"Many people want the government to protect the consumer. A much more urgent problem is to protect the consumer from the government."
– Milton Friedman
There have been 12 recessions since 1946. Guess how many of them have occurred immediately following an expedited oil price increase. Eight have followed major oil price shocks, while a further three have occurred immediately following more modest, but still notable, oil price run-ups. That leaves just one out of twelve recessions that didn’t have any oil fingerprints left at the crime scene. Correlation ≠ Causation? Perhaps, but 11 out of 12 is one hell of a coincidence.
A favorite show of mine from the 1990s is the X-Files. Recently, I’ve had the opportunity to re-immerse as my children have reached ages that make it only slightly “depropriate” for them to watch. My 13 and 11 year-olds seem to do fine, while my 8 year-old has nightmares, but that’s the cost of doing business when you’re the youngest and don’t want to be left out of family X-Files night.
For anyone born after 1995 and unfamiliar with the plot line, FBI Special Agent Fox Mulder runs an investigative unit that looks into all manner of strange and unexplained phenomena. The show follows a great format where roughly every other week Mulder is chasing down incremental clues of a vast government conspiracy about the existence of extraterrestrial life. Chris Carter, the show’s producer, really was about two decades ahead of his time tapping into the American psyche’s emergent distrust of government. The other weeks feature an “MOTW”. That stands for Monster of the Week. While I was always engrossed by the broader conspiracy, I thought the MOTWs were the best. How could you not be riveted watching Eugene Tooms stretch and contort his way through ventilation shafts en route to his next victim in Season 1, Episode 3, “Squeeze”.
What I loved about the show was that there was so much evidence that there were all these incredible things happening around the world, but, aside from a small government circle, only Mulder seemed to know about all of them. Even his partner, Dana Scully, who was regularly exposed to ridiculously outrageous things, was consistently incredulous in the face of what any reasonable person would consider enough to question everything they think they know to be true.
How is this relevant to markets today? I’m starting to feel a little bit like Agent Mulder – seeing all these clear signs – but still trying to convince a skeptical Agent Scully that we’re only in the early innings of this bear market.
Back to the Global Macro Grind…
I began with a reference to oil. Let’s briefly consider the history. Beginning with the end of WWII in September 1945, here’s the progression (oil prices referenced are inflation-adjusted to the present):
- Bretton Woods (July 1944)
- 1947–1948 – Oil prices rise sharply ($20 to $30). Recession 1949.
- Apr 1953–Jun 1953 – Oil prices rise modestly, though rapidly. Recession 2H53 – 1H54.
- Jan 1957–Apr 1957 – Oil prices rise modestly, though rapidly. Recession 2H57–1H58.
- Jan 1969–Apr 1969 – Oil prices rise modestly, though rapidly. Recession 1970.
- Bretton Woods Ended (August 1971)
- Jul 1973–Jan 1974 – Oil prices rise sharply ($20 to $60). Recession 1974.
- Jan 1979–Apr 1980 – Oil prices rise sharply ($60 to $135). Recession 1H80 & again 2H81–1H82.
- Jun 1990–Sep 1990 – Oil prices rise sharply ($40 to $80). (Gulf War) Recession 2H90.
- Nov 1998–Nov 2000 – Oil prices rise sharply ($20 to $55). (Dot.com Bust) Recession 2001.
- Jan 2007 – Jun 2008 – Oil prices rise sharply ($80 to $180). (GFC) Recession 2008–1H2009.
- Feb 2016 – Sep 2018 – Oil prices rose steadily ($40 to $80). (Pandemic) Recession Spring 2020.
- Apr 2020 – Mar 2022 – Oil prices rose steadily then sharply ($20 to $110). Recession ???.
While it’s true that there were significant events like the GFC and Pandemic and Dot.com bust associated with several of these events, it’s still notable that in every case there was an oil price spike that preceded the ultimate downturn.
Now let’s shift gears and consider the Fed’s role in those same recessionary periods. As we only have data back to 1954 we’ll consider the last 10 recessions. Of those 10, guess how many were preceded by an increase in short-term rates? All ten.
Interestingly, the Fed’s policy process has tended to follow a predictable and recurrent pattern for over 70 years. Step one: Be too easy. Step two: that begets energy inflation, which tends to creep into broader headline inflation. Step three: the Fed then begins to tighten its policy and ultimately pricks the energy inflation bubble it created, but, in so doing has 10 for 10 times caused a recession.
It is notable that the Fed has not yet raised rates, but the 2-year yield has moved sharply higher, from 0.25% in September to 1.5% today. It’s also notable that the Fed’s use of QE has come to represent a sort of Von Clausewitz approach to policy, war being a continuation of politics by other means. As such, it’s notable that tightening is already well underway in the form of a reduction of incremental purchasing. Below is the progression on that front:
- 10/15/21-11/12/21 - $80B Treasuries & $40B Agency MBS ($120B net purchases)
- 11/15/21-12/13/21 - $70B Treasuries & $35B Agency MBS per month ($105B net purchases)
- 12/14/21-1/13/22 - $60B Treasuries & $30B Agency MBS per month ($90B net purchases)
- 1/14/22-2/11/22 - $40B Treasuries & $20B Agency MBS per month ($60B net purchases)
- 2/14/22-3/11/22 - $20B Treasuries & $10B Agency MBS per month ($30B net purchases)
- Mid-March 2022 - $0 net purchases
Guess what happens one week from today? The Fed will make its final asset purchases.
To be a bit more quantitative about it, various researchers have undertaken to convert the impact of QE to interest rate policy. One such measure comes from the researchers Jing Cynthia Wu and Fan Dora Xia, who now publish the Wu-Xia Shadow Federal Funds Rate through the Atlanta Fed. As of September 2021, the Shadow Fed Funds rate stood at -1.8%. As of January 2022, it stands at -0.2% and that only reflects a halving of the purchasing volume from $120B/mo to $60B/mo. As such, there has already been an effective rate hike of 160 basis points – or roughly 6 quarter point hikes.
Once we realize/remember that the Fed has already effectively hiked rates by a point and a half in just the last 3-4 months, it becomes easier to see that we’re further along in the tightening process than it would seem. This is a big part of why we see the Fed having already committed the policy mistake and is unlikely to go through with the ~5 additional rate hikes expected over the coming year. Again, with the quarter-point hike expected in the March meeting and the remaining quarter-point of renormalization from ending purchases, Shadow Fed Funds will have moved from -1.8% to ~+0.33% - a tightening of +213 bps or 8-9 quarter-point rate hikes.
Now, let us consider the yield curve. Since September of last year, the 10-YR Treasury yield has risen +70 bps from 1.3% to 2.0%, but currently sits at 1.78%, a net increase of +48 bps vs September. Meanwhile, the 2-YR Treasury yield has risen by +140 bps from 0.2% to 1.6%, but currently stands at 1.48%, a net increase of +128 bps vs September. As such, while curve has move higher, it has also flattened by ~80 bps and currently stands in the 29-30 basis point range. While the spot curve is not currently inverted, it is certainly moving in that direction in a hurry. Bear in mind it was just 5-6 months ago it was at ~110 bps and is now at ~30.
Yield curve inversions have a long track record of predicting equity market corrections and broader economic slowdowns. Often outright recessionary, but always decelerating. The current backdrop appears to be no exception. Consider our current growth outlook for the US. Real growth on a Q/Q SAAR basis was +7.0% for Q4 2021, but we currently expect growth of just +0.7% in Q1 – a 90% reduction. For reference, while the Street is forecasting +1.6% growth, the Atlanta Fed is currently forecasting Q1 2022 growth of 0.0%. Zero point zero.
As a RoC-focused firm, a slowdown from +7% to 0-1% growth in a quarter is not the backdrop that bull markets are made from, especially when the outlook for Q2 is for more of the same. And especially when the Fed is tightening aggressively into that aggressive slowdown. And, on top of that, the tragic Geopolitical events ongoing in Ukraine are pushing energy and food commodity prices higher, which will further depress real growth. Remember where we began, oil price shocks have gone 11 for 12 in coinciding with the last dozen recessions. Then remember what came next – the last 10 for 10 recessions have coincided with the Fed raising rates, and they’ve already implemented 6-7 quarter point rate hikes as reflected in the Shadow Fed Funds rate.
Quad 4 remains the call with the evidence piling up in increasingly obvious ways. The truth is out there. All one has to do is look.
At this point in the episode, even Agent Scully should be starting to believe.
Immediate-term Risk Range™ Signal with @Hedgeye TREND signal in brackets:
UST 30yr Yield 2.09-2.27% (neutral)
UST 10yr Yield 1.71-1.93% (neutral)
UST 2yr Yield 1.32-1.56% (bullish)
High Yield (HYG) 81.98-83.68 (bearish)
SPX 4 (bearish)
NASDAQ 13,095-13,926 (bearish)
RUT 1 (bearish)
Tech (XLK) 146-156 (bearish)
Consumer Staples (XLP) 73.58-76.68 (bullish)
Energy (XLE) 67.91-74.30 (bullish)
Shanghai Comp 3 (bearish)
Nikkei 25,899-27,076 (bearish)
DAX 13,201-14,314 (bearish)
VIX 26.47-35.37 (bullish)
USD 96.14-98.26 (bullish)
Oil (WTI) 97.24-112.99 (bullish)
Nat Gas 4.25-4.92 (bullish)
Gold 1 (bullish)
To your continued Success,
Josh Steiner
Managing Director
