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Here’s the thing: the Fed has had 13 cycles of monetary tightening since 1945, and 10 of them ended in a recession (see chart below). “Soft landing” exceptions: 1965-66, 1983-84 and 1994-95.

The Fed has just started another round of monetary tightening, which should push the fed funds rate from near zero to around 2.5-3%. Stock bulls are hoping the Fed will be able to stage another “soft landing” like in 1994/95. A “soft landing” is the cycle of monetary tightening that does not cause a recession (and the bear market in equities).

Unfortunately, the current monetary tightening cycle is very likely to cause a recession (hard landing) and therefore a bear market in equities (NYSEARCA: SPY), which has actually been running since January 2022.

The soft landing of 1995

Here is the chart that shows historical cycles of monetary policy tightening (raising the fed funds rate), where the shaded bars represent recessions. If you zoom in on the 1993-95 period, you can see that the Fed raised interest rates during that time, but it didn’t cause a recession – “the soft landing of 1995”.

Federal funds rate

Fred

Here is the Fed’s statement from the January 1995 meeting:

The Federal Reserve Board today approved an increase in the discount rate from 4 3/4% to 5 1/4%, effective immediately.

Along the same lines, the Federal Open Market Committee has agreed that this increase should be fully reflected in reserve market interest rates.

Despite tentative signs of some slowing in growth, economic activity continued to expand at a strong pace, while resource use increased again. Under these circumstances, the Federal Reserve considers these measures necessary to contain inflation and thus promote sustainable economic growth.

The most important key word in this Fed statement is “resource utilization”. During the pre-globalization and early globalization period of the 1970s and 1980s, inflation was fueled by the rate of capacity utilization, among other variables.

If you look at the chart below, the US economy was operating at almost 90% capacity utilization in the 1970s, which was one of the key variables that led to inflation spikes. After the 1981 recession, capacity utilization fell to 70% and never exceeded 85% thereafter as globalization policies took hold. This dramatically lowered inflation expectations and allowed the Fed to raise interest rates in the early 1980s and early 1990s without causing a recession.

In fact, in 1993, capacity utilization began to increase by around 80% to 85%, which apparently alerted the Fed to raise interest rates to contain inflation expectations. Yet, throughout the period, from 1993 to 1995, CPI inflation was subdued and remained within the narrow range of 2.5 to 3%. So the Fed proactively raised interest rates in response to increased capacity utilization – while actual inflation was never an issue.

Note that capacity utilization never exceeded 85% thereafter, and continued to decline towards the 80% level in the second half of the 1990s, which allowed the Fed to lower interest rates slightly. interest after the monetary tightening cycle – and put the stock market on fire.

Globalization is disinflationary. Globalization policies have allowed the United States to gradually outsource production, which has reduced inflationary pressures related to all resource limitations – labor and factory.

Capacity Utilization vs CPI

Fred

The inflation peak of 2022

Fast forward to 2022, and you see the situation completely different. Inflation is very high with the current peak up to 7.9% CPI YoY and capacity utilization very low at 77%. It has nothing to do with the situation in 1994-95. Inflation is now a major problem, and it is not due to the capacity utilization of factories – however, it is partially due to the low capacity of labor resources given the unemployment rate 3.8%.

In fact, inflation is currently skyrocketing due to the extraordinary pandemic-related monetary stimulus and pandemic-related supply disruptions, both of which proved to be non-transitory. Thus, the Fed has no choice but to significantly reduce demand, which includes deflating asset prices as a major source of demand due to the wealth effect. This is a hard landing scenario – recession and bear market.

But more importantly, long-term inflation expectations are also rising due to the current de-globalization trend, which accelerated with the Russian invasion of Ukraine. De-globalization is stagflationary – high inflation with low growth. The Fed can only counter supply-side inflationary pressures resulting from deglobalization by further reducing demand. In the longer term, this could lead to a series of inflationary recessions like in the 1970s.

The unfolding bear market

The S&P 500 experienced the first stage of the bear market with the 10% correction in January 2022, mainly caused by the rise in long-term interest rates in anticipation of the end of the Fed’s QE program. However, at the time, the market only anticipated a gradual tightening (4 interest rate hikes in 2022). Moreover, the spread of the yield curve was above 0.70%, suggesting a very low probability of a recession. Thus, I viewed the 10% correction as a tactic purchase opportunity.

However, the yield curve gap narrowed significantly to 0.4% with the geopolitical escalation as Russia invaded Ukraine, increasing the likelihood of a recession and causing a deeper correction in 13% of the S&P 500. Given the lack of an inverted yield curve, I downgraded my view to hold on Feb. 14, advising against buying stocks due to longer-term stagflationary pressures from deglobalization, but pausing before recommending a sell.

However, in the last month since my downgrade, parts of the yield curve have inverted (10yr-5yr), which now signals an impending recession. The widely watched spread between 10-year and 2-year Treasuries has narrowed to 0.20%, still not supporting an impending recession by historical standards. However, the rate at which the yield curve has narrowed over the past 3 months is alarming and the likelihood of a near-term reversal is high. Also, since the stock market may already be in a bear market, this might be one of the very few situations where I would actually recommend to to sell S&P 500. This time there may not be the usual 9-12 month lag between the initially inverted yield curve and the start of the bear market, the current sell off could only accelerate.

Tactical Considerations

Here is the SPY chart. Technically, SPY has been in a downtrend since January 3, 2022. Additionally, there is a “death cross”, where 50dma intersects 200dma. Currently, SPY is likely in a bearish rally – one that could drag on. Since fundamentals and technicals are both bearish, many will attempt to sell short, which opens up the possibility of a very sharp short cover rally. However, these rallies will be the opportunities to exit SPY long positions.

Graphic
Data by YCharts

Risks – bullish thesis

What could change the bearish outlook for the S&P 500? Simply – revival of globalization. The United States should lift all trade tariffs on China, and China should rein in Russia. This would reduce stagflationary pressures and reintroduce the 1990s golden loops of high growth with low inflation.

Why is SPY vulnerable?

The S&P 500 index ETF is considered the proxy of the market portfolio and is widely used as a performance benchmark for active funds, as well as the preferred investment vehicle for passive index investors.

Thus, there have been large inflows of passive investment funds into SPY, which may have inflated the largest and most speculative stocks in the index, such as Tesla (TSLA) which accounts for more than 20 % of Consumer Discretionary (XLY) sector. In fact, Michael Burry warned in 2019 of the possible passive investing bubble. Therefore, as the bear market selloff accelerates, SPY will be vulnerable to a NASDAQ-style selloff, unlike for example 2000-2003 when the S&P 500 was more insulated from the selloff.

Conclusion

The Fed will not be able to stage a soft landing like in 1995. The Fed proactively raised interest rates from 1994 to 1995 in response to increasing resource utilization. Throughout the period, inflation remained in a narrow band of 2.5 to 3%.

Currently, we have a significant inflation spike of 7.9% – and the Fed a long way behind, with interest rates only just breaking above the 0% level. Thus, the Fed will have to raise interest rates very aggressively, which will most likely produce a hard landing – recession and a bear market in equities. The SPY ETF is vulnerable to a selloff due to the passive investing bubble, which has inflated large speculative tech stocks, heavily weighted in the S&P 500 Index.