 years, the United States has experienced seven recessions. They’re an essential part of the business cycle. They clean out the excesses, get rid of zombie companies, and blow off some debt at the expense of investors. Bankruptcy courts are busy, bankruptcy lawyers and corporate restructuring firms are having a field day. And after it’s all said and done, the economy gets a fresh start.
I’ve seen all seven of these recessions.
Six were more or less normal business-cycle events. Some were short and shallow, and they were over before you knew that there was a recession. Others lasted longer and had more of a bite. But for most people, six of these seven recessions were no big deal, unless you lost your job or were looking for a job at the time because you just graduated, and then they turned into a depression.
That happened to me: I emerged from graduate school with a master’s degree and walked straight into a recession. It was tough. No one should underestimate the harsh impact even a mild recession can have on people that get tripped up by it.
The biggie was the Great Recession. It was the seventh recession over the past 50 years. It was a mess. It was a lot more than a business-cycle event. It morphed into a global financial crisis. It scared the bejesus out of the entire world. And it triggered central bank actions whose consequences are now dogging the real economy around the world.
Now when we think of a coming recession, that thing hangs ominously over our thoughts.
We have trouble nowadays thinking about a recession without thinking about the Financial Crisis. And there is the fear that this time around, it’s going to be even worse, given that today’s “Everything Bubble” is far bigger and broader and deeper and more leveraged than whatever bubble there was before the Financial Crisis. And that it could all go to heck together.
We have a huge stock-market bubble.
We have the biggest-ever, all-encompassing credit market bubble that includes bonds and loans around the world. Bond prices have been inflated to such ludicrous levels that $17 trillion of them are now sporting negative yields. The whole concept of negative yields is totally absurd.
Then there is a whole separate bubble. This one consists of people – people who believe, and who go around and want to make others believe, that negative yields are a good thing, a godsend of sorts. But good for whom? We have by now well established that negative yields and even low yields have been screwing up the real economy for years.
Then there are magnificent housing bubbles in many markets around the globe, some of them deflating now. Housing is huge because of the large amounts of money and leverage involved.
And there is a massive bubble in commercial real estate. This includes offices, industrial, apartments, and the heavily marketed asset class called “student housing” that gets nurtured by student loans.
There is the biggest-ever IPO bubble where companies with billions of dollars in losses and no real business model and without a realistic chance of ever making any money, have valuations and market capitalizations in the tens of billions of dollars.
These are not necessarily tech companies that have reinvented how the world operates. These are companies that run taxi operations; tiny outfits that make fake-meat hamburgers, companies that make little offices out of big ones, companies that offer you to store your files on their servers for free.
We got all this going on.
And we have the US Treasury market that is now forecasting a long and hard depression – at least on the surface. The 30-year Treasury yield briefly fell to a record low this week of 1.9%. Below the rate of inflation. This left the entire yield curve inverted, with the 30-year yield below the federal funds rate, which the Fed controls. On the surface it looks like a fear-and-horror trade.
But the stock market is forecasting boom and glory forever. There is no fear in the stock market. Stock prices are way up there in lala-land.
So, how can these two markets see the economy in the United States so differently?
Maybe they don’t. There is something else that powers the US Treasury market right now – and it’s not fear. It’s greed. Reckless greed.
When you succeed in driving down long-term bond yields, such as the 10-year Treasury yield, or the 30-year Treasury yield — or in countries that have them, such as Austria, the 100-year yield – that means that bond prices are soaring. The price of the Austrian 100-year bond has nearly doubled over the past two years. Those are huge gains, particularly in the conservative generally risk-averse world of government bonds.
These bonds have engendered a feeding frenzy. This has nothing to do with fear and everything to do with greed. And these speculators, which includes Wall Street powerhouses, want bond prices to go higher and higher, which means that yields must go lower and lower.
To manipulate up bond prices and push down yields, you drag central banks into it and shove them into a corner, and you lambaste them and force their hands. And you rant and rave about a coming recession, and about the coming negative yields, even for the 10-year Treasury, so that others will jump into government bonds, thereby driving up prices and pushing down yields.
Government bonds are a gigantic asset class. In the US alone, at face value, there are $22.5 trillion of them. If the reckless greed that is behind all this could push down their yields into the negative, especially the yields of bonds with longer maturities, enormous amounts of trading profits could be made. Those profits could be measured in the trillions of dollars.
But here’s the thing. The speculators – the Wall Street powerhouses – would have to sell those bonds to actually take profits, because if you hold these bonds to maturity, all you get is face value, and the premium these bonds are trading at today and your profits evaporate the closer you get to the maturity date. So the only way to get these profits is by selling the bonds long before they mature.
The hope is that others will buy them, led by central banks in a new round of massive QE. That’s the exit strategy.
And there may still be no recession – just the fear mongering about a coming recession.
In the second quarter, consumer spending adjusted for inflation rose at the fastest rate since 2014 – at nearly 5%. Consumers are pulling their weight. They have jobs, and they’re making money, and they’re spending it. Consumer spending is about 70% of GDP. And it’s hard to have a recession without consumers cutting back in a big way.
The weak part is business investment, which declined by 1% in the second quarter. But part of that business investment are inventories, and inventories are bloated from front-running the tariffs. And now businesses are whittling them back down, which lowers business investment in the GDP figures. This process of whittling down inventories lasts about a year or so, and then it dissipates.
So for now, the recession fears are just that – they’re not based on the data emerging from the economy.
But when businesses and consumers start worrying about a coming recession to the extent that they will actually make decisions based on their concerns, and cut back in their hiring and investment plans, and in their consumption, etc. then this fear of a coming recession becomes a self-fulfilling fear.
That recession, if in fact it materializes, would not be the end of the world. The economy can handle a run-of-the-mill recession just fine. It would be part of the business cycle. It’s not what I’m worried about.
But when the feeding frenzy in the bond market reverses, when Wall Street, that has been trying to drive down yields and push up bond prices, is starting to lock in their trading profits by getting out of these bonds, then yields suddenly snap back, as they have a long history of doing.
With as much leverage as there is, and with such inflated bond prices, and as huge as the bond market now is, with excess risk-taking everywhere, with a bond market strung out like this, and with bonds used as collateral — when yields snap back, then suddenly, wow, it can blow up everything.
That will be the fear trade: getting out of these bonds before prices fall – before the rest of the folks involved in the erstwhile feeding frenzy do a 180 and the whole thing turns into a rout, powered by the first-mover advantage.
That would be the event I’m worried about. I’m worried that central banks are accommodating this feeding frenzy and are encouraging it and are trying to keep it going for a while longer, rather than to ease markets out of it.
That makes the bond market, and more broadly the entire credit market, that much more vulnerable to a rout. And a rout in the credit market can get ugly in a hurry – not just for investors, but for the real economy. And then central banks would do even crazier things to prevent the financial system from falling off a cliff. That would be the thing I’m worried about. Not a run-of-the-mill recession. You can listen to and subscribe to my podcast on YouTube.
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