Fed Ignores Deepening Cyclical Downturn

January 28, 2016

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Bad timing and intransigence

Nominal GDP and Non-financial profits trending down

Global profit estimates are in their steepest decline since 2009.

85 year high in US crude inventories

Record debt and the credit cycle

“The Fed doesn’t look at reality, they look at their models” – Jim Rickards

Fed’s leverage now equals LTCM’s before it went bankrupt

Balance sheet expansion policy coming to an end?

“grand experiments that are too big to fail”



Bad timing and intransigence

The chart below shows how obvious and steeply declining the current economic down cycle has become over the last year. Even as the decline accelerated in Q4 the Fed chose this moment to tighten for the first time in a decade. This week the Fed essentially stuck to its position of yet further tightening to come.


Nominal GDP and Non-financial profits trending down

The Fed shrugs off this current downturn as just transitory, but this cycle looks much more deep seated and troubling, as nominal GDP growth slips below 3% and non-financial profits turn increasingly negative.


Global profit estimates are in their steepest decline since 2009.


85 year high in US crude inventories

Crude Inventories have not been this high since the beginning of the 1930s depression, and that time it did not end well.


Also, there is a good reason why lower costs are failing to boost the economy.


Record debt and the credit cycle

In addition, it is probable that the economy is unusually vulnerable to a downturn as debt/equity ratios are at an all time high. Indeed the scale of corporate debt in total has never been higher as the 2015 bubble below is the largest ever. Spreads have already started widening and this trend has never reversed within the same cycle.


In summary, David Stockman argues that the economy could be “at peak debt headed for a recession.”


“The Fed doesn’t look at reality, they look at their models” – Jim Rickards

Why does the Fed not see this? Jim Rickards explains:


How well does the Fed manage its own affairs? For example, how about something as basic for a bank as its own balance sheet? Surely this is matter where the reality is simple for all to see. As the sober custodian of the dollar’s ultimate value, with control of both the entire banking system as well as the money supply, surely it must have the most pristine balance sheet of all to set an example. However …….



“Fed’s Leverage Now Equals LTCM’s Before It Went Bankrupt

The Fed’s leverage ratio has now risen to a jaw-dropping 112.6! To put this number into perspective, that’s similar to the leverage ratio of Long Term Capital Management before it went belly up. The Fed’s leverage is so high that it makes other over-leveraged central banks like the ECB look prudent by comparison. 

The Fed is now the most highly leveraged it has ever been, and probably is the most highly leveraged bank on the planet. It is an alarming development. It means that if the value of the Fed’s assets declines by a minuscule 0.88%, the Fed’s book capital will be wiped out, making the Fed as insolvent as some of the banks it is trying to keep afloat.  

In reality the Fed probably is already insolvent using generally accepted accounting principles that mark its assets to their market value. We know that the Fed still has a lot of paper on its balance sheet that it bought from insolvent banks in the 2008 financial crisis that in a liquidation sale won’t be worth the book value at which the Fed records it. Also, with interest rates rising, it is likely that the mark-to-market value of the long term bonds the Fed holds has been declining, but the Fed does not record these losses in book value.

For these reasons, it seems safe to assume that the value of the Fed’s assets is already less – perhaps even far less – than the 99.12% of their face value they need to be to keep the Fed solvent.”


Balance sheet expansion policy coming to an end?

The whole balance sheet expansion policy is now coming into question from one of the world’s biggest banks – Deutsche Bank. They now appear to believe that this policy has become counter productive!


No central bank has expanded its balance sheet as much as the BOJ, and now overnight they announced that this policy seems to be exhausted (completely failed?)! However, the BOJ must still feel that something must be done, so they are introducing the ingenious concept (perversion?) of NIRP. After all its working so well in Europe!

No surprise that every week another legendary investor seems to lose patience with the Fed and/or central banks in general. This week it was Jeff Gundlach’s turn:


Mark Faber also has a few choice words about the central banks:


“grand experiments that are too big to fail”

All told central bank policy still seems wedded to ideas that can only really be described as “grand experiments that are too big to fail”. ECRI explains in greater detail what this all means for cycles.

“The fate of the global economy depends on the success of these unconventional efforts to boost economic growth. Yet all three ventures are now in danger of failing because none of them addresses the fundamental challenge of structurally slow growth.”



Investors need to be very careful about placing too much trust in the central banks. Policy may now very well be exacerbating the power and intensity of the current cyclical downturn.  Ultimately, cycles are far more powerful than the central banks.

The Fed’s decision this week to stay on its current policy trajectory was met with an unusual market response. The reaction immediately following the Fed announcement was to boost gold and Treasuries, while equities fell. The market seems to have growing doubts about where policy is going.

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