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BEAR MARKET WATCH  •  March 23, 2023  •  Jon Wolfenbarger

What Could Go Wrong With Fed Tightening Into A Banking Crisis And Recession?

ANTWERP, BELGIUM — As expected, Jay “Transitory Inflation” Powell raised the Federal Funds rate by 0.25% to 4.75%-5.00% and reiterated the Fed’s plans to continue to shrink their balance sheet with “Quantitative Tightening”.

Powell said rate cuts are not in their base case and the Fed “anticipates that some additional policy firming may be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time.” 

The Fed reiterated their expectations for the Federal Funds rate to end 2023 at 5.1%, the same as their expectation in December. However, they raised their Federal Funds rate expectation for year-end 2024 from 4.1% to 4.3%, which signals rates being “higher for longer”, which is more hawkish than expected.

Acknowledging the banking crisis they helped create, the Fed said “Recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation. The extent of these effects is uncertain.”

Powell said he still thinks a “soft landing” (i.e., no recession) is “possible”, but the longer the banking crisis lasts, the lower the chances will be. In other words, don’t bet on it!

Meanwhile, Treasury Secretary Janet “Free Lunch” Yellen reiterated the government does not plan to support bank stocks and bonds, saying ”It’s important to be clear: shareholders and debtholders of the failed banks are not being protected by the government”. She also added "no losses from the resolution of these banks are being borne by the taxpayer,” which raises the question of who will be paying for the free lunch to bail out banks from this crisis.

The market currently estimates a 52% chance of another 0.25% hike in May and a 48% chance of no hike. We’ll see how that changes as the banking crisis and recession unfolds.

Leading Economic Indicators Continue To Flash Recession Warning

The Conference Board’s Leading Economic Indicators (LEI) continue to warn of an impending recession and they do not yet reflect the emerging banking crisis.

Justyna Zabinska-La Monica, Senior Manager of Business Cycle Indicators at The Conference Board, explained their latest LEI report:

“The LEI for the US fell again in February, marking its eleventh consecutive monthly decline. Negative or flat contributions from eight of the index’s ten components more than offset improving stock prices and a better-than-expected reading for residential building permits. While the rate of month-over-month declines in the LEI have moderated in recent months, the leading economic index still points to risk of recession in the US economy. The most recent financial turmoil in the US banking sector is not reflected in the LEI data but could have a negative impact on the outlook if it persists. Overall, The Conference Board forecasts rising interest rates paired with declining consumer spending will most likely push the US economy into recession in the near term.”

Source: https://www.conference-board.org/topics/us-leading-indicators

Many “experts” say a recession is virtually impossible given the continued growth of GDP. But GDP is not a leading indicator of recession.

As the following chart shows, the LEI (blue line) historically signals recessions long before GDP growth (gray line) turns negative. In fact, GDP growth never turned negative in the early 2000s recession, when the NASDAQ fell over 80%. Note that GDP growth has already slowed to levels seen in the first part of the early 2000s and 2008-2009 recessions.

Source: https://www.conference-board.org/topics/us-leading-indicators

Industrial Production Is Now Declining

The Industrial Production Index is one of the key coincident indicators of the business cycle. It measures real output in the manufacturing, mining and utilities industries and is produced monthly by the Federal Reserve.

The leading indicators predicted Industrial Production would decline as a recession starts. Like clockwork, Industrial Production is now declining (albeit only -0.25% so far), as it typically does at the beginning of a recession, as shown in the graph below (with recessionary periods shaded gray).

Stocks Are On The Precipice

Despite a banking crisis and signs of a recession, the S&P 500 is only down 17% from its peak in early 2022, after having fallen 28% through mid-October. Incidentally, every single time the S&P 500 has fallen that much over that length of time, there was a  recession. But there has been a lot of back-and-forth churning in the market in recent months and the S&P 500 is still where it was in May of last year. This has been frustrating for both bulls and bears.

As the following chart shows, the 36-month moving average (36-mma) usually provides support for stocks in pullbacks…except when there is a major bear market, such as in the early 2000s and 2008-2009. 

The S&P 500 broke below the 36-mma in September, but bounced back above it in October. It is currently about 1% above the 36-mma. A clear break below it will likely signal significant downside to come, as it did in the last two major bear markets.

Implications For Investors

The Fed continues to tighten monetary policy with rate hikes and Quantitative Tightening, despite the banking crisis and signs of a recession. This is the opposite of their behavior during the major bear markets of the early 2000s and 2008-2009, when they slashed interest rates in vain.

As a result, we believe much more stock market downside potential exists, which will likely occur after the S&P 500 decisively breaks below its 36-mma.