How Weak is the Economy?
It was an upbeat week for the major markets. The Dow and the S&P; 500 gained 1.6% and 1.2%, respectively, while the Nasdaq Composite jumped 2.5%. After fretting all of June and July about rising inflation and the need for rising interest rates, the bond and stock markets seemed to realize finally that the sky was not going to fall. I had said in my first Newsletter in July that the time to worry was not this summer but the summer last year. That was when inflation indicators exploded. The inflation scare this summer came just a little late. Sure enough, 10-year yields have declined from 5.25% at the end of June to 4.72% on Friday. So now that inflation is yesterdays news (for the time being) and stocks have recovered to close within spitting distance of their May highs, what comes next? Lets look at some charts.
The chart to the left gives us a short term picture of the current yield curve structure. The blue line represents 10-year yields, the green line shows the Federal Funds (the interbank lending rate which is almost identical to the the discount rate and therefore set by the FOMC and Bernanke) and the red line shows the difference between 10-year yields and the Fed Funds rate. This difference has now turned negative, meaning that 10-year notes yield less than Federal Funds (or 90-day T-Bills). This inversion last happened in 2000, just before the last recession. The picture on the right shows a longer term view. Here we merely show the difference between long term (10-yr) yields and short term (90-day T-Bill) yields and take the 90-day average of that difference. Several research projects conducted by various Federal Reserve Districts (the most recent one is here)seem to indicate that a 90-day average shows good predictive value. Five of the last 6 recessions were preceded by an inverted yield curve that lasted 90 days or longer. As you can see, the 90-day average has not inverted yet and even makes an effort to stabilize. Further movements of the yield difference will clearly be driven by changes in 10-year notes. These changes need not be dramatic to have a predictive effect. In fact, even if 10-year notes stay where they are for another thirty days or so, the 90 day average will inch further and further into negative and thus recessionary territory. In other words, now is the time to watch the absolute level of 10-year notes rather than their movement from here. In this context it is expecially interesting that speculative long positions on 10-year notes have reached a record high. Speculative long positions (bets that prices will increase) outnumbered short positions in 10-year-note futures by 312,492 contracts on the Chicago Board of Trade in the week ended Aug. 15.This and some chart-technical considerations indicate to me that bond prices are more likely to fall than to rise in the coming weeks. The magnitude and the intensity of this coming sell-off in bond prices (increase in yields) is going to tell us a lot about the likelyhood of a recession within the next 12 months. If the sell-off is mild and occurs on low volume, it most likely means, that bond prices are truly discounting a Fed easing in the not too distant future due to economic weakness. In this case, the likelyhood that the 90-day average of the yield difference will move into negative territory increases and the likelyhood of a recession increases along with it. Most pundits that predict a recession think that the housing sector will be the culprit. The news from that part of the economy is unequivocally bearish. New home sales declined by 21.6% over the past 12 months. Building permits fell by 20.8%. Existing Home sales down 11.2% and on and on. It is widely predicted that the real estate market will drag the US economy down. It is clear that every major recession was at least partly caused by a downturn in the housing market. Suffice it to say that it seems that to much weight is given to the housing bubble. The airwaves are now full of talk of a bust. The covers of the New Yorker, the Economist, The Wall Street Journal and virtually every news magazine and newspaper in America has heralded the bursting of the "housing bubble". If everybody talks about it, chances are that the real surprise, you know, the one that blindsides all of us and really drags us down might come from a totally different corner.
The Economic Research Institute publishes every week the Index of Leading Economic Indicators. The index (according to the Institute) has an average lead of 10 months at business cycle peaks and three months at business cycle troughs. The index itself seems to be holding up but the growth rate is already negative. This does not bode well for the future and is admittedly one of the more bearish indicators that I follow. The picture on the right shows the Non-Farm Payroll gains. The survey showed that 128,000 new jobs were created in August, close to the average for the year and close to the 150.000 the economy needs to absorb new entrants to the labor force to maintain a low employment rate. Education and health services created 60,000 jobs, the most in nearly two years. Construction industries added 17,000, including 4,000 in residential construction. The percentage of industries hiring in August rose slightly to 55.9%. These numbers come as a surprise to many but support my argument that the housing bubble might take longer to deflate and might not turn out to be as detrimental as many market watchers anticipate. In addition to a rising job count (or caused by it) the consumer confidence at least bounced back sharply in late August. I have a hard time believing that the economy is just going to lie down and die. As I said before, recessions are rarely caused by events that are well anticipated, which is why they are almost never heralded on the front pages of newspapers until they are already well underway. Based on the NBER business cycle reference dates, the 2001 recession in the US was all but over by the time it hit the front page. The expansion began in November 2001, yet as late as the September terrorist attacks, there was still a debate raging about whether or not the US was in recession. So let us interpret the markets one step at a time and let them convince us that things are really as bad as they appear. This time, the burden of proof is on the bears and until further notice I will assume that this turns out to be a mid-cycle slowdown.