Viewpoint: The Federal Reserve will not cut interest rates in the short term, but a recession is inevitable, testing global risk assets

Authors: Anna Wong, Tom Orlik

Compiled by: Joey Wu Talks Blockchain

This article excerpts a piece from Bloomberg to summarize some key economic data and thereby make a subjective judgment on whether the U.S. economy can achieve a soft landing in the next six months.

The article mainly expresses two core viewpoints: First, the data that truly reflects economic conditions are U.S. Treasury yields, unemployment rates, deposits and loans, and oil prices. Second, whether a recession occurs is a nonlinear issue, requiring us to make a distribution forecast of future data, but people tend to derive conclusions based on current known data such as CPI, PCE, GDP, and non-farm employment using a linear thinking logic.

This summer, inflation data gradually declined, job opportunities remained abundant, and consumers continued to spend, all of which enhanced the confidence of the public and the Federal Reserve that the U.S. would avoid a recession. When everyone is anticipating a soft landing, be prepared for a hard landing. This is a lesson from modern economic history, and for the current U.S., it is an unsettling lesson.

The following lists six statistical data points to analyze whether the U.S. can avoid a recession. The data includes calls for a "soft landing," U.S. Treasury yields, oil prices, unemployment rates, deposits, and loans.

1. Calls for a "soft landing"

"The most likely outcome is that the economy will move toward a soft landing." This was said by then-President of the San Francisco Federal Reserve, Janet Yellen, in October 2007, just two months before the Great Recession began. Yellen was not the only optimist. Surprisingly, calls for a soft landing are always high before a recession.

Editor’s note: The gray area in the above image represents the period of recession, while the bar chart represents articles or news about "soft landing" in the media. Aside from the brief recession in 2020 caused by the sudden pandemic, there was little discussion about recession prior to the other two recessions, where calls for economic soft landing were quite high.

Why is it difficult for economists to predict recessions? One important reason is that people use linear thinking to predict recessions, while recessions are nonlinear events.

2. Unemployment rate

The unemployment rate is an extremely important key indicator of economic health. The Federal Reserve's latest forecast is that the unemployment rate will rise from 3.8% in 2023 to 4.1% in 2024, based on a linear prediction of current data trends, leading to the conclusion that the U.S. will avoid a recession.

But what if the data suddenly drops significantly during an upward trend? Based on this, Bloomberg has established a distribution model to predict the unemployment rate.

Editor’s note: The dashed line in the figure represents the unemployment rate predicted by the linear model, with the deep yellow representing the unemployment rate distribution range at a 68% confidence level, and the light yellow representing the distribution at a 95% confidence level. Therefore, there is about a one-third probability that the unemployment rate could spike above 7%.

Currently, the strike of U.S. auto workers has expanded to about 25,000 workers. The long-term supply chain shutdown in this industry could have an impact beyond the normal range. In 1998, a 54-day strike by 9,200 General Motors employees led to a drop in employment of 150,000.

Optimists for a soft landing point out that the stock market has performed well this year, manufacturing is bottoming out, and the housing market is also hot. The problem is that these are all areas that respond most quickly to monetary policy. However, the most important economic data for determining whether a recession occurs is the labor market, which typically lags by 18 to 24 months. This means that the impact of interest rate hikes on the unemployment rate will not be felt until the end of this year or early 2024. Moreover, the Federal Reserve has not even stopped raising interest rates.

3. Oil prices and U.S. Treasury yields

Oil prices are one of the truly reliable recession warning indicators because rising oil prices suppress consumer spending in other discretionary areas. Current oil prices have risen nearly $25 from summer lows, breaking through $95 per barrel.

Yield curve: The sell-off in September pushed the yield on 10-year Treasury bonds to its highest level in 16 years, reaching 4.6%. Long-term high borrowing costs have pushed the stock market into a downward channel. They may also plunge the housing market into crisis and hinder corporate investment.

Editor’s note: The left side shows oil prices, while the right side shows the yield on 10-year Treasury bonds. The following editor analysis section will focus on why rising long-term Treasury yields are the most alarming signal.

4. Deposits and loans

The core of the soft landing argument lies in strong household spending. Unfortunately, history shows that this is not a good indicator for judging whether a recession is imminent; on the contrary, consumers usually continue to spend robustly until the recession threshold is reached.

Moreover, the extra savings that Americans accumulated during the pandemic largely came from government subsidies, and these are now about to be exhausted, with the speed of depletion being contentious. Bloomberg's calculations show that the poorest 80% of the population now have less cash on hand than before Covid.

In contrast to the continuous decrease in deposits, credit card default rates are soaring, especially among young people. Following closely is the auto loan market, and finally the mortgage market, as mortgage defaults are the most lagging. Additionally, there is student loan data, as millions of Americans will begin receiving student loan bills again this month, marking the first time since the three-and-a-half-year freeze, and the resumption of repayments could reduce annualized growth by 0.2-0.3% in the fourth quarter.

Furthermore, credit tightening has only just begun. Below is a loan indicator with significant warning capability: the Federal Reserve's survey of senior loan officers, known as SLOOS.

The latest data shows that about half of large and medium-sized banks are adopting stricter standards for commercial and industrial loans. This is the highest proportion since the 2008 financial crisis, except during the pandemic. Its impact will be felt in the fourth quarter of this year—when businesses cannot easily borrow, it usually leads to weakened investment and hiring.

Interpretation: The Inevitability of Recession from Unemployment Rate, Deposits, Loans, and U.S. Treasury Yields

1. High calls for a "soft landing" do not support the conclusion of a recession

When discussing whether the U.S. will enter a recession on social media, an interesting phenomenon occurs: optimists say that since everyone believes a recession is imminent, can a recession still happen? Pessimists express the same sentiment.

This is a typical confirmation bias. Once you preset a conclusion in your mind, you will unconsciously seek evidence that supports this conclusion. Therefore, optimists see the public's call for a recession happening, leading to a sense of satisfaction in being the only one awake; pessimists feel the same way.

So, do all people believe a recession will happen or that it will not happen? Rather than feelings, I prefer to look at data. Bloomberg's data shows how high the current calls for a "soft landing" are.

But I cite this article not to express that the public is overly optimistic, so a recession must happen; on the contrary, I believe that the more optimistic the public is, the more conducive it is to economic recovery. The reasoning is simple: this is the economy, not the stock market. "Be greedy when others are fearful, and be fearful when others are greedy," is the logic of stock trading, not the logic of economic development. For a consumption-driven country, economic development heavily relies on public confidence. The more confidence the public has in the future, the more likely consumption will remain strong, and the less likely a recession will occur.

Therefore, I do not agree with the first data point of this article. So why do I still believe a recession is coming?

Because what the American public currently lacks is not confidence, but money!

2. Unemployment Rate, Deposits, and Loans are the Underlying Logic Leading to Recession

I strongly agree with one point in this article, which is that recessions are nonlinear events, and we cannot draw a linear conclusion from known data. The reason optimists believe U.S. consumption is very strong is based on current non-farm employment, household consumption expenditure, and other data, but based on historical experience, American residents' consumption tends to remain strong until a recession occurs.

What data can truly predict future consumption levels? Unemployment rate, deposits, and loans! A person's money is either earned, saved, or borrowed; if all three sources are decreasing, what reason do we have to believe that consumption will continue to remain strong?

This is also the greatest value of this article, succinctly explaining the underlying logic of recession. Among them, the unemployment rate data and deposit data presented by Bloomberg have a relatively short time span, so the editor cites the following images as a supplement. It can be seen that the unemployment rate among American residents has begun to show a sharp upward trend, and deposits are nearly depleted.

Consumption contributes over 80% to the U.S. GDP. Now, 80% of American residents have less cash on hand than before Covid, bank loans are tightening, and loan default rates are climbing. In this situation, once the unemployment rate begins to turn upward, a recession will be inevitable.

Moreover, the surge in oil prices may become the last straw that breaks the consumer's back.

3. U.S. Treasury Yields

The yield spread between the 10-year and 2-year U.S. Treasury bonds is a well-known leading indicator of recession, but its underlying logic is not as intuitive as the aforementioned unemployment rate data. Additionally, since it is a leading indicator, the economy is usually still quite strong when the yield curve inverts, and this strength often continues until the inversion ends. This is why people often forget historical lessons when the inversion is about to end, believing this time is different.

The same is true this time. The yield curve inversion began in April and July 2022 (April was only a brief inversion, but the inversion since July has been long-term), and it has now lasted over a year. Thus, we find that the current market's concern about the yield curve inversion is far less than it was a year ago, and people are starting to believe this time is different.

However, the reality is that the economic conditions during this inversion have not been better than in the past; in fact, they are worse.

The current fiscal situation in the U.S. is deteriorating, with the fiscal deficit reaching $1.5 trillion in the first 11 months of the 2023 fiscal year, a year-on-year increase of 61%. Therefore, continuing to issue debt has become inevitable. After relaxing the debt ceiling in early June, the U.S. Treasury has net increased its debt by $1.7 trillion in just four months. As of October, the total federal government debt has exceeded $32 trillion (including debt held by the government itself), with an increase of over $2 trillion this year.

This debt level is no longer comparable to that of 2008, when the two major holders of U.S. debt—Japan and China—are now either unable or unwilling to take on such a massive amount of debt. Therefore, the U.S. Treasury market currently lacks buyers, resulting in falling Treasury prices and rising yields. This is also why we have seen the yield on 10-year Treasury bonds continuously climb since July, leading to an upward turn in the yield spread.

The reason I believe the background for this yield curve inversion is worse is that historical yield curve inversions were resolved by lowering short-term bond yields, i.e., through interest rate cuts. As long as the Federal Reserve starts cutting rates, short-term bond yields will immediately turn downward. This method at least stimulates economic recovery. Although a recession ultimately still occurs, the duration of the recession is not long.

However, this time, the resolution of the yield curve inversion is being achieved by raising long-term bond yields. Long-term bond yields reflect the market's long-term expectations for U.S. interest rates, and their upward trend indicates that the market's expectations for the Federal Reserve to maintain high interest rates for an extended period are rising. In the economic realm, the 10-year U.S. Treasury yield is often regarded as the anchor for asset prices, as it serves as the "denominator" in asset valuation processes; thus, its rise will inevitably lead to a decline in the valuation of other assets. Since July, this upward trend has triggered a series of downward trends in the stock and cryptocurrency markets. If the market's expectation of the Federal Reserve is to maintain high interest rates for the long term, then this downward trend is likely to be difficult to stop.

More importantly, long-term bond yields represent the level of debt risk in the U.S. The surge in long-term bond yields indicates that the likelihood of a U.S. debt default is rising sharply.

To lower long-term bond yields, the only way is to find more buyers. There are only two ways to increase buyers: one is to continue maintaining high interest rates to attract more funds to purchase Treasury bonds; the other is to expand the balance sheet, accelerate money printing, and continue borrowing new debt to pay off old debt.

If the second option is chosen, it is tantamount to drinking poison to quench thirst; this year's new debt issuance will likely exceed $2 trillion, equivalent to a 6.5% increase in total debt. If this continues, the scale of debt will accelerate exponentially. The final result is that no economic entity will be able to bear it, and it can only watch it spiral upward until a debt default occurs.

This is also why I believe the Federal Reserve will not cut interest rates in the short term, because only by continuing to maintain high interest rates can it attract more funds to purchase Treasury bonds without further increasing the debt scale, thus avoiding a debt default. Debt stability and dollar stability are closely related; once debt collapses, the dollar loses its credit foundation, and once the dollar collapses, the foundation of the U.S. will be shaken.

When it comes to issues involving the foundation of the nation, economic recession seems less important; after all, the U.S. has experienced recessions before, and this one is simply longer.

Conclusion

This article uses a piece from Bloomberg to emphasize four data points that I believe can effectively predict future economic conditions: unemployment rate, deposits, loans, and U.S. Treasury yields.

Among them, the unemployment rate and deposits and loans predict future consumption conditions. Because consumption contributes 80% to the U.S. GDP. Currently, the deposit levels of American residents have dropped to pre-pandemic levels, second only to 2007. Moreover, credit card default rates and the degree of bank credit tightening have also reached their highest levels since 2007. Most importantly, unemployment rate data has begun to turn upward.

Therefore, a sharp decline in household spending among American residents in the coming year is likely a high-probability event.

Finally, by inferring the current debt situation in the U.S., it is concluded that the Federal Reserve is unlikely to cut interest rates in the short term, leading to the conclusion that a recession is not only unavoidable but may also last longer than previous ones.

This poses a significant test for global risk assets, as evidenced by the high calls for a "soft landing," indicating that risk expectations have not been priced in.