How the Fed Has Caused Every Recession

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US stocks treaded water overnight. The Dow and S&P 500 went nowhere.

The main moves are happening in the currency markets. The US dollar continues to strengthen — more recently against the Japanese yen. This is due to the increasing likelihood of a US rate rise in December.

Gold is certainly worried about the impact of higher rates. Bullion fell another US$10 an ounce overnight. It now trades around US$1,250 an ounce, right at the $1,250 an ounce level I mentioned yesterday.

The reason I mentioned that point is because it represents an important Fibonacci retracement level. The idea is that, after strong rallies, it is natural for any market to give back (retrace) some of the prior gains before resuming the rally.

Fibonacci numbers are a mathematical sequence occurring in numerous places in the natural world…including human anatomy! The rationale for applying it to the stock market is that stock moves are the result of human nature. For this reason, stock prices should also (from time to time) display similar characteristics.

The chart below shows the Fibonacci retracement levels based on gold’s recent stellar advance. The rally got underway in December 2015 and peaked in July, so I use those as the start and end points to work out potential retracement levels.

As you can see, the recent gold correction sees it right on the first (61.2%) retracement level. Gold should find support around here, at least in the short term.


Source: Optuma
[Click to enlarge]

A word of caution, though: I wouldn’t suggest trading these levels. Although it is uncanny how often prices bounce off Fibonacci support, you never know which level support will come in at.

The more important takeaway is to realise that it is not unusual for prices to retrace 50% of their prior gains in a bull market. Therefore, gold could correct all the way back to around US$1,210 an ounce and still be in a long term bull market.

I think that is a lower probability outcome. The way I see it, if gold is now pricing in a December rate hike, most of the damage is done.

There are two reasons for this. Firstly, it would only take one poor data release for the market to suddenly lower the odds of a December hike. We know how timid the Fed is; it will err on the side of caution if the data warrants it.

On that front, tonight, in the US, sees the release of the non-farm payrolls data. That always has a big effect on markets. The current guesstimate is for jobs growth to come in around 172,000. Any number well above or below that will result in some pretty extreme price moves.

Notwithstanding the short term effect on gold of strong employment numbers, the other reason to think gold’s correction is almost done is that an interest rate rise will likely lead to slower economic activity.

The Fed has precipitated just about every post-war recession by raising interest rates, and this time will be no different. I remember making this point in a 2014 essay. Here’s the updated chart I used at the time.


Source: St Louis Fed
[Click to enlarge]

It shows the Fed funds rate (official US interest rates); the shaded lines represent US recessions.

Notice how rising interest rates preceded EVERY SINGLE recession! In other words, as economic activity picked up, the Fed sought to ward off inflation and raise rates. Rising rates then led to an economic contraction.

The other thing to note is that, prior to the 1980s, recessions tended to be more frequent, and of longer duration. But after Fed boss Paul Volcker dealt with inflation in the early 1980s, recessions were less intense and further apart.

That was due to the fact that monetary policy became the main instrument to fight the business cycle. And it was very effective. So effective, in fact, that it led to the wild real estate bubble of the mid-2000s (predicted, by the way, by Cycles, Trends and Forecasts guru Phil Anderson).

Greenspan then panicked and tried to raise rates to cool the market. But it was too late. Higher rates simply popped the bubble. What followed was the deepest US recession since the 1930s.

His successor, Ben Bernanke, took the helm and cut rates sharply in 2008 and beyond. But as you can see from the chart, something had fundamentally changed in the US economy. It could not handle a return to ‘normal’ rates.

That tells you the return on incrementally invested capital (in the aggregate) is very low. Therefore, the natural rate of interest, which approximates this return on capital, is also very low. (This is why you’re seeing speculation take over real investment.)

The risk is that even a few interest rate rises from such low levels will lead to another recession. I think that is a very real risk, which is why I see limited downside for gold from here.

The problem for the US (and global) economy was that the 2008/09 recession, despite being a deep one, didn’t really do the job of a recession. That is, it didn’t clean out the excesses. Bailouts were the name of the game. That’s why you’ve seen tepid growth ever since.

And as the Fed tries to normalise rates, chances are that history will repeat and they’ll lead the world into another recession. If that happens, expect stocks to fall hard from here.

Cheers,

Greg Canavan,
For The Daily Reckoning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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