Forget Recession Worries–The Big Danger Now Is In The Credit Cycle

The Federal Reserve and the world’s other central banks face an impossible choice.

On the one hand, they could have tighten the money supply by raising interest rates or other means. That would have risked sending economies near recession into recession–Germany, for example–and slowing growth further in economies that were already seeing signs of slowing growth. And–and for the Federal Reserve is this a very important part of the calculation–risk a financial market tantrum that revived fears of a bear market. Tightening the money supply would, on the plus side, have sent a strong message to credit markets that the current degree of risk taking was over done and that it was time to pull back on credit to riskier borrowers. In the short, term, unfortunately, that kind of signal to lenders would have added to recessionary forces, even if in the longer-term such action might have headed off a deep credit crisis.

On the other hand, these central bankers could have opted to put off interest rate increases and, in the Fed’s case, to dangle the possibility of an early end to  balance sheet run offs of $50 billion month that had the effect of tightening the money supply. That would reduced fears of a pending recession–which would have the effect of reducing the likelihood of an actual recession since fears of a recession are a major element in bringing on an actual recession. It’s the fear of a recession that leads CEOs to cut back on hiring and spending plans and encourages consumers to save a little bit more and spend a little bit less. The cost of putting off anything that smacked of tightening the money supply would be, of course, to encourage exactly the additional risk-taking that can lead to a deep credit crisis.

In the event, the Federal Reserve at is January 30 meeting opted for alternative #1.

That’s had the effect of extending a stock market rally, reducing recession fears, adding to economic growth (probably), and exacerbating exactly the kind of risk taking in the financial markets that is a big danger at this point in the credit cycle. The M2 money supply for 12 major economies including the U.S., China, the EuroZone, and Japan dipped to $69.8 trillion in November 2018 from an April peak of $73.1 trillion in April, and then rebounded to an estimated $72.6 trillion at the end of January.

Want some examples of how much risk investors and traders are willing to take on?

Ecuador sold $1 billion in new bonds while in the midst of talks with the International Monetary Fund for a package of financial support. A Greek offer for a 2.5 billion euro ($2.9 billion) bond sale was greeted with enthusiastic offers. Uzbekistan is planning its first international debt offering.

And, of course, the United States is moving to sell more than $1 trillion in Treasury bonds year.

What may be worst extraordinary about that mountain of government debt is how little buyers are charging for the use of their money. Italy, for example, has slipped back into recession and ranks as one of the world’s most indebted countries with a debt to GDP ratio of about 132%, but 10-year Italian government bonds still held only 2.79%. As a whole the world is awash in debt that pays nothing or less with $8.6 trillion in debt with a negative yield.

Total global debt hit a new higher in the first quarter of 2018 at $247 trillion.

And its not just government debt that has soared.

Debt among non-financial corporations across the globe rose to a record high of $75 trillion in the second quarter of 2018, the Institute of International Finance said in a report inNovember. China and the United States have been the biggest drivers in setting that record. But they have by no means been alone. A “significant proportion” of Brazilian, Canadian, American and Chinese corporations struggle to pay interests on their debt, the report said. One-third of small firms in France, the United States and China, for example, have an interest coverage ratio that is lower than what is generally seen as providing an optimal margin of safety.

And let’s not forget consumers. U.S. consumer credit rose in November by the most in 16 years as credit-card balances surged, according to the Federal Reserve. Total credit outstanding rose at an 8.8% annual rate in November with revolving credit–credit card debt–growing by $11.2 billion in the month, the biggest increase in a year.

What this all looks like is the build to a Minsky Moment in the credit cycle. That’s the moment in the credit cycle where excessive risk-taking comes home to roost in a major financial market reset. A recession would certainly be enough to trigger such a reset. And a credit crisis would make any recession worse.

And challenge is–as it has been for the last year or two–what do investors do to mitigate the risk of such a credit crisis. More thoughts on that soon.