So what I have been explaining through Parts 1 and 2 is a modern roadmap for how bear markets and recessions are brought on. To reiterate, the playbook for ending a recession has been to cut interest rates in order to make it easier for consumers to borrow to spend. On top of that, the bear markets end as sales increase for companies that benefit from this consumer spending and the declining discount rates used on their share via the net present value formula.
After the financial crisis of 2008, central banks embarked on an unprecedented amount of quantitative easing (asset purchases). This means that the FED and other central banks purchased assets on the market, by essentially creating currency. This speaks to the idea that cutting rates to zero was not sufficient in re-inflating asset bubbles. As you can see below, prior to 2008 the FED was not in the business of buying up assets on the market and holding them on their balance sheet. Also, below you can see the effect that this policy had on the M1 money stock, which includes physical currency and coin, demand deposits, travelers checks, other checkable deposits and negotiable order of withdrawal (NOW) accounts.
A common misconception that occurred back when this policy was undertaken was that it would cause inflation. Many individuals say that we did not experience any inflation due to this policy because the CPI (Consumer Price Index) never rose significantly. As I wrote previously, inflation is the expansion of the money supply, and rising prices are a byproduct. Do not forget that stock prices are prices as well. Stock prices experienced a rise of historic proportion the past 10 years, which has lulled many to sleep.
The market was of the belief that the FED will have success in normalizing its balance sheet and raising interest rates without causing another crisis, recession, or bear market. The bear market is upon us now though. Above, you may notice that the FED’s balance sheet has been shrinking. This is due to the balance sheet normalization effort known as quantitative tightening. If we agreed that quantitative easing boosted stock prices, shouldn’t we agree that quantitative tightening will lower stock prices? You should agree because right as global quantitative easing was ready to run negative for the first time since the 2015-2016 market drawdown, the stock market entered a bear market.
The narrative at the moment is that the stock market does not appear to be able to handle more rate hikes and quantitative tightening, but at the same time the FED has essentially already conveyed to markets that policy normalization would occur. This policy normalization pledge has aided the dollar due to the fact that on a relative basis interest rates in the US are more attractive than interest rates in the rest of the world. Also, remember that priced into the dollar is the idea that the FED will continue to raise rates over the long term.
So here lies the issue, the FED has policy normalized to the point of pricking the stock market bubble. Upon the realization of this, the FED has begun to talk up the markets by suggesting there may be less rate hikes than expected in the future. This has helped in creating the stock market bounce off the December lows. The issue is how much dovish (not looking to hike) talk can the FED convey before this communication policy runs out of juice.
FED policy is subject to something called policy lag. This means that when the FED does something such as raising rates, the effects are not visible until some time later. There is a valid argument to suggest that it is not the future rate hikes that will cause the recession, but the ones that have already occurred. Many will say that raising rates to 2.5% is not significant, but it is significant when the market was used to rates of 0% for about 7 years. Also, something important that many market participants are not aware of is that some economists claim that quantitative tightening has had the effect of quasi rate hikes per the chart below.
At the moment, the FED has the market in limbo of how many rate hikes are to come going forward, but quantitative tightening is still on “autopilot.” If the market resumes its downtrend, one should consider what the FED will do. Will they begin rate cuts? Will they end quantitative tightening? Will they resume quantitative easing? Any of these 3 outcomes would be very bearish for the dollar due to the suggestion that US interest rates would become less attractive, and the supply of US dollars would increase.
Stock market investors may believe that quantitative easing will save the day. I urge those to consider the possibility that the policy does not work again, the public does not allow the government to essentially re-enrich the wealthy, or the dollar declines to the point that the gains in real terms are not positive.
In part 4, I will take an in depth look at the dollar.