One – Yield Curve Inversion

Despite the Fed’s gradualist approach, there is a real risk that they may unintentionally shift into “high gear” with regard to QT (quantitative tightening). According to economic theory, neutral monetary policy typically goes hand-in-hand with a slightly positive yield curve. At the time of writing, the yield curve is flat.

As short-term rates pose less inflation risk as long-term yields, risk premiums tend to rise with maturities. Without a positive yield curve, financial institutions will find it difficult to profit from “borrowing short and lending long,” as the CME analysts explain.

Short-term credit means higher interest payments, mainly affecting commercial businesses that depend on it. On the consumer front, however, rising short-term rates affect mostly home mortgages, making them less attractive.

This condition can worsen if the yield curve moves from its flattened state to an inverted state–a condition in which short-term yields are higher than long-term yields. Inverted yield curves are a strong indicator for future recessions as early as 12 months from the moment of inversion.

 

But another dangerous factor to consider is debt, particularly debt coming from the Federal government.

Right now, two of the largest economies across the globe–US and China–have seen rising debt levels. To be fair, moderate debt increases have been known to “sustain” economic growth, the operative word being “moderate.”

This may not be the case for much longer, at least for the US. As interest rates rise, so do the interest payments. Higher debt loads therefore mean an increase in economic fragility.  

 

Two – Emerging Markets Turmoil

It’s well known that emerging markets economies tend to respond poorly to US Fed monetary tightening. We saw this in Venezuela in 1979, and again in Mexico and Asia in 1994 after the Fed’s rate hikes.

When emerging market economies borrow in US dollars, rate hikes can often disrupt their domestic currencies as the debts become difficult to service, making such events “growth killers.”

Considering that emerging market nations’ participation in the global economy has increased significantly over the last few decades, any disruption to their domestic economies will have a significant impact on global growth. And such disruptions are what we are seeing unfold at the present time.

 

Three – Trade War

Prior to the current “reboot,” trade wars were a relic of the past, its heyday dating back to the 18th and early 19th century. And if you’ve been following coverage on the current trade way, you’ll notice that best and brightest can only speculate its overall effect on the global economy, ending with an admission that we really don’t know what will come out of it.

To take a sober look at the current trade war, let’s begin by stating what we do know. Trade wars raise costs across the supply chain, decreasing corporate profits over a wider spectrum. Also, hurting China’s economy may have a negative impact on growth across a significant portion of the global economy.

But the main risk of the trade war is that it is happening at the worst possible time–that is, during a period of rising rates and emerging market disruptions.

What might this mean? It means that the US economy may look great but only from where we are and where we’ve been.

With the risks of recession stemming from rising rates and emerging market disruptions, the trade war may be the final stroke that plunges our economy toward the recessionary depths that we already know is not only looming but inevitable.

 


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