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Why the Yield Curve May Not Predict the Next Recession, and What Might

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Reprinted with permission from EconomicPolicyJournal.com

Gone Are the days when "green
sh#%ts" was bleated daily on CNBC amongst a chorus of permabull snorts.
Even the experts now recognize the recovery as a BLS swindle,
and it is important to reintroduce the possibility of not only a low growth
future, but one of outright and persistent contraction. As “double dip” has recently worked its way into
the popular lexicon, we will explain why a traditional forecasting tool of
recessions may not flash a warning this time around. Afterward, we explore why
even “double dip” may not be an accurate term, as well as what a cutting
edge-new economic indicator is forecasting.

Gary North wrote an excellent article explaining why yield curve
inversions predict recessions. It is instructive now to illustrate how the
fundamental backdrop has changed amidst unprecedented government intervention.

The interest rates for more distant maturities
are normally higher the further out in time. Why? First, because lenders fear a
depreciating monetary unit: price inflation. To compensate themselves for this
expected (normal) falling purchasing power, they demand a higher return.
Second, the risk of default increases the longer the debt has to mature.

In unique circumstances for short periods of
time, the yield curve inverts. An inverted yield occurs when the rate for
3-month debt is higher than the rates for longer terms of debt, all the way to
30-year bonds. The most significant rates are the 3-month rate and the 30-year
rate.

 

The reasons why the yield curve rarely inverts are simple: there
is always price inflation in the United States. The last time there was a year
of deflation was 1955, and it was itself an anomaly. 
Second, there is no way to escape the risk of default. This risk
is growing ever-higher because of the off-budget liabilities of the U.S.
government: Social Security, Medicare, and ERISA (defaulting private insurance
plans that are insured by the U.S. government).

We are no longer in a persistently
inflationary environment, despite the best multitrillion-dollar reflationary
efforts to the contrary. Disinflation and outright deflation keep popping up in
critical areas of the economy. While the central banks will likely overshoot in
the end, resulting in an hyperinflationary spiral, for the time being, lenders
are not worrying about inflation. And, while one may doubt the BLS’ calculation
expressed by the Consumer Price Index, the below chart of CPI year-over-year is
nonetheless striking, as it indicates the recent crisis brought it into the
most negative territory since inception.



On the rise are medical and food costs, but
continued deleveraging by banks and consumers are offsetting deflationary
drags. Banks are writing down (and off) private and commercial real estate
loans, and consumers will remain in spending retrenchment as long as they
continue to work off credit in a high unemployment environment. Indeed, year
over year consumer credit is in the most negative territory post-WWII.

 


 

Though headline civilian unemployment from the
BLS’ household survey is ticking down from the ominous 10% level, this is
largely a result of the birth/death model adjustmentand the removal of
so-called discouraged workers from the counted pool. When viewed from the
larger perspective of the civilian employment to population ratio, the job
losses are staggering and unprecedented in the modern era. When the economy
eventually does show improvement, these discouraged workers will reenter the
job market and keep the headline unemployment rate persistently high.

 


 

Finally, creation of money supply, as expressed
by non-seasonally adjusted year-over-year M2, continues to reflect slow money
growth, notwithstanding the trillion or so in excess bank reserves sitting at
the Fed earning interest at 0.25%. The very fact that banks are content to earn
interest at this absurdly low rate indicates risk aversion and little fear of
inflation.

 


 

North continues:

What does an inverted yield curve indicate? This: the expected
end of a period of high monetary inflation by the central bank, which had
lowered short-term interest rates because of a greater supply of newly created
funds to borrow.

The obvious failure of the central banks to
reflate the economy has now renewed fears that monetary
inflation will not return for some time.

This monetary inflation has misallocated
capital: business expansion that was not justified by the actual supply of
loanable capital (savings), but which businessmen thought was justified because
of the artificially low rate of interest (central bank money). Now the truth
becomes apparent in the debt markets. Businesses will have to cut back
on their expansion because of rising short-term rates: a liquidity shortage. 
They
will begin to sustain losses. The yield curve therefore inverts in advance.

On the demand side, borrowers now become so desperate for a loan
that they are willing to pay more for a 90-day loan than a 30-year, locked
in-loan.

Aside from government darlings, businesses and
critically, small businesses, have largely stopped expanding and are in
defensive retrenchment. The problem is a reduction in both the supply and demand for new loans. There is definitely a
liquidity shortage, but it is being expressed unconventionally as central bank
quantitative easing and government stimulus are directed into non-productive
parts of the economy. It is these zombie behemoths in the financial and
transportation sectors that are most desperate for funds, yet they are not
penalized for it. Instead, they are encouraged to feed at the government trough
even as their smaller (and more productive) competitors are edged out through
oppressive regulation and inability to access loans at a similar rate. This
will continue to be a drag on overall growth, and without small business
growth, the threat of recession relapse is greatly heightened.

On the supply side, lenders become so fearful about the short-term
state of the economy -- a recession, which lowers interest rates as the economy
sinks -- that they are willing to forego the inflation premium that they
normally demand from borrowers. They lock in today's long-term rates by
buying bonds, which in turn lowers the rate even further.

Though long term US Treasurys are benefitting
from safe haven flight-to-quality status, short term Treasurys are similarly
benefitting to a greater degree, thus widening the spread between the two. As
stated above, banks are content to park over a trillion dollars in excess
reserves at the Fed earning interest at 0.25%. A combination of a (currently
low but slowly rising) fear of eventual US default, extreme desire for short
term safety in T-Bills, and low fear of inflation is keeping the spread wide.
Also troubling is the recent disconnect between short term Treasury yields and
the borrowing rates actually available to businesses with excellent credit.

 



North concludes:

An inverted yield curve is therefore produced
by fear: business borrowers' fears of not being able to finish their on-line
capital construction projects and lenders' fears of a recession, with its
falling interest rates and a falling stock market.

Indeed, these are the fears being expressed,
but in different manners that are not immediately obvious. Small productive
businesses are throwing in the towel as their larger competitors build Potemkin
villages.

 

A further problem is that nearly all yield
curve studies look back no further than the mid-1950’s, the inception of Fed
data on US Treasury rates. Inasmuch as every recession since then (save the
last) has been manufacturing based as opposed to credit based and has occurred
in an overall inflationary backdrop, there lacks a crucial window into prior
deflationary times concurrent with extreme government meddling—in particular,
the Great Depression.

 

Many economists from the Austrian school
follow M2 money supply as a harbinger of economic growth or contraction, as it
tracks the creation and destruction of money through economic activity at the
margins. As noted previously on EPJ, Rick Davis and others
at the Consumer Metric Institute have created a novel indicator that tracks, in
real time, consumer demand for capital goods. Accordingly, it should and does
reflect similar activity, though with enhanced granularity. Indeed, it anticipates
US GDP by an average of 17 weeks. A future post will explore this aspect of
their data and possible uses for market timing. For now, Davis tells
a different story
 than the governments that collude to forge a
statistical recovery:

Our 'Daily Growth Index' represents the
average 'growth' value of our 'Weighted Composite Index' over a trailing 91-day
'quarter', and it is intended to be a daily proxy for the 'demand' side of the
economy's GDP. Over the last 60 days that index has been slowly dropping, and
it has now surpassed a 2% year-over-year rate of contraction.



The downturn over the past week has emphasized
the lack of a clearly formed bottom in this most recent episode of consumer
'demand' contraction. Compared with similar contraction events of 2006 and
2008, the current 2010 contraction is still tracking the mildest course, but
unlike the other two it has now progressed over 140 days without an
identifiable bottom.

 


As we have mentioned before, this pattern is unique and unlike
the 'V' shaped recovery (or even the 'W' shaped double-dip) that many had
expected. From our perspective the unique pattern is more interesting than the
simple fact of an ongoing contraction event. At best the pattern suggests an
extended but mild slowdown in the recovery process. But at worse the
pattern may be the early signs of a structural change in the economy.

While confounding the average GE cheerleader,
this new normal of increasing destructive intervention is intuitively
understood by the consumer, who responds to this reality by pocketing the debit
card. So what can we expect in the ensuing quarters?

 


 

Davis aptly describes what has happened so
far:

[I]t has instead, unfolded so far as a mild but persistent kind
of
contraction, more like a 'walking pneumonia' that keeps things miserable for an
extended period of time.

Until governments stop
punishing innovation, stop rewarding incompetence, stop distorting economic
signals with arbitrary econometric targeting, stop coddling failures--we will
continue to walk with this pneumonia indefinitely. The solution, as always, is nothing.
Stop intervening and let the chips fall where they may. Markets will correct
things faster
than you might think.

 

 

 

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Fri, 06/25/2010 - 15:41 | 434150 Diogenes
Diogenes's picture

"Until governments stop punishing innovation, stop rewarding incompetence, stop distorting economic signals with arbitrary econometric targeting, stop coddling failures--we will continue to walk with this pneumonia indefinitely."

So, when Hell freezes and Satan organizes a hockey team.

Fri, 06/25/2010 - 13:09 | 433836 DR
DR's picture

Good...but I question the last paragraph.  Every blog at ZH starts with the premise that there is a budding entrepreneurial class in the wings just waiting for the inept US government to recede its support in the markets and that this class will usher in renewed productive growth. But is there such an entrepreneurial class? The children of the elite are fat and spoiled-they hardly have the drive and sacrifice to start an enterprise. I ask who will lead  the next generation of innovation and job growth?  Without such a generation the economy will continue into it's deflationary spiral....

Fri, 06/25/2010 - 16:34 | 434271 EB
EB's picture

Inasmuch as generations proceed in cycles, and not linearly, each generation rejecting part of the former, I expect the up and comings--elite and non-elite alike--to shun grotesque gluttony.  The degree of entrepreneurship will depend on what survives of the state after the great meltdown.

Fri, 06/25/2010 - 14:52 | 434052 i.knoknot
i.knoknot's picture

the koreans?

oh, sorry, you meant in amerika? i dunno.

Fri, 06/25/2010 - 14:31 | 434020 QQQBall
QQQBall's picture

The key in our nation, and any nation for that matter, is opportunity.  Look at Australia, the gov't is "allowing" natty resource companies a whopping 6% ROI while they snap up 40% of anything over that. If you think in terms of the low-hanging fruit getting picked first, the 6% "yield" will not even allow for replacing reserves on a risk-adjusted basis.  We don't have to know "who", but we do have to allow opportunity.

Fri, 06/25/2010 - 12:38 | 433774 EManBevHills
EManBevHills's picture

Interesting article. 

 

Fri, 06/25/2010 - 12:32 | 433757 InconvenientCou...
InconvenientCounterParty's picture

enriching...

Fri, 06/25/2010 - 12:26 | 433746 greg merrill
greg merrill's picture

Funny how I just blogged about this but from a slightly different direction:

 

http://merrillovermatter.blogspot.com/2010/06/is-steep-yield-curve-leading-us-astray.html

 

Fri, 06/25/2010 - 16:20 | 434250 EB
EB's picture

I considered using the Shiller data too, but decided not to as it was only reported annually.  I think you created a good analog, though with the earnings angle.

Fri, 06/25/2010 - 12:24 | 433740 JoeStealth
JoeStealth's picture

The last paragraph says it all---Excellent!

Fri, 06/25/2010 - 12:01 | 433713 CoopDeluxe
CoopDeluxe's picture

Why do I hear Kudlow in my head bitching about yield curves and recessions?  Melissa Francis looks like a red pimple today, bring juicy Mandy back!! 

Fri, 06/25/2010 - 11:47 | 433689 hellboy
hellboy's picture

Brilliant! Thanks.

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