Though Trump’s legal difficulties, erratic behavior, and trade war with China served as catalysts (and dominated media narratives), ultimately it would be the tightening of monetary and credit policy by central banks around the world which deflated the largest asset bubble in history, setting the stage for the economic collapse which followed.
In response to the 2009 financial crisis, central bankers engaged in an monetary experiment labeled “quantitative easing” (aka QE). During Quantitative Easing central banks created new money which was used to purchase trillions of dollars in bonds and distressed assets. This was the digital equivalent of running printing presses nonstop for years.
Between 2009 and 2014 the Federal Reserve was spending 40 billion a month on on these assets. By the time all was said and done the Fed alone had added 4.4 trillion dollars to its balance sheet, while the ECB and the Bank of Japan added 5.6 trillion and 5 trillion respectively (for a total of 15 trillion).
In parallel, central banks brought interest rates down to zero following the housing crisis, and held them at this level for almost a decade, fueling a massive credit expansion. This set off a secondary wave of money creation through a mechanism referred to as “fractional reserve banking”. Fractional reserve banking is a fancy way of saying that banks are allowed to loan out money they don’t have. In most countries banks can legally loan out 10 times more than they hold in reserves. As this new money entered into circulation consumer spending increased, businesses expanded, and the economy grew.
This influx of new money flowed mostly into stocks, real estate and other investments inflating the largest asset bubble in history. A short glance at the relationship between the S&P 500 and the Fed balance sheet makes the correlation crystal clear.
It should be obvious that if low interest rates and mass bond purchases stopped the previous crisis and sent the stock market through the roof, then the reversal of these policies must have an inverse effect.
The Federal Reserve began raising interest rates in 2015, and began selling bonds in 2017, thus tightening monetary and credit conditions simultaneously. By October of 2018 the Fed was unloading 50 billion in bonds bonds every month. Money was being sucked out of the economy even faster than it had been added.
By the end of 2018 the early signs of an impending downturn were everywhere. Stock markets were bleeding out, the yield curve was inverting, and the housing market was showing signs of weakness. In spite of these signals — and to the shock of market participants — the Federal Reserve stayed the course; raising rates and unwinding their balance sheet… until something broke.