The Other Shoe Hasn’t Dropped Yet!

CALM BEFORE THE STORM: The Other Shoe Hasn’t Dropped Yet!

The seas are tranquil in the financial markets – at least for now. Volatility in the S&P 500 and NASDAQ are at their lowest point in at least a year. Complacency and greed are the prevailing sentiments, and that’s exactly why you need to be on your guard.

Alarmingly, short-term traders are ignoring signs of weakness in the economy. Potential homebuyers are increasingly choosing to pull out of the market as interest rates climb again. The volume of home purchase applications has decreased by 10% compared to last week, and overall home purchase demand was down 36% year-over-year.

These figures have to be put into context. The rate on the average 30-year fixed mortgage is currently 6.39%. Two years ago, a 5% rate would have made the headlines. 6%+ mortgage loan interest rates are apparently the “new normal” now, but people being used to it doesn’t mean it’s sustainable because persistently elevated interest rates could cause a collapse in the residential real estate market.

If the housing market is the backbone of the American economy, then there are deep cracks in the foundation that cannot be ignored. Believe it or not, the mortgage payment required to buy the median-priced home for sale in the U.S. just moved up to $2,538, a new all-time high.

This evidence directly contradicts perma-optimists like Treasury Secretary Janet Yellen, a recession denier who says she’s “not anticipating a downturn in the economy” since “the U.S. economy is obviously performing exceptionally well.” Meanwhile, the Federal Reserve Board is actually predicting that a recession will occur later this year.

Ask yourself this: when was the last time you heard the nation’s central bank, which typically uses soft language, forecast an imminent recession? They know (and Janet Yellen knows it, even if she won’t admit it) that ultra-tight lending standards in wake of a major banking sector crisis are bound to place tremendous pressure on the economy.

Even the Federal Reserve can’t deny it at this point; the “no landing” scenario is impossible now, and it’s only a question of how hard the “hard landing” will be. Credit is the lifeblood of America in the 21st century because borrowing and lending activity keep the economy running. Tightening credit conditions spell disaster for the economy even if amateur traders have turned a blind eye to it.

It could also be said that liquidity – the availability of cash in the banking system and the economy as a whole – is what has kept the house of cards from tumbling. If the Federal Reserve increases its balance sheet by purchasing Treasury bonds and mortgage-backed securities from big banks, this keeps the system flooded with capital.

However, the Fed is now back to removing liquidity from the system (quantitative tightening) because its balance sheet is now shrinking again. That liquidity bump you see in the chart above is largely what’s kept the markets in a good mood lately.

As the liquidity bump fades, expect the other shoe to drop in the S&P 500 and NASDAQ, though there’s typically a lag since short-term traders can stay stubbornly bullish and ignore reality for a while. The weighing machine of the financial markets always kicks in sooner or later though.

Additionally, don’t celebrate the 5% CPI print yet. Inflation still isn’t close to the Federal Reserve’s 2% target, which the central bank is hellbent on achieving at all costs. If getting inflation down to 2% means putting small businesses out of commission, causing more regional banks to fail, and jacking up the unemployment rate, so be it.

That’s the Fed’s attitude, and nothing that Federal Reserve Chairman Jerome Powell has said recently contradicts the central bank’s single-minded objective of bringing inflation down. Even if there’s no volatility in the financial markets right now, this isn’t indicative of reality – and reality can be ignored for a while but not forever.