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The Signs of the Next Financial Crisis Are Getting Louder Lombardi Letter 2018-05-28 11:42:05 us economy recession market crash volatility inflation federal reserve jerome powell interest rates There is a misplaced, yet difficult to reverse, expectation of higher inflation. Not long ago, economists and central bankers were pestering us that inflation was too low. Now it's too high. Beware bad diagnoses and worse prescriptions. Analysis and Predictions,Inflation,News,Stock Market,U.S. Dollar,U.S. Economy https://www.lombardiletter.com/wp-content/uploads/2018/05/iStock-866239818-150x150.jpg

The Signs of the Next Financial Crisis Are Getting Louder

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Signs of the Next Financial Crisis

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A Financial Crisis May Arise as the Economy’s Signals Are Misinterpreted

The world markets in the next few months will face ever greater volatility. Or, if you prefer, they will experience wild and more frequent “mood swings,” such that a financial crisis seems unavoidable.

There is a misplaced, yet difficult to reverse, expectation of higher inflation. Not long ago, economists and central bankers were pestering us that inflation was too low. There was talk of negative interest rates.

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Apparently, that has all changed; inflation is the economic term of the year. U.S. bankers see it everywhere, even as there are far more realistic factors that could contribute to an imminent financial crisis.

Inflation may be getting the bigger headlines, but the escalation from tariff debate to full-blown trade war is imminent.

The wrong diagnosis about the risks of a financial crisis is the biggest risk of all. Yet, everyone seems determined to proceed along the “inflation” narrative.

It’s Time to Prepare for the Next Financial Crisis

The most likely scenario for 2018 is a recession. There is too much anxiety concentrating in the markets, and it could lead to the wrong economic prescriptions. Thus, it’s time to take measures to prepare for the next financial crisis.

The probability of a crisis is high. Yet, what makes it more dangerous is that there’s no timeline. In other words, the stock market could continue as normal and absorb the volatility. Yet, investors cannot ignore the fact that a crisis could materialize at any moment.

The best that investors can do is be aware of the dangers that are lurking.

Volatility appears to have increased compared to the recent past. Simply, there have been overly frequent mood swings in the financial markets.

Although it’s difficult—if not impossible—to predict the scale of the next financial crisis (will it be more like the tech bubble of 2000 or like the subprime mortgage crisis of 2008?), some relevant factors have emerged.

Encouraging Signs vs. Reality

There are two major interpretations of the current economy. Some see encouraging signs. They still believe that Donald Trump’s tax cuts will produce a “trickle-down” effect and address the problem of excessive income disparity.

These same optimists are prone to believe the economic narrative about inflation and growth. Yet, inflation remains moderate at best. The main place where Americans detect it is at the gas pump.

Higher oil prices have also affected the cost of most goods on store shelves. That’s what’s causing inflation, not the alleged fact that more Americans are working.

The Federal Reserve and the markets are confusing signals.

Indeed, if unemployment is as low as the statistics suggest (and as President Trump boasts), why are wages stagnant? Wages are supposed to increase when unemployment is low. There are fewer workers looking for jobs in such a scenario. Thus, job seekers can command or expect better wages. (Source: “How America Broke Its Economy,” The New Republic, May 8, 2018.)

So much for the free market.

The End of Easy Money

Many have attributed the current economic situation to the Federal Reserve wanting to raise interest rates.

It’s causing a strange confusion. Oil prices and the U.S. dollar are moving higher simultaneously. Oil rises when supply risks are higher.

The geopolitical climate has not been this hot—in the sense of risky—in years. So it makes sense for oil to be hitting its highest price since 2014.

But why is the dollar so high? In the current climate, the investments that make the most sense are of the refuge or safe-haven variety. Gold and precious metals should be increasing in price. And yet, they are not.

Consider that the financial recoveries in the United States, Europe, the United Kingdom, and Japan (the economies that the 2008 subprime crisis damaged the most directly) would not have been possible without quantitative easing (QE) policies.

The monetary policy approach that we might summarize as “easy money” is coming to an end.

Interest rates had literally gone past zero percent in order to inject otherwise reluctant liquidity into the markets and the economy.

Meanwhile, inflation is increasing artificially, encouraging central bankers to misinterpret the signals. Either that, or they’re fooling us.

QE Exposed Inherent Weaknesses

As the economy recalibrates, we will find out just how well the QE policies worked.

They were supposed to prime the global economic engine. But QE has also masked the inherent economic weaknesses that have been lingering since 2008 (and long before that).

This means an increase in short- and long-term interest rates. And, no doubt, the stock markets will have to endure repeated threats and shocks.

Meanwhile, as QE and abundant liquidity comes to an end in many advanced economies—starting with the United States—the stock markets will no longer sustain the fast and intense pace that began in 2009.

Either governments give in and launch a new QE program or they accept the risk and allow the house of cards to fall. Will those cards fall in 2018?

2018 was supposed to have been a great year for the U.S. economy. And certainly, stocks came out of the gate in January like a rocket. The Trump tax cuts were supposed to encourage reinvestment and growth.

Instead, not even halfway into this year, the scenarios and interpretations have changed. 2018 has become a year of moderation and low volatility. The economy was even going to feature considerable stability of consumer goods prices and interest rates.

Treasury Yield Rise Makes No Sense

What’s striking about these largely mainstream interpretations is their nonchalance in the face of enormous risks at the global level.

First, without the liquidity and the low interest rates, borrowing will slow down. Then economic growth will slow down and interest rates will be rising to confront an inflation that isn’t really there.

That’s why the rapid growth in U.S. Treasury yields makes no sense. It has distorted the markets and prompted investors to focus on the wrong problems.

Therefore, we have phenomena such as a fast-rising dollar in the middle of a geopolitical and economic quagmire that could explode any moment.

That’s why Wall Street appears to have entered limbo after the January rally. Meanwhile, the dollar strengthened against all other major world currencies.

More significantly, perhaps, U.S. Treasury yields remain above three percent. The last time this happened was in 2008…

And that should end any argument about what direction the U.S. economy is taking. This is the root cause of the next financial crisis.

Should yields continue to exceed three percent, the situation could get hazardous indeed. Morgan Stanley (NYSE:MS) thinks that this will eventually lead to financial collapse. (Source: “Morgan Stanley thinks it knows when the bull market will end,” CNN, May 16, 2018.)

The Federal Reserve will continue to raise interest rates. Fed Chair Jerome Powell promoted this plan in February.

This is a vote of no-confidence on the U.S. economy. The higher the interest rate, the lower the confidence in the economy. That means low confidence in the financial markets as well, of course.

The real economy, we are told, is healthy. But for how long, given that the financial markets are clearly stalling? The economy and stock valuations have increasingly become detached from one another.

Higher yields literally scream “Financial Crisis.”

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