Almost every recession in history has been preceded by speculation that the economy is in for a “soft landing.” After the early warning signs, nothing much happens. The stock market keeps climbing despite rising interest rates, raising hopes of a “lucky escape”.
The four most expensive words in the English language are: “This time it’s different.” ~ Sir John Templeton
The economy takes time to adjust to changed circumstances and there can be a lag of two years or more between the first rate hikes and the inevitable rise in unemployment. Plenty of time for self-delusion as stocks keep rising and unemployment stays low.
The difference between a hard and soft landing is best measured by unemployment. At 3.5%, the March reading shows no sign yet of an approaching recession.
The lag between an inverted yield curve — caused by Fed rate hikes — and unemployment can vary quite widely between recessions, depending on other influences. The chart below shows how an inverted yield curve in July 2000 was followed by the first sign of rising unemployment in January 2001, and shortly afterwards by a recession in March. The next yield curve inversion started in February 2006, the first sign of rising unemployment in July 2007, and the recession only in December of that year. Red bars below represent the lag between yield curve inversion and the first sign of rising unemployment.
The current yield curve inversion (10-Year minus 3-Month Treasury yield) started in November 2022, so the earliest we are likely to see a rise in unemployment is late-2023.
Why is unemployment expected to rise?
Every yield curve inversion (10-Year minus 3-Month above) since 1960 has been followed by the NBER declaring a recession within two years.
Every time the Conference Board Leading Economic Index declined below the red line at -5.0% has signaled recession.
Why do we expect a hard landing?
Every economy runs on credit and the US is no different. The severity of a recession is determined by the extent of the contraction in credit growth, as shown by the red circles below. Note how late the contraction generally is, often occurring after the official recession (gray bar) has ended.
What determines the size of the credit contraction?
Firstly, bank net interest margins.
Banks tend to borrow short-term and lend long, enhancing their net interest margins in good times. But an inverted yield curve pulls the rug from under them, with short-term rates spiking upwards.
The more that net interest margins of commercial banks are squeezed, the more they avoid risk, restricting lending to only their best clients.
The percentage of domestic banks tightening lending standards on C&I loans climbed to 44.8% in March 2023.
Second, is the level of uncertainty facing banks.
The S&P 1500 Regional Banks index plunged after the collapse of Silicon Valley Bank (SVB), Silvergate Bank and Signature Bank.
Shocks in the financial system tend to occur in waves. Latest is the threatened collapse of First Republic Bank (FRC) which has lost almost 100% of value in the past few months**.
The CSBS Community Bank Index of Business Conditions is lower than at the height of the pandemic.
Third is liquidity.
A strong surge in money market assets, warns that money (+/- $450 bn) has flowed out of the banking system and into the relative safety of money market funds.
Money market funds are primarily invested in Fed reverse repo and Agency and Treasury securities, bypassing the banking system.
Conclusion
Bank net interest margins are being squeezed, uncertainty is rising following the Silicon Valley Bank collapse, liquidity is being squeezed, and banks are tightening lending margins. The only party who can prevent a severe credit crunch is the Fed. By reversing course and injecting liquidity (QE) into financial markets, the Fed could attempt to create a soft landing for the economy.
But the Fed is bent on taming inflation and restoring their lost credibility after their earlier “transitory” error. The cavalry is likely to arrive late and low on ammunition.
We expect a hard landing.
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Acknowledgements
EPB Research for the Conference Board LEI chart.
