The chart below is gaining popularity in the bearish community on Twitter because it shows near unanimity in investors’ opinions that the economy won’t go into a recession in 2017 or 2018. I agree with what the respondents said if the tax cuts are passed to boost 2018 GDP growth. If they aren’t, a 2018 recession is possible. This shows how optimistic investors are about the economy. Either they think tax cuts will boost the 2018 economy or they think that the Fed may change policy if the economy shows weakness like what happened in early 2016. This uniform trust that everything will work out fine is worrisome. It makes sense to be worried when everyone is complacent and bullish when everyone is nervous. It would be interesting to see their thoughts on the next few years to see if most investors agree with the CBO that a recession won’t be coming in the next 10 years. If investors trust the CBO, that would be downright frightening.

The chart below shows the 2s10s which Zero Hedge mentions in every market recap because it’s bearish. Keep in mind when the website shows an arrow pointing to before the recession, it doesn’t imply the yield curve is signaling a recession. Last cycle, the yield curve flattened to inverted and then steepened before the recession. If that happens again, another recession is in about 3-4 more years. While I’m not as bearish as Zero Hedge, I think a recession could come sooner than that.

According to Goldman Sachs’ chart below, the most prominent reason recessions have occurred since WWII is monetary policy tightening. It’s not that the Fed decides recessions should occur. Recessions would occur with or without the Fed. It’s that the Fed controls the timing of the business cycle. It can postpone recessions and amplify growth periods, like it has done in this cycle.

While the bulls claim that the yield curve doesn’t reflect the reality of the market because of Fed bond buying, I’m skeptical of the Fed funds rate being a good measure of monetary policy because of QE. This point implies a more bearish view because, as you can see from the chart below, the Krippner shadow rate (which includes QE) shows 650 basis points of tightening already. The past 4 tightening cycles only had 305 basis points of tightening on average, with the largest being 421 basis points last cycle. With the Fed about to raise rates in December and unwind the balance sheet, this is poised to be a historically dramatic tightening cycle for the shadow rate. That implies a recession is coming sooner than the next 3-4 years.

To further dig in to the Fed funds rate and the shadow rate, the chart below shows them in rate of change terms. As you can see, when the shadow Fed funds rate accelerated growth to 3% year over year, the bull market ended in the past two cycles. The tightening slowed in 2016 as the economy was potentially nearing a recession. In the next accelerated tightening phase, both the Fed funds rate and the shadow rate will be increasing. Based on the Fed’s guidance, the year over year increase in the Fed funds rate will never increase as fast as the previous two cycles because the Fed only sees the Fed funds rate getting to 3.00% in the long run and it’s already at 1.00%. To get to that goal and push the growth rate to 2% per year, the long term expected rate would need to be achieved in the next year which is unlikely because the dot plot says it will occur after 2019. The rate of change of the Fed funds rate doesn’t imply there won’t be a recession because this economy can’t handle high rates as well as it did in the previous two cycles as inflation growth, GDP growth per capita, and wage growth are all lower.

Moving on to the near-term economic outlook, my expectation for Q2 GDP declined today as the durable goods orders fell 1.1% month over month which was below expectations for a 0.6% decline. As you can see from the chart below, this indicator has declined for 2 straight months. That has been a common occurrence in the last 3 years. As you can see, every year from 2014 has had at least a string of 2 straight months of declines. That doesn’t signal that that’s the norm for the economy; it signals the economy has been in disarray for a while.

Delving into the details of the report, the non-defense capital goods orders fell 0.2% which is sharpest decline since December 2016. Core capital goods orders also fell 0.2% which is a disappointment from the 0.3% growth expected by economists. This number is used for the GDP calculation. You would have thought, this disappointment would have caused the GDP Now Q2 GDP growth estimate to have been cut, but the forecast remains 2.9% as you can see in the chart below. That’s because this negative report was matched by the positive new-home sales report from Friday which hadn’t been put into the forecast until today’s update.

Of note, the demand for motor vehicles and parts increased 1.2% which signals the weakness in the car market may have temporarily paused. The NY Fed and St. Louis Fed will revise their models lower once this durable goods report is integrated because they already took into account the new home sales data. As you can see from the chart above, the blue chip is now seeing 3.0% growth. I expect that estimate to fall further as I see Q2 annualized GDP growth coming it at between 2.0% and 2.5%.

Conclusion

The Fed tightening is the reason for most recessions since WWII. With the shadow Fed funds rate already up 650 basis points, some would say it has already done enough to cause a recession. The durable goods orders show a different story from the poll of Citi clients. I’m not calling for a recession in 2017, but with the 0.2% decline in core capital goods orders, it’s surprising to see no one expecting a recession. They are only concerned with the price action.