Don’t shoot the messenger: The next recession is unavoidable and is programmed into everything we see right now. In fact, recent tax cuts may end up being the trigger of this next recession and that reality may slowly be dawning on some market participants. Hence I call it the Tax Cut Recession.
Let me walk you through the evidence.
Firstly let’s start with a macro chart which I think is super key here. Macro of course moves at a glacial speed, but from my perch it’s all coming together in a major way.
Many of my readers may have seen this chart combination of the S&P 500, the $VIX, the ratio of $SPX and $TNX (the 10 year yield) and unemployment showing us at to be nearing the end of an employment cycle:
Of particular interest has been the relationship between $TNX and $SPX, the heads and shoulders pattern in particular (Ultimate Bear Chart). My thesis has been that markets have been engaged in a 30 year exercise of ever lower managed rates to sustain macro economic growth and fix the damage of corrections and bear markets and these ever lower rates have enabled the largest debt expansion in human history helping mask structural problems underneath.
Recent highs and recent rallies have not been able to change the trajectory of this $SPX/$TNX ratio. Why? Because rates have been moving higher and the ratio needs lower rates to move up, unless stock gains are outweighing the rise in yields, which they haven’t been able to do. So yet again markets need lower yields to avert a breakdown in the ratio.
Now the Fed has been slowly trying to raise rates again in this cycle and history shows that the jig is up at ever lower highs in the fed funds rate hike cycle before the next recession hits:
None of this is new, but what is new is that the Fed is already freaking out and rightly so.
The short end has been screaming higher:
This all has consequences. Remember TINA? There is no alternative? Well, there is now:
And perhaps this partially explains why all of a sudden dividend yielding sectors are struggling, i.e $XLU:
But more importantly perhaps it highlights why everybody is freaking out about the yield curve:
They are worried about an inversion clearly.
Here’s the Fed’s Bullard yesterday:
“I do think we’re at some risk of an inverted yield curve later this year or early in 2019,” Bullard said. “If that happens I think it would be a negative signal for the U.S. economy.”
Even some market bulls are starting to get cautious. Here’s Tom Lee yesterday:
So the coast is clear until it inverts right?
Unclear from my perch, because history suggests another possibility, the inversion following a market peak:
The pattern on the yield curve is bullish as it is, technically it looks it’s only a question of when it inverts not if.
In 2000 one could argue that the popping of the Nasdaq bubble actually produced the inversion and not the other way around, that’s at least the timeline on the chart.
My premise: The recent tax cuts will force the inversion and thereby bring about the next recession.
As many of you know I have been highly critical of these tax cuts and I won’t rehash the arguments here (Tax Scam, Hangover), but to reiterate my original thesis: Wrong policy at the wrong time ultimately benefitting the few and blowing up deficits and debt and leaving the US out of bullets during the next recession.
Tax cuts are supposed to be a stimulus tool when the economy is in trouble to spur investment and incentivize growth. These tax cuts are spurring buybacks:
But perhaps worse: They are forcing a massive amount of debt financing at higher rates virtually guaranteeing a massive rise in the 10 year.
“To meet the growing debt load, the U.S. will have to issue more bonds at a time when the Federal Reserve is no longer a player in the market.
More supply and fewer buyers will mean the government will have to pay investors more to buy U.S. debt. And that will mean higher interest rates.
Goldman specifically projects the benchmark U.S. Treasury note will be yielding 3.6 percent by the end of 2019, up from a shade below 3 percent where it’s trading now and at a point where it could start applying pressure to economic growth.
“The sizeable demand boost provided by the recent deficit-increasing tax cuts and spending cap increases at a time when the economy is already somewhat beyond full employment is a striking departure from historical norms that is likely to contribute to further overheating this year and next and tighter monetary policy in response,” Goldman economists Daan Struyven and David Mericle said in a report for clients.
“The unusual increase in the deficit is even more surprising because it comes at a time when the federal debt-to-GDP ratio is already approaching historical highs,” the economists wrote. “The resulting increase in Treasury issuance will require the public to absorb considerably more government debt in coming years.”
The rising deficits likely will be responsible for 30 of the 60 basis point rise that Goldman is predicting.”
This is huge as deficits are now a massive perpetual mathematical reality:
That’s without a recession. And we already see the consequences this early in the process:
Federal Budget through April for 2016, 2017, 2018
Interest on debt +36%
Corporate taxes -24%
Individual Taxes +11%
Social security +8%
Total Outlays +5%
In case you’re wondering who really benefits from the tax cuts pic.twitter.com/qDf5k2NZng
— Sven Henrich (@NorthmanTrader) May 14, 2018
The fastest growing line item is interest on debt expense and it will balloon higher. Corporations pay massively less in taxes and will not contribute, in fact their lack of contribution will accelerate the deficit finance requirements.
The main message: The US government being forced to finance ever more debt will cause the inversion of the yield curve and the next recession and there is nothing the Fed can do to stop it. Bullard knows it hence he’s already ringing the warning bell.
And guess what: This all means that this $TNX $SPX ratio heads and shoulders pattern will trigger unless bulls can get a massive blow-off rally:
It’s preprogrammed into the macro structure now.
What’s the main message of all this?
There are large levers influencing these markets and the demand and supply equation in debt issuance has enormous consequences. Technicals give us a lot of insights, but from my perch these big macro levers are moving, and they are moving against bulls in a major way.
I can’t say when the yield curve inverts, but I can tell you the US government is forced to issue debt like a bandit, the amounts are about to reach the peak levels of the financial crisis in 2009:
The numbers are staggering:
The U.S. Just Borrowed $488 Billion, a Record High for the First Quarterhttps://t.co/KVRmJTBsyN
— Sven Henrich (@NorthmanTrader) April 30, 2018
“Tax cuts pay for themselves” Treasury Secretary Mnuchin pic.twitter.com/6jBe9YMF7F
— Sven Henrich (@NorthmanTrader) April 30, 2018
But it’s not only the US government. Corporations, having taking on the largest debt burdens since before the financial crisis are facing a mountain of debt refinancing to come:
“Companies will need to refinance an estimated $4 trillion of bonds over the next five years, about two-thirds of all their outstanding debt, according to Wells Fargo Securities. This has investors concerned because rising rates means it will cost more to pay for unprecedented amounts of borrowing, which could push balance sheets toward a tipping point. And on top of that, many see the economy slowing down at the same time the rollovers are peaking.
“If more of your cash flow is spent into servicing your debt and not trying to grow your company, that could, over time, if enough companies are doing that, lead to economic contraction,” said Zachary Chavis, a portfolio manager at Sage Advisory Services Ltd. in Austin, Texas. “A lot of people are worried that could happen in the next two years.”
The Fed is not buying this debt.
And this is why the 10 year keeps poking higher:
Remember, that the $TNX $SPX ratio chart requires lower yields and rising equities to NOT break its neckline. If yields keep rising it would require an asymptotic blow-off topping move in equities to prevent the breakdown, but that seems ever less likely as higher rates and rising prices will cut ever more into the disposable income of consumers and eat away at any tax cut benefits.
Take crude price as an example:
“While the tax cuts have lifted take-home pay for the vast majority of workers, rising gasoline prices are eating into that benefit,” Morgan Stanley said in a note to clients this week”.
And be clear: Personal interest payment expenses have been rising already:
The benefit of temporary tax cuts for average Americans becomes less obvious if rising rates and prices eat away at the supposed benefit. And once tax cuts expire consumers will still have hight prices and rates to contend with. The net long term effect: Recessionary.
The Fed is trapped and it explains their ever so cautious approach in raising rates. They are concerned about inverting the yield curve, hence Bullard is opposed to rate hikes.
The larger problem: As debt issuances will continue to balloon the Fed CAN’T cut rates if debt issuance will force rates higher and the yield curve will invert no matter what. Done. And there’s your trigger for the next recession, one that was accelerated by unfunded tax cuts forcing the US government to massively increase their debt issuance at a time when the Fed was leaving markets.
The only choice the Fed will eventually have to influence this new supply demand equation in the debt markets is to go back to being a player in the very market they left. In short: QE is coming back. It’s just a matter of when, not if.
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