Batten the Hatches: the coming recession
Sun Feb 20, 2005 at 04:34:03 PM PDT
In this week's testimony before congress, Fed chief Alan Greenspan described it as a "conundrum."
What was he talking about? The looming specter of the Inverted Yield Curve.
For several months now, the Fed has been slowly raising interest rates to put the brakes on signs of increasing inflation. But a funny thing has been happening on the way to the bank. While the Fed increases have brought up short term rates, long term rates have continued to fall. For both loans and investment vehicles, long term rates and short term rates are now nearly the same.
The magic "inverted yield curve" occurs when these two rates cross and short term interest rates are actually higher than long term rates. Why is this more than a piece of economic trivia? Because the inverted curve is the best known predictor of a coming recession.
Want to see how nice a job the yield curve does at predicting upcoming trouble in the economy? Take a look at this chart from TheStreet.com:
Notice all those downticks in the curve? Like the one that appeared just before the last Bush recession in 2001. And the one that hit Poppa Bush just before he was steamrolled by the Big Dog. And the whole horrid mess that the economy suffered in the late 70's, early 80's is clearly visible. So is the "Whip Inflation Now" era of the early 70's. You have to go back into the 60's to find a spot where the curves crossed, but the economy didn't crash (in that case, we came to a "soft landing" and merely had a couple of years of essentially zero growth).
From the chart, you can see that we've not yet reached the point of crossover. In fact, we're still at a point that's... well, not great, but not horrible. A decent spread. But we're going down. Take a look at how many times this chart records a rate curve moving down at the point we're at today. Then take a look at how many of these pulled out before the crossover - very damn few.
When absolutely no sign of a slowing in the gap closure, we appear headed for a crossover in the next six months to a year.
Money men are shocked and puzzled by the current outcome. See, for the last four years, the Fed has looked like wizards at keeping the curve high and the economic stimulus at a "goosed by an electric cattle prod" level.
The current move back toward a flatter curve is unusual in two respects. The first is its starting point: The Federal Reserve's grand experiment from 2001-2003 produced the steepest yield curve since the start of the Fed's H15 weekly series in 1962. The results of the aggressive monetary stimulus in 1991-1992 are dwarfed in comparison.
See, the Fed has bled the tank dry for Bush, and it worked. What would have otherwise been an extended recession was turned into a long stretch of mere economic blahs by keeping rates so low that Americans were tempted to borrow themselves into oblivion. Now the curve is flattening faster than at any time in recent history, and Alan and the boys seem to be doing some head scratching.
The second difference is the speed at which the flattening has occurred. The Federal Reserve has raised the overnight federal funds rate six times since June 2004, and the federal funds futures market is pricing in another three rate hikes by the end of this summer. These increases are reflected in the short end of the curve, represented above by both the one-year and the two-year notes.
The Fed would like to keep the rates low in an effort to pry the curve open, but there's a problem with that. Last month's wholesale inflation rate was
0.8 percent, much higher than expected and a sharp increase from the previous month. With that kind of rise, the Fed is caught by its own "raise the rates to starve inflation" theories. Alan had no choice but to tick the dial up another notch this week. The stock market took this news hard. It was only down marginally for the week, but the real unease was masked by rising drug stocks that caught a big tailwind when the FDA advised returning Vioxx and kin to the market.
While our own stock market pundits remain for the most part chipper, playing their role of worshipful acolytes to he-who-can-do-no-wrong (Bush or Greenspan, take your pick), the folks up on Canada's Howe Street seem a lot more downbeat about stocks, the dollar, and damn near everything else.
Stocks have been rallying since last October. That rally could end at any time...and might be ending now. When the upward momentum on this plane runs out, passengers will find a lot more downside that upside. That is, at these levels stocks have much more room to fall than room to rise.
...
The dollar is extremely vulnerable. Buffett and Gates are betting against it, and they're probably right. Which is why you don't want to leave too much money in U.S. assets of any sort, including U.S. Treasury bonds.
What are they recommending? Buy gold. Whenever stock advisors start saying buy gold, things are not good.
For an audio discussion of the topic, check out NPR's Market Place.
