Everything you thought about interest rates is wrong (updated)

The global economy has been on life support since 2008. In 2020 doctors jump-started its heart. So now what? Are we entering a new economic cycle or recession?

This is a (continuously updated) Macro breakdown of pre US election crossroads in the economy.

Because I’ve been challenged on my bullish thesis that we are entering a new business cycle, and the recession is behind us, I’ve been thinking long and hard about the real economy and markets lately. Also because my business strategy depend on where we are in the economic cycle.

As I learned from my mentor Jacob Skaaning it is crucial to keep several scenarios in mind – at least a bullish and bearish one. So here we go for the triple kill (3 scenarios) but first a quick look at growth for the last 5 years and a paradigm shift:

Paradigm shifts

1. The primary concern I have is the yield curve, which has reverted for the second time since 2019. This means that the 10 year US government bond yield rate is now higher than the 2 year US government bond yield rate. This is how it should be, but when this happens after an inversion (period of the opposite) a recession has occurred shortly after.

2. The second is a paradigm shift in how and to what extent interest rates affect the economy. This has been changed by the empirical study from 2022 by Dr. Richard Werner and can be somewhat brutally summed up as such:

"Interest rates are not negatively correlated with economic growth and do not cause growth. Instead, we find evidence that the relationship may be the opposite in both dimensions. This adds to recent doubts about the prevailing conduct of monetary policy and common theoretical models. Specifically, lowering interest rates may be counter-productive when trying to stimulate the economy.

Our empirical findings reject the theoretical argument that interest rates affect economic growth causally, and in an inverse manner.

On balance, our empirical results show that (1) the correlation between economic growth and interest rates is not negative but positive in virtually all countries examined over most time periods, and; (2) when significant, the majority of evidence suggests that the causal link does not run from interest rates to economic growth, but more likely from economic growth to interest rates;

Interest rate reductions towards or beyond zero may even hurt economic growth. Our evidence shows that policy-makers aiming at higher economic growth should instead be looking to arrange for interest rates to be moved higher. Our simplest intuition for these findings is via the effect of a steepening yield curve, which would render supplying credit for business investment more attractive for banks undoubtedly a positive factor for output and growth, as well as financial stability.

On the other hand, lowering short rates and pushing long rates down flattens the yield curve and drives banks to lend for asset purchases (or drives them out of business), hurting economic growth. The role of the yield curve in monetary policy is thus an important area for further research(in line with Lucas et al., 2019; Drakos, 2001)."

Werner, Dr. R. A. et al. 2022 https://onlinelibrary.wiley.com/doi/full/10.1002/ijfe.2630

So, based on that we will look at 3 different scenarios:

1.????? Bullish: We are beginning a long-term secular cycle (bullish equities and real estate, recession is behind us: 2020-2023)

2.????? Bearish: We are entering a near-term recession (recession was in 2020 and we will experience a recession end of 2024)

3.????? Hybrid: We are entering recession in the real economy with a boom in equity and financial markets while everyone else suffer.

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1.????? Let’s start with my first and most bullish thesis, which is the one I have been most convicted of and held through 2022 until now, which I will challenge based on input from Flemming S?lvstad Nielsen Dr. Daniel Walther Ulrik K. Lykke Chris Mallin and others. I’ve held this thesis too firmly lately and therefore I must revise it.

1. Bullish thesis:

• We did in fact have a recession in the real economy in 2022-2023 with two quarters of negative growth – especially prevalent in Europe.
• Shortly after equities were roaring and so did inflation along with immigration numbers, which in combination with a massive expansion in money supply from 2020 cushioned a large part of the western population from the recession.
• Most indices are trending bullish on monthly timeframe, this is a significant momentum after all.
• So the thesis is that we have left recession behind us and continue into a new cyclical bull market.

Recession

Working class and middle class, especially younger than 35 definitely felt the recession as the cost of food forced people to cut the nutritional value of their diets to a bare minimum, live in their cars, unable to afford clothing, dentist bills let alone saving. Don’t talk about owning a home.

"During the last four years, real M2 and real other deposit liabilities (ODL) fluctuated from highly stimulative/inflationary to extremely restrictive/disinflationary. Based on the annualized growth rate, detrended real M2 swung from slightly above zero in late 2019 to a post-1950 peak of 5.6% during 2021 to a deeply negative -2.6% in the last 48 months (Chart 1)."

"The last four years also point to the harm caused by such massive swings in monetary growth. The surge of monetarily induced inflation in 2020-21 resulted in a falling standard of living for most of the U.S. households who could not protect themselves from rapid inflation."

So this gives us a very good look at the wealth destruction in recent years. If you have owned practically any assets you would not have felt this wealth destruction to the same degree because your assets would have "gone up in price" relative to the actual destruction of your purchasing power.

Also, have a look at Viktor Shvets description of wealth inequalities and conditions for younger generations (bottom 50% own absolutely nothing and millennials go into debt to uphold a reasonable living standard) :

To further underline the issue consider this chart on German inflation from Christof Leisinger and note that real wages have not kept up to CPI:

The yield curve:

Now here comes the conflicting part which support the thesis but is very contrarian:

According to Dr. Richard Werner’s empirical study “A steeper yield curve—where long-term rates are higher than short-term rates—encourages banks to supply credit for business investments, thereby stimulating economic growth. In contrast, flattening the yield curve by lowering rates may push banks towards less productive lending practices, ultimately harming growth.”

Read the study here: https://onlinelibrary.wiley.com/doi/full/10.1002/ijfe.2630

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Lower rates encourage demand for credit, which is the common explanation for increased liquidity and therefore economic growth. But demand doesn’t equal supply and banks are in control of supply, which is regulated by rates. High rates incentivize banks to provide a high supply of credit.

The issue is that we are seeing a reversion and every time longer rates have exceeded shorter rates, we have seen a recession. But this is at least for a short time contrary to Werner's finding:

“A steeper yield curve—where long-term rates are higher than short-term rates—encourages banks to supply credit for business investments, thereby stimulating economic growth."

Now this is quite contradictory to the common conception that the reversion (above 0 after inversion below 0) of the yield curve indicate recession. I have not yet solved this puzzle and if anyone can illuminate this, I would appreciate it.

It seems from the study that when central banks lower rates as we are about to see, it is a reaction to lowered economic growth. This makes sense as we have already seen adjusted job numbers from the US (down about 800.000 jobs) and low inflation (2-3%).

But that means that a lower rate is not favorable contrary to what the market wants and it would be favorable to keep rates high.

Below is a conceptual illustration of the 1st. thesis: a bullish scenario.

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2.????? Bearish thesis:

• The yield curve has reverted above 0 after several years below 0. This indicate a high probability of recession.

• The ISM Purchasing Managers Index is below 47 which indicates 80% probability of recession.

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• Global debt to GDP over 300% is a big red flag. This forces governments into deleveraging in order to lower the debt level as it is simply unsustainable to counter such high debt levels with growth alone. It was at 349% according to S&P Global last year so it has decreased somewhat.
• As of the first quarter of 2024, global debt reached a new record high of $315 trillion, which represents approximately 333% of global GDP. This figure marks a significant increase and signals a resumption of the upward trend in the global debt-to-GDP ratio after three consecutive quarters of decline. According to Institute of International Finance and Reuters.

https://www.reuters.com/business/global-debt-hits-new-record-high-313-trillion-iif-2024-02-21/

https://www.iif.com/portals/0/Files/content/Global%20Debt%20Monitor_Nov2023_vf.pdf

https://www.spglobal.com/en/research-insights/special-reports/look-forward/global-debt-leverage-is-a-great-reset-coming

This is bad. Really bad. And the debt has to a larger extent gone towards non-productive endeavors.

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• So the thesis is that we are entering a recession end of 2024 or start 2025 before starting a new cyclical bull market. Perhaps in 2026.

Below is a conceptual chart of the 2nd. thesis: a bearish scenario.

In relation to Dr. Richard Werner’s empirical study, this would mean that as central banks lower rates they in fact confirm a recession.

"Our empirical findings reject the theoretical argument that interest rates affect economic growth causally, and in an inverse manner. On balance, our empirical results show that (1) the correlation between economic growth and interest rates is not negative but positive in virtually all countries examined over most time periods, and; (2) when significant, the majority of evidence suggests that the causal link does not run from interest rates to economic growth, but more likely from economic growth to interest rates;"

"Interest rate reductions towards or beyond zero may even hurt economic growth. Our evidence shows that policy-makers aiming at higher economic growth should instead be looking to arrange for interest rates to be moved higher."

Read the study here: https://onlinelibrary.wiley.com/doi/full/10.1002/ijfe.2630

The lower the rate, the lower the incentive is for banks to supply credit and thereby liquidity is strangled. Banks are in control of credit after all – besides governments running deficits of course, which bring us to the 3rd thesis:

3.????? Hybrid thesis:

• Equities and financial markets will thrive after a somewhat dramatic fall (mostly emotional to market participants) after governments provide massive amounts of stimulus through deficit spending (printing money) and private market capital takes favorable positions after decades of capital accumulation.
• The real economy will suffer massively as we see deflation (prices fall) because people simply lose their jobs and are over leveraged.
• Meanwhile, the increase in money supply will deteriorate purchasing power of common people and increase the nominal value of assets like real estate, equities, commodities and alternative investments. Just like we saw in 2022-2023.
• So the thesis is recession or at least stagflation in the real economy while assets go higher.

Below is a conceptual illustration of the 3rd scenario: hybrid

This scenario would align well with Russell Napier’s financial repression thesis:

A structural change in the economy further towards governments and their fiscal policy who engineer the economy through relatively high inflation and government deficit driven economy.

Central banks and governments attempt to balance interest rates and inflation in order to lower debt levels with inflation and avoid serious recession. Global debt to GDP must come down either through direct taxation or inflation (indirect taxation through expropriation of purchasing power).

Yikes.

To understand the mechanics of how this was done in 2020 I recommend these 11 slides:

Especially the below chart should give an overview on how the 30s and 40s went, but as Victor Shvets suggest markets and central banks have become much more rapid at responding to market fluctuations as we saw lately in the US regional banking crisis.

Also read Russel Napier's financial repression thesis here: https://themarket.ch/interview/russell-napier-the-world-will-experience-a-capex-boom-ld.7606

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The hybrid scenario would also align with Viktor Shvets thesis which is quite aligned with Russell Napier: that we are in a 1930s scenario and geopolitically face degrees of restriction in freedom as the neoliberal paradigm is exhausted. He expects lower global growth and the certain eclipse of China as an economic growth engine along with strict policy.

The question is whether we can avoid the mistakes of the 30s and head directly to 1950s policy based on moderation and a certain degree of discipline in both political and fiscal terms.

Conclusion:

I have a bad feeling about this, but then again statistically markets go up way more often and for longer than down. This is surely countered by some very positive trends in energy technology as we see ever increasing support for nuclear power and technological ingenuity.

The general public has to a large extent adapted to more uncertain and volatile times with unprecedented stability behind us.

Therefore it has been difficult to pick where I personally think the economy is heading.

What helps to some extent is an overview on where we are in the liquidity cycle. Now this depends somewhat on the eye of the beholder, so as you can see in the charts below by Flemming S?lvstad Nielsen and CrossBorder Capital we are either in the early part of a bottom or exiting a bottom.

This is important as liquidity steer asset prices and general economic growth:

So I've decided that the 3rd thesis (hybrid) is most likely and some form of recession or stagflation is quite likely. Although the severity will be determined by US fiscal policy. For the first time I cannot actually put a probability estimation on this right now.

Update: I have decided to give the following probability to each scenario, that is on a timeframe of Q22024-Q12026:

1. Bullish thesis: 30% probability
2. Bearish thesis: 20% probability
3. Hybrid thesis: 50% probability

Ultimately we are at a crossroad that boils down to the US election at this point.

And don't forget that markets usually correct around October :)

240830 Edit: added chart to the 3rd thesis hybrid and spelling, syntax etc.