Six reasons why a recession might be unavoidable

That the financial markets and the Federal Reserve aren’t seeing eye-to-eye about the direction of monetary policy should be a moot point—only one has its hands on the wheel. The recent rally in risk assets seems like wishful thinking in the face of the Fed’s determination to slay inflation. Here are six reasons why we think the economy is headed into a recession later this year, despite the resilience of the labor market, and why we think a conservative approach is warranted.

No. 1:  Money supply is shrinking Ample liquidity is critical for the health of the economy, one of the reasons the stock and bond markets love accommodative policy. Weak growth of the money supply would be bad news, but liquidity is now actively draining from the system. The last time it declined on a sustained basis was during the Great Depression. 

No. 2: That other tightening tool Lost in the fervor over hikes is the continuing reduction of the Fed’s balance sheet, which has a much bigger impact than the markets realize. The San Francisco Fed estimates that the impact of the $95 billion monthly roll-off suggests the economy is actually facing a fed funds rate over 6% rather than 4.5–4.75%. If that’s true, real interest rates across the entire Treasury curve are deeply negative and a significant drag on the economy.

No. 3: LEI is DOA It's not that bad, but the Index of Leading Economic Indicators has fallen for 10 consecutive months. With its components measuring many aspects of the economy, a decline in this broad metric is a strong clue that a recession is coming.

No. 4: Follow the line Sometimes it’s best to keep it simple. The Treasury yield curve remains inverted—perhaps the most reliable predictor of a recession.

No. 5: Declined! Banks have brought back the infamous trope of a loan officer informing a couple across a large desk that he’s turned down their loan application. It’s not exactly that bad, but since the 1960s, banks have tightened consumer credit on only nine occasions and a recession has followed in eight of them.

No. 6: Earning their keep Since 1950, every recession has been preceded by a significant correction in corporate profit margins. That hasn’t happened yet, but most of last year’s revenue came not from increased sales volume but from companies raising prices. That will be harder to repeat as inflation pressures fade. Also, profit margins are getting squeezed between falling pricing power and sticky wages.  Further, operating cash flow for S&P 500 companies in the aggregate is running 15% below reported earnings. That’s pretty rare, and usually an indicator earnings will fall.