How the Fed Has Caused Every Recession

US stocks treaded water overnight. The Dow and S&P 500 went nowhere.

The main moves are happening in the currency markets. The US dollar continues to strengthen — more recently against the Japanese yen. This is due to the increasing likelihood of a US rate rise in December.

Gold is certainly worried about the impact of higher rates. Bullion fell another US$10 an ounce overnight. It now trades around US$1,250 an ounce, right at the $1,250 an ounce level I mentioned yesterday.

The reason I mentioned that point is because it represents an important Fibonacci retracement level. The idea is that, after strong rallies, it is natural for any market to give back (retrace) some of the prior gains before resuming the rally.

Fibonacci numbers are a mathematical sequence occurring in numerous places in the natural world…including human anatomy! The rationale for applying it to the stock market is that stock moves are the result of human nature. For this reason, stock prices should also (from time to time) display similar characteristics.

The chart below shows the Fibonacci retracement levels based on gold’s recent stellar advance. The rally got underway in December 2015 and peaked in July, so I use those as the start and end points to work out potential retracement levels.

As you can see, the recent gold correction sees it right on the first (61.2%) retracement level. Gold should find support around here, at least in the short term.


Source: Optuma
[Click to enlarge]

A word of caution, though: I wouldn’t suggest trading these levels. Although it is uncanny how often prices bounce off Fibonacci support, you never know which level support will come in at.

The more important takeaway is to realise that it is not unusual for prices to retrace 50% of their prior gains in a bull market. Therefore, gold could correct all the way back to around US$1,210 an ounce and still be in a long term bull market.

I think that is a lower probability outcome. The way I see it, if gold is now pricing in a December rate hike, most of the damage is done.

There are two reasons for this. Firstly, it would only take one poor data release for the market to suddenly lower the odds of a December hike. We know how timid the Fed is; it will err on the side of caution if the data warrants it.

On that front, tonight, in the US, sees the release of the non-farm payrolls data. That always has a big effect on markets. The current guesstimate is for jobs growth to come in around 172,000. Any number well above or below that will result in some pretty extreme price moves.

Notwithstanding the short term effect on gold of strong employment numbers, the other reason to think gold’s correction is almost done is that an interest rate rise will likely lead to slower economic activity.

The Fed has precipitated just about every post-war recession by raising interest rates, and this time will be no different. I remember making this point in a 2014 essay. Here’s the updated chart I used at the time.


Source: St Louis Fed
[Click to enlarge]

It shows the Fed funds rate (official US interest rates); the shaded lines represent US recessions.

Notice how rising interest rates preceded EVERY SINGLE recession! In other words, as economic activity picked up, the Fed sought to ward off inflation and raise rates. Rising rates then led to an economic contraction.

The other thing to note is that, prior to the 1980s, recessions tended to be more frequent, and of longer duration. But after Fed boss Paul Volcker dealt with inflation in the early 1980s, recessions were less intense and further apart.

That was due to the fact that monetary policy became the main instrument to fight the business cycle. And it was very effective. So effective, in fact, that it led to the wild real estate bubble of the mid-2000s (predicted, by the way, by Cycles, Trends and Forecasts guru Phil Anderson).

Greenspan then panicked and tried to raise rates to cool the market. But it was too late. Higher rates simply popped the bubble. What followed was the deepest US recession since the 1930s.

His successor, Ben Bernanke, took the helm and cut rates sharply in 2008 and beyond. But as you can see from the chart, something had fundamentally changed in the US economy. It could not handle a return to ‘normal’ rates.

That tells you the return on incrementally invested capital (in the aggregate) is very low. Therefore, the natural rate of interest, which approximates this return on capital, is also very low. (This is why you’re seeing speculation take over real investment.)

The risk is that even a few interest rate rises from such low levels will lead to another recession. I think that is a very real risk, which is why I see limited downside for gold from here.

The problem for the US (and global) economy was that the 2008/09 recession, despite being a deep one, didn’t really do the job of a recession. That is, it didn’t clean out the excesses. Bailouts were the name of the game. That’s why you’ve seen tepid growth ever since.

And as the Fed tries to normalise rates, chances are that history will repeat and they’ll lead the world into another recession. If that happens, expect stocks to fall hard from here.

Cheers,

Greg Canavan,
For Markets and Money


Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

 


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