The recent plunge in U.S. stock markets may be the harbinger of a looming economic downturn, a scenario that spells trouble for President Joe Biden’s administration and Vice-President Kamala Harris’s presidential campaign. Their attempts to promote a successful economic track record now face significant challenges, as global markets decline and U.S. unemployment rises, making their task of selling this narrative increasingly difficult.
This market turmoil and the potential recession are unfolding more than two years after the U.S. Federal Reserve commenced its aggressive interest rate hikes to combat inflation. The delayed yet direct consequences of this policy are becoming evident, aligning with the Fed’s objective of cooling an overheating economy, despite inflation having peaked and begun to decline independently of the Fed’s measures.
Recession Signals and Market Indicators
Traders and investors should take note of the historical significance of an inverted yield curve, which has been a consistent predictor of recessions over the past four decades. Key years such as 1980, 1982, 1989, 2000, 2006, and 2019 saw the 90-day Treasury bills’ interest rate surpass that of 10-year Treasurys, followed by an economic downturn within a year. Although the inversion often ends by the time the recession hits, the correlation remains strong.
The current cycle saw the yield curve inversion in October 2022, but a recession did not immediately follow, primarily due to counterbalancing forces such as significant fiscal deficits, substantial national debt interest payments, and considerable bank reserves’ interest payments. These factors sustained the economy despite the Fed’s efforts to temper it.
Unemployment and Economic Stress
Recent data indicates a nearly one percentage point increase in U.S. unemployment over the past year, with job creation significantly reduced. The number of newly unemployed, part-time workers due to economic reasons, and those desiring employment but not in the labor force increased by over one million from June to July. The “Sahm rule,” which signals a recession with a half-point rise in the unemployment rate over a three-month moving average, is currently flashing red.
Political Cycles and Monetary Policy
A crucial aspect for investors to consider is the Fed’s tendency to adjust its monetary policy based on the political landscape. Historical analysis reveals that the Fed adopts a more accommodative stance when Republicans control the White House and a more restrictive one under Democratic presidents. This pattern, studied and confirmed through various economic models, suggests that the Fed’s actions are influenced by presidential election cycles, impacting the yield curve and overall market conditions.
Implications for Investors
The current economic scenario aligns with historical trends, where low unemployment under a Democratic president leads to a tighter monetary policy, contributing to an inverted yield curve. This inversion, approximately 1.5 percentage points at present, would likely differ under a Republican president or higher unemployment rates.
For traders and investors, understanding these dynamics is crucial. The Fed’s reluctance to lower interest rates despite declining inflation reflects its historical stance and the broader political and economic context. Democratic presidents’ long-standing deference to the Fed’s autonomy and the appointment of Republican chairs have led to a recurring challenge for progressive economic policies.
Conclusion
As the economic landscape evolves, traders and investors must stay attuned to the interplay between political leadership and Fed policies. The potential recession and market volatility present both risks and opportunities. By recognizing the historical patterns and the Fed’s policy tendencies, investors can better navigate the market, make informed decisions, and anticipate potential shifts in the economic cycle.
