OFFICIALLY, THE WORST CASE SCENARIO

What is taking place right now is officially the worst case scenario for markets and the economy. Sold to the public as a "soft landing"...

The multi-decade collapse in interest rates to the zero bound was driven by mass outsourcing, mass immigration, and of course mass automation which was accelerated by the infinite rate of return implied by "free money". This theory that record low interest rates could abide infinite valuations as the economy collapsed, will soon be viewed as one of the greatest  mass delusions in human history. After 2008, the patented borrow-your-way-out-of-debt crisis gambit worked so long as economic growth remained stagnant. 

Then, along came the pandemic at the end of the cycle which foiled the Fed's attempts to normalize interest rates for the first time in history. The pandemic forced the Fed to record ease into pandemic-exacerbated global supply chain bottlenecks. The worst case scenario for end of cycle normalization. In addition, pandemic fiscal stimulus programs drove up demand for durable goods as services collapsed. And then QE drove up asset prices into the largest asset bubble in world history.

Now, investors are trapped in what I call the Fed punishment zone. 

Why? For ignoring end of cycle risk, which came back with a vengeance as soon as the economy re-opened. 

Now it's all unwinding, however the decelerating rate of economic change has concealed the end of the cycle. Goldman Sachs said just this week that "soft landing" is STILL on the table. When the year started, Fed futures predicted four rate hikes for 2022, now they're predicting 16 rate hikes, but the soft landing is the same:

We are to believe that the longest cycle in U.S. history was corrected by the shortest recession in U.S. history - two months - featuring not only NO de-leveraging, but a massive increase in debt. The pandemic was the first time in history that corporate debt rose during a U.S. recession. 

Over the next two weeks amid incipient global meltdown, the ECB and Fed combined will attempt to raise interest rates by somewhere in the range of 1.5% (.75% each). This is 6x the amount of monetary firepower that exploded global markets in 2018 (Not including the Fed's double QT gambit).

It's a dumbfuck idea, in the tradition of ever-increasingly dumbfuck ideas.

Which means I'm all for it. 

Fortunately, for today's con men, by the time the public realizes this is all a massive con job, it will be far too late. 

Because as the first chart above clearly shows the NBER has an unbroken history of declaring recessions long after most of the stock market damage is already done. And that's just fine by Wall Street, because what else can they say when official confirmation arrives, but  it's too late to sell, you may as well ride this one out. 

Which explains how investors end up BURIED in the "valley of death" wherein returns are negative for years if not decades.

Any questions?

PREPARE FOR SYSTEM TEST

Gamblers are convinced it's different this time.

They're right, it's far worse...

Let's see, newbie gamblers piling into a bear market lured by Reddit-ordered pump and dump schemes. Peak Boomer retirement. Central banks correcting their massive over-easing error by massively over-tightening. Europe's Lehman Moment. China's Lehman Moment. Japan-U.S. largest monetary divergence since 1998. Tech bubble imploding, housing bubble imploding. Record low liquidity.

What's next? System test.

This coming week is all about Europe because Russia finally cut off natural gas supply and stated that it won't be coming back online. The nuclear option. 

Back in June, many pundits warned this would catalyze Europe's Lehman Moment:

June 23rd, 2022.

As we see in the bottom pane, in August German economic confidence was already the lowest since 2008, even before this latest gas cutoff. Now consider this chart in the context of an ECB STILL planning to raise interest rates on Thursday. 

It's totally ludicrous. 

 

This past weekend, in a very rare warning El-Erian told investors to get the hell out of these "distorted" markets.

"Stock and bond markets appear "distorted," meaning it's high time for investors to tweak their portfolios, according to Mohamed El-Erian... El-Erian's embrace of cash is somewhat contrarian, as historically high inflation is eroding the value of currencies"

Contrarian indeed. 

El-Erian's warning is far too little, too late. 

As we see above, the August AAII positioning report indicates that investors are far too over-loaded on stocks going into recession. This is because they believe the inflation hysteria and are convinced "Cash is trash". Which means the impending losses will be exorbitant.

As I showed on Twitter, investors are now in a bind between a Fed intentionally forcing recession and a Fed rate that is  currently nowhere near high enough to offset recession. In both 2000 and 2008, the Fed had to cut rates by 5% to forestall depression. However with the CPI far higher today, the Fed has no choice but to keep pushing rates higher. All of which means that the 2000/2008 -50% stock decline is now the best case scenario. It also happens to be the least likely scenario.

The most likely scenario is markets meltdown and a lack of stimulus at the zero bound.

Bailout failure means system failure. First and foremost because it portends extreme volatility and market dislocation. Secondly because it means that people will lose faith in the "system". They have poured their life savings into a dead end Ponzi scheme. As John Hussman constantly points out, at these levels of over-valuation, future returns are deeply negative years into the future. However, that's not how it happens in the real world. What really happens is that losses are "front loaded", after which forward returns become positive again. Once the masses panic out of the casino at the bottom. 

 "Prepare for an epic finale," Grantham said. "If history repeats, the play will once again be a Tragedy."

Zerohedge: In Order To Hit New Lows Markets Would Have to Do Something They've Never Done Before:

"The S&P has never set a lower low in any of the 13 post-World War II bear markets after recovering 50% of its peak-to-trough decline"

Pre-War World II. The most famous crash in history. 

 

Finally, investors will ask themselves the question ALL pundits should be asking right now - Why are WE different than Japan and China, who are already stuck at the zero bound? And the answer is because we're not.

COUNTDOWN TO MELTDOWN

Bulls can thank rampant inflation hysteria for initiating global meltdown...

Again. 

The inflation hypothesis is now extremely well "anchored" in the minds of today's economists. Few if any of them question central bank policy at this juncture. One must ask the obvious question: why is inflation considered structural now versus cyclical as it has been during every recession since 1980? The answer is because there is now an abiding belief among economists that employees have the "upper hand" in job negotiations. Around the U.S., unions are forming at various fast food outlets and service businesses that formerly have never been unionized. All of which is feeding into this manic drive to not only kill inflation but to weaken the job market. 

The main reason the job market remains strong is because real wages are NEGATIVE which means it's highly profitable to keep hiring people. Therefore what none of these pundits is considering is the DEMAND side of the equation.  Negative real wages means that consumers are not keeping up with inflation and therefore they are running down savings and increasing debt. Therefore it's only fitting that having cheered the supply side decimation of the middle class since 1980, these pundits would back the largest monetary policy error in modern history. All because they believe that the middle class has been reconstituted by profit-driven inflation and exploding cost of capital. 

Sure.

Spot the inflation:

And because inflation is now secular instead of cyclical, these pundits are all willfully ignoring cyclical deleveraging risk.

Which will be their fatal denouement. All indications from markets since Jackson Hole is that the countdown to a global Minsky Moment has now started:

"The U.S. dollar strengthened to a 20-year high against a collection of foreign currencies this week, spelling more trouble for heavily indebted smaller nations around the world. The stronger dollar makes payments on loans owed in U.S. currency more expensive"

"If you look at the history of emerging markets debt crises...All of those periods always coincide with periods of interest rate hikes in the U.S."

"The number of emerging market borrowers that have debt trading at distressed levels has doubled over the last six months"

Here we see the EM currency ETF is camped at a similar level as September 2015 when the Yellen Fed pulled back on a quarter point rate hike. Then in December they went through with it and imploded global markets. This month global markets are facing potentially a .75% hike in Europe and the U.S. $95b/month QT in the U.S.

Alternatively, we can compare to December 2018 when the Fed imploded global markets with a quarter point rate hike and $45b/month in QT:

In summary:

Of course I don't agree with the assertion that inflation is no longer cyclical. But, clearly that's irrelevant. What matters is that the majority of pundits now share this same belief. What it means is that having conditioned investors for fourteen years of expansion to expect bailouts, now in recession, no bailout is forthcoming.

Which means the July "pivot" rally was a bull trap:

"The S&P 500 has slumped 7% since its mid-summer rally in a sign markets are starting to realize inflation isn't cyclical, and investors won't be able to pressure the Federal Reserve into a making a dovish pivot"

 

GLOBAL COORDINATED COLLAPSE

Global central banks agreed at Jackson Hole to tighten as quickly and brutally as possible. The exact inverse of the pandemic. What we are watching in real-time is a global coordinated collapse...

The major policy mistake being made globally is believing that inflation is driven by wages and is hence "sticky" and intractable. Today's inflation is driven primarily by asset prices and therefore it will collapse far faster than anyone predicts. Central bankers are already tightening far past the point of "neutral" and thereby collapsing the global debt bubble that has grown inexorably since 2008. You have to be a dunce not to see this coming, hence it's largely unforeseen.

Another widely ignored "feature" of the pandemic and resulting inflation was mass hoarding across every consumer and industrial sector. Buyers responded rationally to the supply side shortages by increasing their inventories. Now we are facing a glut of everything at the same time. What started with toilet paper is now reaching semiconductors, housing inventories, mainline retailers, durable goods, and smartphones. Next it will be automobiles. 

The hoarding artificially inflated profits which sucked in maximal capital. Now, as central banks unwind liquidity, they will force asset values lower which will reverse the wealth effect. This in turn will implode the economy and bring profit margins back down to the historical baseline. The pandemic in effect created an end of cycle bull trap for global capital. 

EM currency crisis is the locus of maximum risk. China is allowing their currency to weaken dramatically. The British Pound is near record lows relative to the dollar. The European central bank is planning to potentially increase rates by .75% on September 8th. Their second shock rate hike in consecutive meetings. Central banks are now competing to see who can raise rates the fastest in order to avoid currency-driven inflation. So far, the Fed and U.S. dollar are winning by a long shot. However, all it would take is for Japan to join this hunt and the Yen carry trade would explode global risk markets spontaneously. There is already talk of currency market intervention to support the Yen. 

The other enormous policy error is not understanding that Quantitative Easing will be inert at the zero bound. All it will do is ensure that asset prices are totally disconnected from the underlying fundamentals. Central banks have no means to bail out the middle class which will lead to extreme societal acrimony. Financial institutions are in no way equipped to deal with the impending level of insolvency. They have not been "stress tested" to withstand a global margin call on a scale larger than 2008. 

As I've said many times, Wall Street analysts have been intentionally slow to re-rate their 2022 earnings estimates. Now this Powell hawkish pivot puts them even further behind the curve. Analysts who had been pounding the table for a Fed pivot, finally got crushed on Friday. It took a Powell sledgehammer to finally get the message across. An indication of the level of denial that has been weaponized against the public. The level of fraud and criminality that is about to be exposed will make 2008 seem like a boy scout jamboree by comparison. 

The likelihood of an economic hard landing just increased dramatically. However most economists still believe that recession can be "avoided", which is to assume it's not ALREADY happening. It would indeed be a miracle if somehow two negative quarters of GDP could be reversed after the fact. Only China's government can pull that off.    

“We’ll definitely have a recession as the lagged impacts of this major monetary tightening start to kick in...They haven’t kicked in at all right now”

“Go back to the type of pain Paul Volcker had to impose on the U.S. economy to wring out inflation. He had to take the unemployment rate above 10%”

We learned recently that half of U.S. companies are already planning to cut jobs and the other half are freezing hiring.

August 18th, 2022:

"Half of respondents said they’re reducing headcount or plan to, and 52% have implemented hiring freezes"

In summary, what investors face is either a markets crash which very quickly brings down inflation and forces global central banks to quickly pivot. Or, central banks will continue tightening monetary policy until an economic depression is a foregone conclusion. Regardless, in either case asset prices will decline to a nadir far below this current level. At which point depression becomes inevitable. Amid all of the sturm and drang surrounding the stock market on Friday, it's shocking that no one mentioned the impact this will have on the already imploding housing market. We face a GLOBAL housing collapse of biblical magnitude. Which will bring far greater economic dislocation than the stock market which is skewed towards wealthy households. 

Of course investors always want to know the precise timing of the event, so they can front-run other investors in and out of the market. What I call the "FIFO" method of investing, as demonstrated on Reddit via Gamestop and AMC. However, this event is binary and it's highly unlikely anyone will "time" it with any sort of satisfactory precision. Suffice to say the velocity of this next decline will make the first half decline - already a record - look gentle by comparison. 

We're all gamblers now and when the music stops what we will face is an epic everything glut at the same time. Spilling out onto the streets alongside rioters.

There it is - the most likely outcome and therefore least predicted.

THE BAILOUT TANTRUM

The full cost of sugar coated bullshit is about to be revealed...

Allow me to be the first and last person to inform today's bulls that their final season of Bailout Watch is over.

 

“Restoring price stability will likely require maintaining a restrictive policy stance for some time. The historical record cautions strongly against prematurely loosening policy.”

That last line is a nod to the 1970s when the Fed eased too quickly following a tightening regime only to watch inflation surge back even stronger. As I've shown many times, this period is nothing like the 1970s with respect to unionization, employee job security, capacity utilization or bond yields. Oil prices are lower than they were in 2014 and 2008. Therefore this idea that the Fed can keep tightening with impunity until the CPI returns to 2% is lethally delusional with an economy already in recession. 

The risks of a global market crash have now risen to record levels. Far from being a "Black Swan" event, a global Minksy Moment is now the most likely scenario. It's what I call a Brown Swan event - what happens when bulls have an "accident" because they don't get bailed out for the first time since 2008. The Fed has never been this far from an easing bias. Featuring double tightening at both ends of the yield curve at the same time.

It's abundantly clear that most people have never heard of or don't understand the concept of moral hazard. Which is why the most widely telegraphed hawkish pivot in history came as a shock to markets. A warning to bullish investors that the market is no longer discounting any form of reality. The only thing that was priced into markets up until Friday is bailout fantasy.  

The conference kicked off on Thursday and the conference host Esther George gave an interview to Bloomberg prior to Powell's speech. She indicated she had already previewed Powell's speech but she couldn't comment on it. But she believed that rates would have to be raised north of 4% and remain there for an extended period of time. Only a hyper fool would believe she would contradict her boss in the 12 hours prior to his seminal speech. Right up until Powell's speech, Wall Street had been assuring investors that Powell would not be overly hawkish.

Zerohedge:

Goldman's Biggest Bear Expects Powell To Be Dovish

Goldman Sachs doesn't have any bears. That's not how the model works. Giving investors false hope is the Wall Street business model. The stock market is now badly lagging the economy. Over on Marketwatch, Mark Hulbert asserts that the fundamentals of the market have improved since the beginning of the year. Which is a load of crap. What he means is that the price / earnings multiple has improved IF we assume that today's earnings projections can be relied upon. Unfortunately, at the end of the cycle, Wall Street earnings extrapolations have the veracity of a Magic 8 ball. What most people call "fundamentals" is merely a guess at where things will stand a year from now based upon where they are today. That type of "prediction" doesn't make the turn. The game Hulbert and company are playing works great through most of the cycle and then fails catastrophically when it causes the most pain to investors. 

Taking 4% as a likely end target for the Fed Funds rate, means that the Fed is about halfway done tightening. Hence, bulls made a very bad miscalculation when they bid the market following BOTH the June and July rate hikes. 

What I call premature misallocation.

What comes next I call "System test". It's what happens when a generation of new gamblers discovers the sell order for the first time. 

Those who tell themselves that the "smart money" this time around are the ones who trusted Wall Street, will soon realize they are the dumb money.

In summary, what was widely viewed over the summer as the last chance to buy, was very likely the last chance to sell. The exact opposite. So far, the Nasdaq has declined -30% in 2022. So about half way to a bullish Fed "pivot".  

 

IT WAS GOOD FOR SOME WHILE IT LASTED

The pandemic was a last stage consumption orgy prior to global collapse. The first pandemic in world history in which demand went up instead of down. The bill is due, but the accounts have already been plundered...

 

Macron's detour into the truth today was a shocking bolt from the blue:

"I believe that we are in the process of living through a tipping point or great upheaval...because we are living through the end of what could seem like the end of abundance...A tipping point that can lead our citizens to feel a lot of anxiety"

...Faced with this, we have duties, the first of which is to speak frankly and very clearly without doom-mongering"

Three paragraphs of truth before returning to sugar coated bullshit. Not bad for a politician. It's not going to "seem" like the end of abundance it IS the end of abundance. And what a wild ride it has been. For some. But not so great for the majority on this planet. When I first started blogging in 2007 I was writing about the collapse of the U.S. middle class. Now, here we are talking about the collapse of Globalization. While so many were eagerly telling me I'm wrong, the table stakes grew by an order of magnitude. And yet like a tsunami in the open ocean this incipient collapse is imperceptible to the average person, because the super wave has yet to break on shore. We all have a personal choice to step back and gain historical perspective or just get buried under a deluge of disinformation.  

The anxiety Macron speaks of is something we all must confront. I have embraced the fact that pursuing a less stressful lifestyle is a central part of life now. A critical part of repudiating what I call the corporate death style, which is physically, mentally, and spiritually toxic on every level. 

Getting back to the topic of markets and the economy...

One year ago at the Jackson Hole meeting, Powell was doubling down on his transitory inflation theory while at the same time, continuing record monetary easing. Which is where it all went wrong. He basically stated that loose policy would be indefinite but inflation would be transitory. We all know that inflation is "always and everywhere a monetary phenomenon". Or at least we used to know. Therefore how could the continuation of record easing lead to transitory inflation with the CPI already at 5%?

No surprise, inflation accelerated right after Jackson Hole last September (see chart below). 

This year, he is making the exact same error in the opposite direction. While engaging in record tightening, he is telling people that inflation is no longer transitory. He has already forgotten the fact that he's been playing catch up on rates for six months now. He raised rates as much in the past six months as the Fed raised rates in eight years after 2008.

These two Jackson Hole meetings one year apart are at the polar extremes of Fed policy error. Here we see the CPI in the top pane with the 30 year mortgage in the bottom pane. Since he announced inflation is transitory, prices skyrocketed and mortgage rates DOUBLED. Both of which are deflationary to a middle class far behind the curve on wage increases. 

This week we learned that unsold housing inventories are rising at the fastest pace in 75 years of data i.e. likely in history.

For the past year, the middle class has been imploding due to inflation shock, oil shock, war shock, and now rate shock. Not a day goes by when we don't learn that this mid-market retailer or another is seeing collapsing demand. Today it was the dollar store (DLTR). And yet at the high end of consumption everyone is fat and happy.

One thing NO pundit wants to admit is that Quantitative Easing is inflationary. The bailout drug of choice since 2008 is the primary driver of today's trickle down asset inflation. 

So it is that the Fed must now specifically target asset markets. Meaning the Fed "put" is now the Fed "call". Instead of bidding up risk assets from below, they will be selling down risk assets from above. 

"When interest rates were at rock-bottom levels, market analysts used to talk about “the Fed put” — the notion that the Fed would step in to backstop the market if equity prices tumbled. Now that the Fed is in tightening mode, this relationship has become inverted"

Unfortunately, a swirling cloud of disinformation has enveloped the permanent plateau of financial delusion. Fully exploiting financial PTSD. Financial pundits have been behind the curve all year on adjusting their wrong forecasts. Every day they are falling further behind the curve and they have ZERO incentive to catch up. Therefore we can fully expect that the economic data will continue to surprise to the downside until such time as this society realizes they have been led into the abyss by serial con men. 

However where some see risk, some see opportunity:

"The growing risk of a “major financial accident” that causes a market capitulation later in the year could open up opportunities for investors to “pile up on quality risk assets,”

He said there is a danger that a “weak link” in the financial system breaks and investors flee en masse, providing investable bottoms for shrewd investors"

We are watching an accident alright. 

It's called FOMC: Fear of missing crash.

GLOBAL LIQUIDITY TRAP

Both Japan and China are now in deflationary liquidity traps. The U.S. and Europe are following close behind. Soon the masses will learn the hard way, you can't borrow your way out of a debt crisis. They will all find out, once it's officially too late...

 

As of this writing, Japan and China are both easing while Europe and the U.S. are both tightening. It's the biggest global policy divergence we've seen in our lifetimes. Despite the falling Yen, Japan has steadfastly maintained easy monetary policy. Why? Because they know what happens when you don't respect the zero bound. Consider that Japan's inflation rate is currently 2% while the U.S. inflation rate is 9%, even though Japan is easing and the Fed is record tightening. Which makes even less sense when you consider the dollar is sky-rocketing and the Yen is collapsing. It only makes sense in the context of a country that has been caught in a liquidity trap for decades. Which means that consumers are averse to borrowing money, whereas in the U.S., consumers are not averse at all. YET.

China is also well along the path to liquidity trap. In 2008, China pulled the world out of recession as their GDP growth rate was 14% that year. It never went negative during that global recession. Subsequently, they built massive empty "ghost cities" and real estate development is now 30% of GDP. So it is they find themselves at a point wherein lower interest rates no longer spur demand. 

"Taken together, the data shows banks are flush with cash but are struggling to boost lending to customers against the backdrop of weak growth and turmoil in the property market.

The data is a classic sign of a liquidity trap. Liquidity is ample, but no one wants it. Under these circumstances, monetary policy can do little to support the economy”.

Sound familiar?

China's GDP is collapsing faster than Wall Street can keep up. Not a month goes by when they don't revise lower China's full year growth rate. Only a serial fool would believe that this current GDP reduction will be the last. 

Now consider that in all of the major stumbles since 2008: 2015, 2018, and 2020, global central banks were all on the same page with respect to monetary bailout. Whereas now, they are diverging massively between Asia and Europe /U.S. /Canada /Australia etc.

What happens when there is a global collapse and two of the largest central banks are already flailing away. And the remaining central banks refuse to bailout markets?

What happens is a far worse crash that damages markets, the economy, and consumer confidence. Followed by a clusterfucked bailout and loss of confidence in central banks. 

Many of today's bulls are claiming that this currently collapsing housing bubble is not as big a risk as 2008 because there's "no subprime this time". What they don't acknowledge is that most of the global economy IS subprime this time.

This epic risk of a global liquidity trap combined with global monetary policy divergence are the two biggest economic and financial risks, however they are completely ignored. Investors are currently betting on an imaginary pivot to an imaginary Fed bailout followed by an imaginary global recovery. 

And no one will tell them any different, because today's financial press have the attention span of a coked up flea. Today's financial press are eagerly monetizing false optimism because that is their largest market for readers and they don't want their audience to be disappointed by reality. They have gladly sacrificed all shred of credibility on the altar of continuous monetary bailout. They are in the exact same closed loop as investors, incapable of seeing the risk to their groupthink circle jerk.

In the U.S., the biggest beneficiary of "inflation" was corporate profit. So, bringing prices down, axiomatically means lowering profit margins from record highs back down to historic levels. 

What we see from this chart is that after the pandemic, it took a mere one year for corporate profits to skyrocket to new all time highs. Versus four years in Y2K and 2008.

Profit is 90% correlated to CPI (not shown). 

In 1980, Paul Volcker purposely engineered a recession to bring down inflation, because he knew that he had ample dry powder in case he needed to cut rates to bring back the economy. In the event, he brought rates down 12% to offset the worst recession since the Great Depression.

This Volckerized Fed has a 2.25% rate buffer on the economy. And yet untold numbers of pundits have been pounding the table for them to raise rates as quickly and brutally as possible. To bring down "inflation".

At no time in this entire debacle did the Treasury market believe that inflation was ANYTHING like 1980.

What these people all need is an education on economics. And they're going to get one. 

When it's officially too late.

"The velocity of money is a measurement of the rate at which money is exchanged in an economy. It is the number of times that money moves from one entity to another. It also refers to how much a unit of currency is used in a given period of time. Simply put, it's the rate at which consumers and businesses in an economy collectively spend money"