Ep.79- How the Fed Created the Looming Recession It's Trying to Prevent

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A LOOMING RECESSION IN 2020

A RECESSION IS NOW MORE LIKELY THAN EVER. Specifically, three major financial events have happened in the last two months. They all point to the trouble ahead.

  • Fed Cuts Rate: The Federal Reserve has cut the Fed Funds Rate target twice since July, with the attempt to stimulate the economy. This is the FIRST time since the 2008 recession.

    • What does it mean? The idea of the Fed cutting rates is simple. The Fed wants to make borrowing cheaper, so people can borrow more, thus injecting more money into the economy. Cutting rates sort of works like Draino to a slow-moving sink, in the sense that it lubricates the system.

  • Inverted Yield Curve: The heavily talked about the inverted yield curve occurred in August. For unknown reasons, it has consistently correlated with a recession in the next 18 months.

    • What does it mean? The yield curve is inverted when long term borrowing is cheaper than short-term borrowing on treasury bonds. In layman’s terms, currently, the reason the long term bond yield dipped is probably because people have been dumping stocks to buy bonds in order to seek safety. Why? These people are making a pre-emptive move to recession-proof.

  • Fed’s Cash Injection: The Federal Reserve has poured $75B per day for the fourth day in a week into the repo market to provide short-term liquidity. For context, this is an insane amount of money. It is more more than the $40B per month at the peak (3rd round) of the Quantitative Easing in 2012. Again that’s $40B a month, this is $75B a day.

    • What does it mean? In layman’s terms, for some reason, there’s suddenly an over-supply of treasury bonds, but a shortage of cash to absorb it in the repo market, so it caused a glut. In order to absorb all the treasury bonds, the Fed gave the banks a lot of cash so they can use the Fed’s money to buy up the bonds the Fed sold.

THE FED CREATED THIS PROBLEM IT’S TRYING TO SOLVE

From the outside, it seems like the Fed is the hero who’s trying to prevent a recession by actively cutting rates and providing liquidity to the repo market. However, 11 years ago, it’s the Fed that’s created a ticking bomb it did not yet know how to diffuse through the Quantitative Easing programs.

The term, Quantitative Easing, sounds intimidating, but it pretty much means providing liquidity to the economy by buying up stuff, mostly Treasury bonds and mortgage-backed securities. The Fed indeed bought so much, that in six years after 2008, the Fed’s balance sheets went up by 500%.

Now let’s break it down to see how the Quantitative Easing program from the Fed led to today’s looming recession.

2008: THE FED CREATED A TICKING BOMB IT CAN’T DIFFUSE

First, you need to understand that recession is all about liquidity, meaning the system needs money to move around, not all in a sock drawer. In 2008, the economy was in the worst shape, and money was not moving at all. As a result, the Federal Reserve did what it does best, printing money, but in a clever way.

The Fed created a program, “Quantitative Easing” (QE), in November 2008. It's mostly like any other money printing operation, except in two ways, the scale of money printing, and what it bought with it. With this program, it issued over $1 Trillion dollars into the economy and absorbed the kind of financial assets no one else wanted, namely mortgage-backed securities. Great! The Federal Reserve’s assets now have grown from $800B to $2.1T from September 2008 to December 2008.

The Fed kept on repeating this through more shopping sprees in 2010 and 2012, namely QE2 and QE3. It reached its peak in December 2014 with $4.5T dollars in assets, 5X of what it was before the 2008 recession.

The $4.5T amount is steady until October 2017, but then the Federal Reserve knew it has to sell them at some point, probably when the economy is good. They thought the best way to do so is to reduce slowly, steadily and quietly. And this started in early 2018.

2018: THE INITIAL UNWINDING OF QUANTITATIVE EASING

At first, the Fed was cautious. It only sold off a small amount to test the market. According to the August report from the Federal Reserve , it reduced the total assets by less than 5% ( -$188B) to $4.28T. What’s important is that this is the first time the Fed is unwinding its book. We all knew this day was coming, but I think, in 2018, the average person has long forgotten about this ticking bomb caused by QE.

2019: UNWINDING ACCELERATED

In 2018, the Fed reduced its balance sheet by $188B, a relatively small amount. Then in 2019, the number dramatically increased to $474B. As of August 2019, the Fed’s balance sheet is down from its peak at $4.5T to $3.8T, about 15% less. THAT is significant!

How does that relate to a recession? It means nothing if there is enough money to buy them. But it means trouble when there’s not enough money because more bond supplies than demand could lead to rising borrowing costs. This is exactly what happened last week in the repo market, where the borrowing cost was apparently going out of control to nearly 10%.

2019: THE FED COMING TO THE RESCUE TO ITS OWN DOING

When the Fed sold off $474B of assets in a short 12 months, it caused a glut in the system. In order to solve the glut problem, the Fed has to pour money into the economy so the commercial institutions can have the money to buy up the huge amount of financial assets the Fed has sold off.

It’s sorta like owner financing on a property. The Fed lends you the money so you can buy stuff from the Fed.

SEPTEMBER 2019: COURSE CORRECTED

The Fed has already corrected its course. Since September 11, the Fed’s balance has reversed from decreasing to growing. In other words, it means, the Fed stopped its unwinding of QE because of the fear of further inundating the market with more assets that the economy cannot yet absorb.

2020 AND ONWARD: THE ASSETS HAVE GOT TO GO

The assets have got to go. The Fed has to reduce its balance sheet at some point. But it needs to do so with finesse more so than ever.

The good thing is that I believe there’s an increased need for it because more people are now cautious and gradually selling out financial assets in risky places (e.g. stocks) for safer places (high-yield savings or long-term treasury bonds). While there’s an active outlet for the Fed to reduce its assets, the Fed needs to manage it at the right pace.

If the Fed manages to reduce its assets too fast, as it has this year, I believe it could directly lead to the next recession it’s trying to prevent.