Here’s What Will Cause The Next Recession

Financial professionals frequently opine that asset prices are a function of economic conditions. Assets like stocks, bonds and real estate rise in value when the economy is expanding. They fall in value when the economy contracts.

The problem with those statements is that they represent a flawed understanding of 21st century credit cycles. In particular, recessionary pressures did not cause the tech wreck (2000-2002) nor the housing collapse (2008-2009); rather, the bursting of each asset bubble sparked the recession that followed.

Let’s examine the respective timelines.

In the latter half of the 1990s, the Federal Reserve’s easy money policies became even easier when the central bank slashed rates to contain the Asian Currency Crisis (1998). The Fed then scrambled to restrict the ubiquitous use of credit by rapidly tightening overnight lending rates from 1998’s low of 4.75% to May of 2000’s pinnacle of 6.5%.

fed-funds

Perhaps unfortunately, the dot-com balloon had been pricked (3/2000). The severe price depreciation, particularly in tech stocks, led to consumers feeling much less wealthy and to businesses laying off millions of employees. Importantly, the stock bear occurred a full year prior to the recession’s inception in 2001.

What about the Great Recession in 2008? After many years of extremely loose monetary policy on the part of the Fed, tightening of the overnight lending rate topped out at 5.25% in 2006. Housing prices peaked at that very same time. They began dropping in earnest by 2007. Meanwhile, financial stocks via SPDR Financial Select Sector (XLF) fell 20% in 2007.

xlf-2007

Once again, an asset bubble had burst. And a wealth effect reversal was underway, triggering a recession where millions lost their livelihoods and hundreds of millions slowed their consumption to a crawl.

In the same vein, then, the next recession will not cause stocks to plunge 30%, 40% or 50% in value. Rather, when the “Everything Balloon” pops, real estate prices will drop significantly and stocks will fall precipitously. The severity of the wealth effect reversal will trigger the next recession.

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ETF Expert is a web log (”blog”) that makes the world of ETFs easier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser ...

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Gary Anderson 1 year ago Contributor's comment

Cool article. Reversal of the wealth affect happened also in 2007, when the commercial paper market that buoyed the subprime market cratered. Then also in 2008, both the heloc market curbs and interest on excess reserves were implemented. So, it was one thing after another.All these tightenings were ignored by the Fed in that no offset was provided, and the tightenings were actually implemented or welcomed by the Fed.

Bindi Dhaduk 1 year ago Member's comment

How often does something like that happen?

Gary Anderson 1 year ago Contributor's comment

Well, rarely. But since fiat money multiple tightenIngs could happen more often.