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Remember all the talk about how bullish the first hike of a tightening cycle was supposed to be? Really smart guys like Omega Advisors’ Leon Cooperman trotted out all sorts of statistics about how the stock market typically rises something like 10% after the first rate hike.

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Much to many of these old timers surprise, the stock market failed to follow their playbook.

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Instead of shrugging off the rate hike, the S&P 500 has plummeted by almost 8%. Small cap stocks have fared even worse.

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What Cooperman and all the other economic optimists are missing is the fact we are in a balance sheet recession. The natural state of the global economy is for credit to be paid back, not expanded. Absent aggressive monetary (or fiscal) policy measures, credit will be destroyed. When Bernanke’s Fed was engaged in all the various forms of Quantitative Easing, the natural credit contraction was offset enough to put off the deleveraging. But ever since Yellen has taken over as head of the Federal Reserve, she has ended all the QE programs and proceeded to raise rates. This has ushered in a massive contractionary credit destruction cycle. With the supply of US dollars shrinking the greenback has rallied. The declining liquidity has starved the global financial system of the much needed lubricant to keep the precariously balanced unprecedented debt burden from collapsing.

Yet it’s not like Yellen wasn’t warned. Smart guys like Ray Dalio, Jeffrey Gundlach and Larry Summers (although it pains me to call this tool smart) have been warning of a 1937 policy mistake.

From Bloomberg:

Ray Dalio, founder of the world’s largest hedge fund firm, Bridgewater Associates, told investors there’s a risk that the Federal Reserve could create a market rout similar to that of 1937 if it raises interest rates too fast.

“We don’t know — nor does the Fed know — exactly how much tightening will knock over the apple cart,” Dalio and Dinner wrote. “We think it would be best for the Fed to err on the side of being later and more delicate than normal.”

Dalio joins Jeffrey Gundlach in warning that the Fed runs the risk of having to reverse course if it raises interest rates too aggressively. Gundlach, the co-founder of DoubleLine Capital, this month called the Fed “a blockhead” for not learning from errors made by global counterparts, which raised rates too soon and then had to cut them.

What worries me is that the attitude of many Fed officials is that markets go up and down, and this is just a normal market response. Don’t misunderstand me – I have no desire to keep aloft this asinine stock market bubble. I think Bernanke’s policies were incredibly damaging as they only served to lift asset prices to even more outrageous levels. Although the Federal Reserve’s policies have so far not resulted in any extreme economic pain in the US, the rest of the world is getting absolutely crushed.

The global financial system is centered around the US dollar, and Yellen’s policies have starved the world of much needed US dollar liquidity. This has tipped almost every non-US economy into a debt destruction vicious circle. Although many Central Banks have tried to counter this slowdown with their own aggressive monetary policies, in most cases it has simply not been enough to stop the cycle the Fed has started. Too many assets and liabilities are priced in US dollars, and the world cannot operate with US dollar liquidity being withdrawn.

Fed officials are looking at their own economy and concluding it’s not that bad, but they don’t realize the incredible deflation staring down the barrel. It is only a matter of time until the US economy also rolls over hard.

And in the mean time, I think there is a good chance the Fed has started something that will not be easily stopped. Once a deleveraging starts, it takes an incredible amount extra to stop it.

A couple of weeks ago I thought all we needed was the Fed to ease up on the hawkish rhetoric and we could stop this rout. Well, I have changed my thinking. The recent damage to these other world economies has created an environment where deleveraging will continue until the Fed actively returns to expanding liquidity. We will get rallies, but Yellen & Co. have pushed this down so far that credit will continue to be destroyed until the Fed aggressively eases again.

Yellen, Cooperman and all the other economic optimists are using an old playbook. They don’t realize the world’s massive indebtedness has changed the rules.

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Yellen has indeed made a 1937 style mistake. The only question is how long before she figures it out? How’s your burger Janet?

Thanks for reading,

Kevin Muir

the MacroTourist