The Causes of Recessions & Bear Markets, a Recap

This is an excerpt from the May 7, 2024 Yardeni Research Morning Briefing.

There are three ways that recessions typically are triggered: 1) a monetary-tightening-induced financial crisis turns into a credit crunch; 2) a geopolitical crisis causes oil prices to soar; or 3) speculative asset bubbles burst. All three have caused recessions in the past.

Consider the following relevant points:

(1) The most common reason recessions have occurred in the past is the tightening of monetary policy, usually as the Fed became concerned about consumer price inflation. Along the way, the yield curve inverted, signaling that investors were starting to buy bonds on their expectations that something would break in the financial system. They were usually right; the resulting financial crisis quickly morphed into an economy-wide credit crunch, when even borrowers with good credit histories found it hard to borrow. The credit crunch would then cause a recession (Fig. 1). Melissa and I started writing about this in our 2019 study “The Yield Curve: What Is It Really Predicting?” (You can find a pdf of it here on our website.)

That hasn’t happened so far during the latest round of tightening. There was a financial crisis last year in March. But it turned out to be a mini-banking crisis limited to three banks because the Fed responded rapidly by establishing an emergency banking facility—the Bank Term Funding Program—that contained the crisis quickly, thus averting a credit crunch and a recession (Fig. 2). The program was terminated on March 11.

Fed officials got lots of experience setting up these facilities during the Great Financial Crisis (GFC) and the Great Virus Crisis (GVC) (Fig. 3). They’ve learned how to play Whac-A-Mole in the financial system very effectively.

(2) Geopolitical crises can trigger recessions if they cause the price of crude oil to soar. That happened during the two energy shocks of the 1970s (Fig. 4). It happened again in 1990, when Iraq invaded Kuwait (Fig. 5). The price also soared during the GFC to almost $150 a barrel. It wasn’t attributable to a geopolitical crisis; it might have been related to strong Chinese demand. In any event, this didn’t cause the recession associated mainly with the GFC but probably exacerbated it. There was also no recession in the US after the price of oil spiked when Russia invaded Ukraine in early 2022.

(3) Recessions also can occur after speculative asset bubbles burst. That explains much of the recession at the start of the 2000s, when the tech bubble of the late 1990s burst, resulting in the Tech Wreck (Fig. 6). Speculative bubbles in commercial and then residential real estate burst in 1990 as well as during the GFC in 2007-08, resulting in recessions (Fig. 7).

(4) The severe two-month recession during March and April 2020 was attributable to the lockdown imposed by the government during the GVC.

(5) Bear markets in the stock market have usually been associated with recessions when revenues, profit margins, earnings, and valuation multiples all fell (Fig. 8). The exceptions were the 1987 and the 2022 bear markets.

(6) If inflation continues to moderate as we expect, dropping to 2.0%-2.5% by the end of this year, then the Fed likely would ease monetary policy if necessary to avert a recession. Again, we aren’t expecting a recession this year, so we aren’t expecting easing this year; we don’t think it will be necessary.

However, in our opinion, investors’ expectation that the Fed would nip a recession in the bud by easing means that the Fed Put is back. Its return reduces the risks of a recession and a bear market. It increases the risk of a meltup in the stock market.

On the other hand, the geopolitical risks that might cause oil prices to soar seem to have diminished somewhat in recent weeks, but they still pose a potential risk of causing a recession and a bear market.

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