Whenever the U.S. economic recovery is discussed, it is important to rewind the movie and understand the reasons why the economy was in a recession to begin with. Just as the golden rule of accounting states that every credit must equal a debit, it is a fundamental concept to understand that the financial markets operate on a cycle: for every boom, there is a bust.
The most recent financial crisis that stemmed from the housing market collapse began at the turn of the 21st century. It was a nationwide belief in the heartland of the USA that home ownership was a good thing- daresay even, that you had not achieved the American dream until you owned your own home. And with the zeitgeist of the day being so, the banks facilitated this concept by lending money to the millions of American families that wanted to buy a home. The subprime mortgage market was booming. The combination of easy lending standards and growing pressure from the demand side, created a bubble in housing prices. The adjustable rate mortgages (ARM) were a simple scheme to fool the unknowing- no money down and low payments for the first few years, before the inevitable rate adjustment, as well as the eventual default from not being able to meet new payment obligations under a higher interest rate.
With families all over the country defaulting on their mortgages at an unprecedented scale, the financial system that strung everything together started to tumble apart. The insurance companies went bankrupt on an expensive bet insuring the mortgages through relatively new and unknown derivatives, known as credit default swaps. The big banks on Wall Street also could not cope with the copious amounts of toxic and illiquid assets on their balance sheets. The financial system was in a meltdown akin to the puppeteer’s strings being snipped one by one.
With the collapse of the financial system, the economic balance in the U.S. retreated into a deep recession. Houses were being foreclosed, jobs were drying up because of economic activity stalling, and businesses were unable to operate as a going concern. The Obama Administration had to react in a big way - and indeed they did, with massive bailout programs financed by the Quantitative Easing of the Federal Reserve. The bond buying program amounted to printing money and injecting a supercharged supply of liquidity into the engine of the economy in an attempt to revive it. As the money supply grew, the cost of borrowing dropped dramatically to nearly zero percent interest rates. Corporations rejoiced in the ability to borrow cheaply and reinvest the money to earn higher returns and fund operations. Today, the vital signs of economic recovery are present with unemployment numbers falling, wage growth improving, and the stock market robustly soaring to bullish heights.
With such optimism afloat in the markets, history must serve as a valuable reminder that markets become bubbly precarious when everyone believes that the bull will keep running forever without tiring. The US economic recovery’s bumbling steps are similar to that of a toddler with unsteady feet- any misstep could awaken a bear market that has seemingly encroached into hibernation. With the world today so globally intertwined, the economic weakness in Europe coupled with China’s artificially propped up markets are forging waves in the path forward for the U.S. economic recovery. Smooth sailing requires implementing policy deliberately and tactically to navigate the treacherous waters.
At the forefront of policy decisions is the pending rate hike, speculated to occur in the latter half of 2015. The Federal Reserve has let the tap run too long with easy money liquefying the previously insolvent credit markets. If interest rates are kept constant, the market could very well overheat. The time has come to turn off the faucet by raising the Federal Funds Rate, thereby raising the cost of borrowing. However, this action will effectively take the steam out of the bubbling engine of the economy and raising the rate too quickly could cause turbulence in the road to a full recovery.
The hamartia of economic forecasts is that nobody has a crystal ball that can predict the future. In recognition of this fact, the best practice is to be acutely aware of which phase of the boom-bust cycle the economy is in, and to act accordingly. So the global economy will wait and observe, with bated breath, the effects of the rate increase. In this situation, fortune will favor the cautious. The hope for now will be that the rate hike is introduced slowly and gradually enough to prevent the supply of money from flowing out of the stock market and awakening a disgruntled sleeping bear. To quote the Oracle of Omaha, “the first rule is to never lose money and the second is to never forget the first rule.” The risk of permanent loss of capital is increasingly present in today’s economic environment and strict discipline should be employed to avoid undesirable outcomes.
Chief Macroeconomic Strategist, ASIF