Recession is a buzzword in the news right now, as due to a variety of factors—ranging from the post-Covid-19 recovery period to the conflict between Russia and Ukraine—one might be just around the corner for many countries in the world. In fact, in mid-August, Bloomberg wrote that there was almost a 100% probability of a recession before the end of 2023.
The higher interest rates needed to tame inflation were expected to trigger a period of slow economic growth and high unemployment. Tight central bank monetary policy is often a catalyst for recession, but another potential cause can be a surge in energy prices, which has also occurred in 2022. At other times, when consumers hold back on spending, or when the prices of houses slip, the economy can also be tipped into a downturn.
Despite the warning signs, not all traders have been convinced a recession is on the way. In June, the S&P 500, which tracks risk assets, went on a rally, boosting economic confidence. No one wants to believe in a recession since the results are sometimes dire for people’s financial wellbeing, and we saw this fairly recently during the 2008 recession.
In a recession, demand from consumers and businesses goes down, which forces companies to cut costs. As a result, workers have to be laid off, creating a further drag on demand. Thereafter, the low production and sentiment feed off one another, and the economy quickly loses altitude.
In 2008, US unemployment reached 10% and nearly four million Americans lost their homes in a downturn that spread all the way to Portugal, Spain, Greece, and Ireland. However, each recession emerges in a distinct context and follows unique rules, so the consequences are not always this bad. In addition, central banks have the benefit of learning from historical recessions, and they try not to make the same mistakes. In this article, we’ll take a look at some past recessions with an eye out for relevant lessons—especially where commodity trading is concerned.
The US Recession of 1973-75
Students of commodity trading know that, after the American embargo on Arab oil, oil prices mushroomed by a factor of four, which was a key factor in sparking this downturn. The background to this 16-month recession was a period between August 1972 and August 1973 when inflation in the US rose from 2.4% to 7.4%.
The Fed responded by doubling the federal funds interest rate to 10% by mid-year 1973, and then adding on another 3% in the first half of 1974. The result was an unemployment issue that outlasted the recession into 1975. One of the more obvious lessons from all this goes out to the recession-doubters in 2022: the combination of high interest rates and elevated energy prices can be difficult for the economy to resist.
The Volcker Recession of 1980
As 1979 was getting underway, inflation in the US had risen to 7% due to dovish Fed monetary policy aimed at solving an unemployment problem. At this time, the revolution in Iran led to a ballooning of oil prices.
Fed Chair Paul Volcker responded to the twin threats by raising interest rates from 10.5% in August 1979 to 17.5% by April 1980, spawning a severe recession in which millions of people ended up out of work. Following this, however, came a long period of good economic growth and low inflation, which was Volcker’s goal. His predecessor, Arthur Burns, by contrast, was criticized for allowing inflation to rise too high and stay that way too long. The result in that case was stagflation, which is a period in which high inflation, high unemployment, and slow growth all co-exist.
The present Fed Chair, Jerome Powell, has responded to rising inflation in a way that is “Closer to Volcker’s vigor than Burns’s anguished inaction”, even though he may have not recognized the extent of the problem as early as he might have, says Bloomberg.
A lesson to draw from the 1970’s and 1980’s may be that the Fed should not spare the economy the bitter medicine of high rates. Even though the human effects of rates-driven recessions are painful and real, this is necessary to put healthy long-term dynamics in place.
The 2008 Recession
Easy credit and lenient lending standards in 2007 led homebuyers to borrow more than they could afford, resulting in bloated home prices. Banks took these mortgages and sold them to investment institutions on Wall Street, which converted them into financial instruments called CDOs (Collateralized Debt Obligations). Home prices began to drop in 2006, and people were left with homes worth less than they were currently paying.
Wall Street banks soon found they had trillions of dollars of securities based on worthless mortgages. In March 2008, stock markets around the world plummeted and investment bank Bear Stearns went bankrupt. In September, the same happened to Lehman Brothers. Millions of people globally felt the pain of the recession.
Ben Bernanke, the Fed Chair back in 2008, answered the problem by cutting the federal funds rate to 0%, buying trillions of dollars of bonds, and offering forward guidance (assuring the market that rates would stay low in the short term). By March 2009, stability had been achieved and then came a bullish rally on the stock market. Powell’s Fed may want to take advantage of all three of these tools in months to come.
The bottom line
Whether or not a recession comes into full bloom, it’s important to follow the many factors that can affect key commodity trading instruments such as wheat, natural gas, and oil—all of which could be impacted by a recession. Armed with this knowledge, you can make more informed trading decisions during the best—and worst—of times.
