This Is What Happened The Last Time The Fed Hiked While The U.S. Was In Recession

Tyler Durden's picture

Back on June 17, Bank of America started its 66-day countdown to the moment it was convinced the Fed would hike rates, September 17, 2015. We, correctly, said that "we disagree entirely" with BofA's conclusion that the Fed would hike rates, and sure enough, it did not after the Chinese August devaluation unleashed the ETFlash crash, the EM debt rout, a surge in the VIX and a correction in the S&P500, which crushed the Fed's carefully laid rate-hike plans.

But while we disagreed with BofA's countdown timing, we agreed with something its strategist Michael Hartnett said, namely that "gradual or otherwise, the first interest rate hike by the Fed since June 2006 marks a major inflection point for financial markets."

BofA then laid out several key factors why "this time is indeed different" when evaluating the global economy's receptiveness to a rate hike:

  • Central banks now own over $22 trillion of financial assets, a figure that exceeds the annual GDP of US & Japan
  • Central banks have cut interest rates more than 600 times since Lehman, a rate cut once every three 3 trading days
  • Central bank financial repression created over $6 trillion of negatively-yielding global government bonds
  • 45% of all government bonds in the world currently yield <1% (that’s $17.4 trillion of bond issues outstanding)
  • US corporate high grade bond issuance as a % of GDP has doubled to almost 30% since the introduction of ZIRP
  • US small cap 5-year rolling returns hit 30-year highs (28%) in recent quarters
  • The US equity bull market is now in the 3rd longest ever
  • 83% of global equity markets are currently supported by zero rate policies

However, to the Fed none of these matter: only the price action of the S&P500 does, which as everyone knows, is trading just shy of its all time highs so "all must be well."

Which is why Janet Yellen and the Fed are now intent to hike rates, steamrolling over the Fed's "data dependency" and committing the latest error, this time of communication, with the rate hike coming at a time of non-existent headline CPI inflation, of GDP which in Q4 will be 1.4% according to the Atlanta Fed, and when the US manufacturing sector officially entered into contraction for the first time since the crisis. The reason for this is the following statement from her just delivered speech laying out "The Economic Outlook and Monetary Policy":

... recent monetary policy decisions have reflected our recognition that, with the federal funds rate near zero, we can respond more readily to upside surprises to inflation, economic growth, and employment than to downside shocks.

Translated this means that the Fed is desperate to hike rates just so it can lower them when the recession is too entrenched to be ignored any longer by the NBER.

But therein lies the rub: as so many pundits have already noted, the Fed has woefully missed its window to hike rates, and is instead preparing to do so just as one half of the US economy is in recession. In other words, the Fed has waited too long and now the economy is already on its downward glideslope.

So what happens if the Fed does tighten conditions as the economy is slowing?

Conveniently, we have a great historical primer of what happened the last time the Fed hiked at a time when it misread the US economy, which was also at or below stall speed, and the Fed incorrectly assumed it was growing.

We are talking of course, about the infamous RRR-hike of 1936-1937, which took place smack in the middle of the Great Recession.

Here is what happened then, as we described previously in June.

[No episode is more comparable to what is about to happen] than what happened in the US in 1937, smack in the middle of the Great Depression. This is the only time in US history which is analogous to what the Fed will attempt to do, and not only because short rates collapsed to zero between 1929-36 but because the Fed’s balance sheet jumped from 5% to 20% of GDP to offset the Great Depression.

Just like now.

Then, briefly, the economy started to improve superficially, just like now, and as a result the Fed tightened in a series of three steps between Aug’36 & May’37, doubling reserve requirements from $3bn to $6bn, causing 3-month rates to jump from 0.1% in Dec’36 to 0.7% in April’37.

Here is a detailed narrative of precisely what happened from a recent Bridgewater note:

The first tightening in August 1936 did not hurt stock prices or the economy, as is typical.


The tightening of monetary policy was intensified by currency devaluations by France and Switzerland, which chose not to move in lock-step with the US tightening. The demand for dollars increased. By late 1936, the President and other policy makers became increasingly concerned by gold inflows (which allowed faster money and credit growth).


The economy remained strong going into early 1937. The stock market was still rising, industrial production remained strong, and inflation had ticked up to around 5%. The second tightening came in March of 1937 and the third one came in May. While neither the Fed nor the Treasury anticipated that the increase in required reserves combined with the sterilization program would push rates higher, the tighter money and reduced liquidity led to a sell-off in bonds, a rise in the short rate, and a sell-off in stocks. Following the second increase in reserves in March 1937, both the short-term rate and the bond yield spiked.


Stocks also fell that month nearly 10%. They bottomed a year later, in March of 1938, declining more than 50%!

Or, as Bank of America summarizes it: "The Fed exit strategy completely failed as the money supply immediately contracted; Fed tightening in H1’37 was followed in H2’37 by a severe recession and a 49% collapse in the Dow Jones."

As can be seen on the above, in 1938, the stock market began to recover some. However, despite the easing stocks didn't fully regain their 1937 highs until the end of the war nearly a decade later.

It needed a world war for that.

But wait, the Fed hiked only to ease? That's right: in response to the second increase in reserves that March, Treasury Secretary Morgenthau was furious and argued that the Fed should offset the "panic" through open market operations to make net purchases of bonds. Also known now as QE. He ordered the Treasury into the market to purchase bonds itself.

Fed Chairman Eccles pushed back on Morgenthau urging him to balance the budget and raise tax rates to begin to retire debt.

How quaint: once upon a time the US actually had an independent Fed, not working on behalf of the banks, and pushing back on pressure to monetize debt and raise stock prices.

So is the imminent rate hike which guarantees the ghost of 1937 is about to wake up and lead to stock losses which could make the Lehman crash seem like a dress rehearsal just the precursor to QE4, as happened nearly 80 years ago? We don't know, but neither does the manager of the world's biggest hedge fund. This is what Ray Dalio says ahead of the upcoming rate hike:

... in our opinion, inadequate attention is being paid to the risks of a downturn in which central bankers' abilities to ease are significantly impaired. Please understand that we are not sure of anything but, for the reasons explained, we do not want to have any concentrated bets, especially at this time.

What we do know that if the S&P is cut in half following the Fed's upcoming "policy error" the Fed will launch not just QE4, but 5, 6 and so on, together with NIRP, resulting in every other central bank doing the same as global currency war goes nuclear, and the race to the final currency collapse enters its final lap.

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Looney's picture

Do not audit the Fed.



Hitlery_4_Dictator's picture

LOL the qestion was just asked to Yellen " The common people are confused about what the FED does, they are not economists, what would you like to tell the American people about why the FED is important and what it does?"  FUCK YOU, all of you scumbag criminals. WE KNOW WHO YOU ARE AND WHAT YOU'VE DONE. Your lies won't work. The cats out of the bag. We know who to blame. 

prefan4200's picture

Do you see what happens, Larry?  Do you see what happens? This is what happens when you fuck a stranger in the ass, Larry.

mtndds's picture

There will be no right hike.  If they do then they will have another plan in the background that will offset the effects of the rate hike.

The Pope's picture

All this hand wringing 'FEDSPEAK' is ancient Hebrew code which translates to "No matter what you goy do, we're gonna front run your @sses in paper markets before & after until your @sses bleed"


I warned all of you about this a few months ago when PM's spiked. I said to STAY AWAY because the banksters would mainpulate the markets down just in time for the December FED meeting & the payout of year end bonuses.


Banksters can't be paying premiums to take physical PM's off the market now can they? My LCS has a 3-4 week delay on Ag bullion at the moment. FOR SOME STRANGE REASON, their shipments have become delayed over the past 2 weeks.

H. Perowne's picture

Long nooses and petrol. Also, we need to bring back breaking on the wheel.

Noplebian's picture
Noplebian (not verified) Looney Dec 2, 2015 1:57 PM
Lindsey Williams Latest – I Beg You, Watch These Video Messages From My Elite Friend Regarding The Next Fed Rate Hike......

cpnscarlet's picture

Ditto that...

Still worse - notice how Jim Sinclair was sounding just like Lindsey Williams with his August "We won't 't get past September" predictions - BAD SANTA!

thetruthhurts's picture

smack in the middle of the Great Great DEPRESSION!

LawsofPhysics's picture

The audit is important for the executions.


Yeah, that last rate hike worked well, didn't it ?

The end result was the Dirty Thirties.

Depression only alleviated by the start of World War Two.

The more things change, the more they remain the same.

. . . _ _ _ . . .'s picture

"It needed a world war for that."

History repeats.

Aaronson.Jones.Rutherford's picture

They will have their war one way or the other, it's China V USA & it's on the way whether we like it or not.

Government needs you to pay taxes's picture

This time around, the cartel has spooled up anywhere between 5 and 10 wars, simultanously.  So dont worry, be happy!

Demdere's picture

Yes, end the Fed.

Look at the balancing act they have to do : interest rates to keep the banks alive, interest rates to keep the country from busting the budget due to interest costs, and interest rates to keep the economy alive, and interest rates high enough to keep the electroate happy with politicians.  Fortunately, most of the people with real money are either Ds or too smart to be taken in by gov, so they aren't hurting and politicians aren't unhappy.

That equation probably can't be satisfied, but the Fed has neither the information nor the understanding to solve it if it could be.

They did a political balancing act on a tightrope favoring big money interests, not an economic balancing act that could favor us all. That can only be done by a real economy functioning without constraints. I do not view insisting on hones and opent behavior such as dealing with pollutants as constraints.

HowdyDoody's picture

Yes, end the Fed.

Look at the balancing act they have to do : Make humungous profits for the private members of the bank .... and some other stuff.


junction's picture

The SEC passed the uptick rule in 1938 to rein in Wall Street short sellers who, taking advantage of the Fed rate hike, went on a short selling spree and wrecked the U.S. economy again.  Wall Street short sellers in 2007 triggered the 2008 market collapse, after their accomplices running the SEC got rid of the uptick rule.  

From wikipedia: The U.S. Securities and Exchange Commission (SEC) defined the rule, and summarized it: "Rule 10a-1(a)(1) provided that, subject to certain exceptions, a listed security may be sold short (A) at a price above the price at which the immediately preceding sale was effected (plus tick), or (B) at the last sale price if it is higher than the last different price (zero-plus tick). Short sales were not permitted on minus ticks or zero-minus ticks, subject to narrow exceptions." 

The rule went into effect in 1938 and was removed when Rule 201 Regulation SHO became effective in 2007. In 2009, the reintroduction of the uptick rule was widely debated, and proposals for a form of its reintroduction by the SEC went into a public comment period on 2009-04-08. A modified form of the rule was adopted on 2010-02-24.


Immortal Flatulence's picture

Looks like this generation is going to be learning the frugal ways of our grand/great grandparents generation….and sooner than we think.

Either that, or we learn what it is like to live in a third world country...because we'll be one.

Or worse...both of the above.

Sudden Debt's picture

I don't think it will take a year to bottom out.

People are so scared that when the first newsflash about a crash pops up, they'll all try to sell.

50% in 2 weeks is more likely.

And in about 2 weeks, everything that pushed stocks higher is gone.

My bet is that the last week of this year, we'll start to go down.

One more week and I'm putting my cash where my mouth is.

Dre4dwolf's picture

I think everything is starting to go down, we really haven't re-captured that 18300ish top yet I think May was the top for the next 7 years or so.

Soph's picture

Shoulda never gone to 0 in the first place. Arguing that it can't go up now because things still suck is just nutty, and only perpetuates the problem. Gotta take the pain at some point, now is as good a time as any (should have been 7 years ago). Free money ain't helping things.

daveO's picture

The 'problem' = theft, government takeover of economy, according to plan. End the FED.

Tjeff1's picture

WW2 did not end the depression, that is a myth

Dre4dwolf's picture

When your country isnt being destroyed, and everyone dumps/invests their money into your country because its the only place on the planet not getting blown to shit, your country tends to do better economically.

If the U.S. was getting bombed to shit the Depression wouldn't of ended like it did.


This is why its best to stay out of foreign wars/entanglements for as long as possible, let everyone else blow eachother up and you come in at the end of the war to cleanup/take the profits.

Starting a war yourself is the worst thing you can do.


NoDebt's picture

Exactly right.  The US would have had to try real hard NOT to become an economic power house after WWII.  Only developed country that didn't have all it's infrastructure bombed flat coming out the back of that war and in a clear position of military dominance.  Worked good for a long time but, you know, eventually we fucked it up anyway.

Johnny Horscaulk's picture
Johnny Horscaulk (not verified) Dre4dwolf Dec 2, 2015 4:38 PM

+1. Economists like priests, stop seeing their assumptions as such and see their theories as immutable law..

Johnny Horscaulk's picture
Johnny Horscaulk (not verified) Tjeff1 Dec 2, 2015 4:36 PM

Its not an either or world.

Ask a historian - the destruction of europe as america was geared up to manufacture absolutely helped.

What - you think it was decisions economists made? The economists nade a bad situation worse from 33 on

Banker Buster's picture

Looks like a retest of the lows to me and perfectly natural.  What isn't healthy or natural are these V bottoms that never look back.  

CHoward's picture

Let's say the Fed raises it rates 0.25%(wow) in December.  I think there is going to be a LOT of people embarrassed when nothing - zip - nada - happens.  I can't believe the hysteria.  Pansies.

madbraz's picture

when $6 trillion in repo markets lubricate the ubber-leveraged system with rehypothecation, any increase in the cost of funds from zero can tip the scales violently.

MFL8240's picture

Sadly this group of idiots will try and raise rates and it will collapse this pathetic puzzle of lies they created with green shoots and made up reports.

billbengen's picture


Why draw their attention to this? Don’t you want better, cheaper stock prices?

AlltheWine's picture

Worthwhile comparing these diametrically opposed statements.  These fools clearly have failed to develop anything resembling internal consensus around what to do here and Yellen increasingly looks like a lunatic.

Brainard's comments last night:

Because we have more space to respond by raising rates if inflationary forces accelerate than by cutting rates if disinflationary forces emerge, when nominal neutral rates are likely to be lower on average, we should be cautious about raising rates, do so gradually, and carefully assess the effects on economic and financial conditions as we go. 

Yellen today:
Were the FOMC to delay the start of policy normalization for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of our goals. Such an abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into recession.
Dragon HAwk's picture

So somewhere in the Fed building, there are a couple terminals tuned in to Zero Hedge.. just for Humor mind you

 I wonder if they have a couple employees who have to read everything and write a report or something.

mayhem_korner's picture



I bet there are more than a couple.  As with all employers, not all of the employees are bought into what the place is doing.  It's a sure bet that there are some well read folks at the Fed.  But those aren't the ones writing the counterpoint reports.  That's still left up to the shills.

madbraz's picture

this is all very cute, but bridgewater is incorrect.  there was no sell-off in bonds, at least not in US Treasuries as 10 year yields decreased slightly.  corporate bond yields went up 100 basis points.

EdSav's picture

Keep a lid on it, Mr. Hedge. The last thing anyone wants is the fed to pull a BoE and not hike for eternity. 

Lmo Mutton's picture

You have to crush the economy before you crush the US.

silverer's picture

I'm waiting for the fiat paper to asswipe chart.  I don't think I'll be waiting too much longer.

Thomas Sowell's picture

Wars bring depressions, not booms. The only "benefit" might be fewer people. Young male people. With the increased sunshine people will probably see through the war as cover up for intentional free money bubbles.

larz's picture

Call me crayzee but i dont think the jeenyuss phd's at the fed nor ANYone else knows what the hell is going on. That would include myself

Thomas Sowell's picture

Smart - it's the new dumb. Most are not properly monetizing their smart-dumb potential myself included. 

litemine's picture

The Banks though have been funded.......Now with ownership over vast assets and unlimited fiat currency they will ride hard over everyone.  The fed is corrupt, backed by a Goverment lobbyests buy. All in America's Interests. Seems like various wars of different type on many fronts.

Obama stated that America has no friends......only opportunities.........Fuck the USA and their corruptions. It is your leadership you voted him in. Worldwide the USA is painted by the same brush.

Falling Down's picture

Just in time for the election cycle to heat up.



marts321's picture

Janet Yellen - queen of convoluted bullshit. Tomorrow the s&p begins it's main descent.

Raymond_K._Hessel's picture
Raymond_K._Hessel (not verified) Dec 2, 2015 2:29 PM

maybe its just me, but - I dont think comparing Aug’36 & May’37 to current circumstances is even in the solar system of reasonable.

Got confounds?

herkomilchen's picture

Agreed.  Economic conditions and markets are so fundamentally different then compared to now, that's it's dumb to think that past will predict our future.

Ajax_USB_Port_Repair_Service_'s picture

I'm thinking rate hike in December. Then, Obama can play the hero in January. During the State of the Union Address, Obama can announce a rate cut and a helicopter money drop for the masses.