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