Make Or Break Time For The Fed... And Us

Written by Adam English
Posted October 3, 2018 at 4:07PM

It has been most of a decade in the making, but we're coming up on a critical moment.

The Fed is rapidly approaching a period of time when it needs to thread a dangerous needle.

If it misses its mark, the economy is going to plunge towards recession, possibly one far worse than the last.

In the past, it has proven incapable of doing it well. Each time, the smartest people in the room think they are going to get it right. For the past half-century, they have been wrong every time.

If it only had to work with the two headline variables — the Fed fund rate and GDP — everything would be great. It'd be a problem a grade schooler could manage.

If only. Instead, there is a whole host of problems that are going to come to a head over the next couple years all at the same time.

The Long List

Where should we even begin with what to factor in?

We can start with ballooning deficits and total debt in the U.S. Both have increased dramatically as tax cuts were passed and Congress utterly failed to keep spending flat.

We can extend that out to total global debt. That's up to $247 trillion now by some estimates, 11% up in just a year.

While we're at it, we can add a very strong dollar that probably won't continue to stay above the 14-year average through next year. It's only doing well because everything else looks increasingly terrible. Some of the currencies out there are all but guaranteed to collapse under the weight of national debts, destroying capital, and sending money fleeing elsewhere.

I'm looking right at you, Turkey. Italy is number two on the list with its Finance Minister's effort to promote his government’s new fiscal strategy ending in utter failure.

Specters of the Greece implosion are appearing in major economies yet again.

The trade war will hurt the U.S. economy at a time when the one-year pop from the tax cuts wears off, and as it is predicted to cool down by about half a percent by optimistic estimates.

The Fed has to navigate all of this far better than it would in more “normal” times too. After all, it is steadily pushing rates straight towards an inverted curve.

The timing couldn't be worse.

False Hope And Ignorance

Mid-September, Federal Reserve Governor Lael Brainard stood up in front of the Detroit Economic Club and said something a lot of her predecessors clearly thought, and got very wrong.

She sees no reason that the Federal Reserve should avoid pushing us into an inverted yield curve because it wouldn't necessarily lead to a recession.

She claimed that she is “attentive to the historical observation that inversions of the yield curve between the 3-month and 10-year Treasury rates have had a relatively reliable track record of preceding recessions.”

But she thinks this time is different. Famous last words, and ones that anyone "attentive to historical observation" should know to avoid.

Let's see the track record, taken with all due respect from Dr. Horstmeyer at George Mason University’s Business School.

There are a couple things to note here. First a little caveat, this is the 2-year versus 10-year Treasury rates. Slightly different than the 3-month versus 10-year mentioned above, but very similar.

Second, note the time period when inverted curves did not precede a recession. The U.S. was a very different place. The economy was neck deep in the New Deal and WPA era and going into the fixed wartime economies of the World Wars.

Then it carries through the period when virtually all global currencies were based on the U.S. dollar, which was still theoretically backed up by, and convertible to, gold by sovereign nations.

Of course the yield curve didn't invert before recessions. There were functionally no other options BUT bonds based on the U.S. dollar with massive government intervention, and it was the golden age of Pax Americana.

Plus, there were no collateralized debt obligations or algorthmic trading systems that could tank prices in seconds. Bond trading desks were the sleepy backwoods of the investing world.

Bond holders had to grit their teeth and hoped for the best. It was all that could be done.

As the post-war system gradually loosened — especially after the Nixon shock which ended the link between the U.S. dollar and gold overnight and sent global currencies reeling — realistic market forces took over, and inverted curves predicted recessions 100% of the time over the last half-century.

In Conclusion...

The point of all this is just to reinforce that the Fed is facing one of its most defining moments in its history, and everyone is affected by how it has been lulled into complacency.

I'm afraid it is abundantly clear that this even includes the experts in the ivory tower.

And on a final note, look back at the performance of various investments one year and two years after an inversion.

Gold and bonds stand out. The rest suffer dramatically over the first year and on average start climbing out around two years.

On average... Do you think with U.S. debt over $20 trillion and global debt at about $250 trillion it will be average this time around?

All signs point to it being a dangerous time to be complacent, and a wonderful time to make sure you have some of your money in gold.

You don't have to go full gold bug, just keep some of the best investments in the sector tucked in your portfolio.

Whether it is just a small allocation to hedge or one designed to build wealth, now is the kind of time when it can really pay off.

Take care,

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Adam English

follow basic @AdamEnglishOC on Twitter

Adam's editorial talents and analysis drew the attention of senior editors at Outsider Club, which he joined in mid-2012. While he has acquired years of hands-on experience in the editorial room by working side by side with ex-brokers, options floor traders, and financial advisors, he is acutely aware of the challenges faced by retail investors after starting at the ground floor in the financial publishing field. For more on Adam, check out his editor's page

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