Wildfire is a serious threat in the western U.S. Record wildfires over the past several years have killed dozens of people, burned thousands of structures and destroyed hundreds of thousands of acres of timber. California used to have a summer wildfire season, but the megadrought is enabling wildfires year round. The foregast for 2022 is for increasing wildfire potential.
https://wildfiretoday.com/2022/06/01/increasing-wildfire-pot…
Part of the problem is the buildup of fuel. The natural cycle of forest growth includes fire to remove dead undergrowth. The ecosystem benefits since regular fires are not hot enough to seriously damage the forest. Some tree species require fire to release seeds and re-start the growth cycle. Native Americans traditionally set intentional fires to clear out undergrowth during seasons that the fires wouldn’t spread widely. This enables new growth (food for game animals) while clearing out dead fuel.
The U.S. Forest Service, with all the best intentions, fought forest fires for many decades. By interrupting the natural ecology of fire, they produced forests with a huge build-up of fuel that causes infernos that kill even the older trees and seeds that would survive smaller fires. The longer this continues, the more dangerous the fires and the less likely the burned area will recover quickly.
We all admire the brave firefighters. It seems obviously beneficial that the Forest Service prevents fires from devouring valuable timber land. But the long-term unintended consequence is more damaging fires.
The Federal Reserve’s mandate is to maximize employment while maintaining low inflation. They have done this successfully (with a couple of crises) since they began to suppress the fed funds rate after the recovery from the 2001 recession. Employment didn’t rebound as quickly as they expected. The Fed cut rates to encourage productive uses by industry. They instituted ZIRP (zero interest rate policy) along with QE (Quantitative Easing) after the 2008 financial crisis during the high unemployment of the Great Recession. They added unprecedented lending programs along with ZIRP and QE after the 2020 Covid crisis. The scale of Fed interventions is breathtaking. It is described in the book, “The Lords of Easy Money,” along with the details of the unintended consequences.
https://fred.stlouisfed.org/series/FEDFUNDS
https://fred.stlouisfed.org/series/WALCL
Like the brave firefighters, the Fed succeeded in their mandate. The economy did eventually rebound to record low unemployment. Inflation was 2% or less for many years. The flood of money inflated asset values so investors felt flush and happy.
But the unintended consequences built up over time. Like the flammable undergrowth, zero interest rates (negative REAL rates) pumped money into the hands of private equity and other investors who bought assets that didn’t produce profits that would make sense in a historic positive yield environment. Private equity bought productive businesses and loaded them with debt while cutting workers’ income and often cutting the workers themselves. These companies became zombies whose function was servicing debt, not producing the goods and services their businesses appeared to be about.
Zero-interest debt enabled companies to provide services for under their actual cost. In effect, these start-ups, backed by venture capital, were paying the consumers, to buy their products. This has been called “the Millennial Lifestyle Subsidy.”
https://www.theatlantic.com/newsletters/archive/2022/06/uber…
With interest rates rising, unprofitable companies have to cover their costs. Zombie companies won’t be able to roll over their maturing debt at the higher rates. Many will be forced to raise their prices or even go bankrupt.
According to the Federal Reserve, “There is no formal definition of a zombie firm, but it is generally agreed that these firms are economically unviable and manage to survive by tapping banks and capital markets. Accordingly, we identify zombie firms in U.S. data by requiring that they are highly leveraged and unprofitable. More precisely, we require that zombie firms have leverage above the sample annual median, interest coverage ratio (ICR) below one, and negative real sales growth over the preceding three years. High leverage and low ICR help identify firms that cannot cover their debt-servicing costs, while negative sales growth identifies firms with low growth prospects, as sales growth is a good predictor of firms’ future performance.”
https://www.federalreserve.gov/econres/notes/feds-notes/us-z…
In 2020, the Fed identified 9% of listed firms as zombies.
There’s a lot of debt. Nonfinancial Corporate Business; Debt Securities and Loans is over $12 Trillion, an all-time high.
https://fred.stlouisfed.org/series/BCNSDODNS
That’s a LOT of risk built into the indexes. The markets are beginning to price in this risk on junk bonds.
https://fred.stlouisfed.org/series/BAMLH0A3HYC
The buildup of corporate debt is like the buildup of dry fuel in forests where fire has been suppressed for many years.
Maybe there’s too much risk? Maybe the Fed should just…forget about the whole monetary tightening thing and go back to ZIRP?
Uh-uh.
https://www.wsj.com/articles/central-banks-should-raise-rate…
**Central Banks Should Raise Rates Sharply or Risk High-Inflation Era, BIS Warns**
**The bank cautions that the steps necessary to get inflation under control could raise global economic costs**
**By Tom Fairless, The Wall Street Journal, June 26, 2022**
**...**
**The world’s central banks must raise interest rates sharply, even if it significantly hurts growth, the BIS, known as the central banks’ central bank warned on 6/26/2022. If they don’t, the world risks a 1970s-style inflationary spiral, the Bank for International Settlements said in its annual report. Even if they do, the global economy could face a toxic combination of low or negative growth and high inflation, known as stagflation, it said....**
**The Switzerland-based BIS, which acts as a bank and think tank for central banks, drew uncomfortable parallels with the 1970s. Then as now, real policy rates fell far below zero, meaning central banks were stimulating rather than slowing economic activity as inflation surged.**
**Adding to the risks: Overvalued assets and high debt, which were much less of a concern in the 1970s, could magnify any growth slowdown....Economies are more likely to land in a recession during an interest-rate hiking cycle if inflation was high to start with and if their policy rates were low after adjusting for inflation, according to a BIS study of 35 countries between 1985 and 2018....** [end quote]
The BIS introduced its just-released Annual Report with an editorial titled, “No Respite.” That doesn’t sound too optimistic.
https://www.bis.org/publ/arpdf/ar2022e.htm
Anytime the Fed releases a fed funds rate, subtract the current inflation rate from the fed funds rate. If the result is negative, the REAL rate is negative and borrowers are being paid to borrow money. That is stimulative and inflationary. Inflation won’t decline until the real rate is positive.
But the markets are addicted to money that is negative-yield.
Any hint that the Fed might back away from increasing the fed funds rate and QT is greeted by the market with whoops of joy.
That happened on Friday. Only the day before, Fed Chair Jerome Powell told Congress that the Fed would increase rates if inflation does not decline for months. But a separate reading of consumer inflation expectations was a fraction of a percent lower so the market rejoiced.
The Control Panel reversed some trends last week. Stock and bond prices rose together, indicating that the markets expect looser money. The trade was risk neutral. The Fear & Greed Index improved to Fear.
Oil, natgas and copper fell together over the past couple of weeks. This is concerning because it may indicate lower demand in the real economy – perhaps an approaching recession. The Treasury yield curve has some negative slope areas.
I think that the Friday bounce was noise, not a trend. I believe that winter is coming. I think the markets (all the asset markets) have much further to drop. But that will take a while to bottom.
The METAR for next week is cloudy at best but could be cold and rainy. The noose is gradually tightening. The next event will be the release of inflation figures followed by the Fed’s response.
Will there be a series of small wildfires as zombie companies fold? Or will there be another massive conflagration like 2008 as unknown “fingers of instability” join and collapse the whole sandpile?
Wendy
https://stockcharts.com/freecharts/candleglance.html?VTI,$SP…
https://stockcharts.com/freecharts/candleglance.html?$IRX,$U…
https://stockcharts.com/freecharts/candleglance.html?$SPX,$U…
