Canary in a Coalmine

In 1996, the New York Federal Reserve did a study on what indicators were the most reliable predictors of a recession. The only one of six indicators that was significantly reliable was an inverted yield curve. They later did a private study with over 20 factors and still the only dependable indicator was the inverted yield curve. I read the studies in 1999.

In a normal world, short-term rates are lower than long-term rates. This makes sense, as investors want to be compensated for the risk of the longer holding period. There are exceptions to this rule, and at times short-term rates rise above long term rates, giving rise to what is known as an inverted yield curve. Typically, when the yield curve is inverted or negative for 90 days, you get a recession in about 12 months. Actually, it is more than typical. In the United States, every time we have had a period of negative yield curves, we have had a recession within a year.

Thus, in August of 2000, as the yield curve in the United States went negative, I predicted the United States would enter a recession in the summer of 2001, and since the stock market loses an average of 43% in a recession, it followed that the stock market would tank. Quite the out of consensus call at the time. Although the NASDAQ was still in a swan dive, the New York Stock Exchange was climbing to within shouting distance of its previous high. The economy seemed to be moving along quite nicely. But the yield curve was staring us right in the face.

Now, I was not the only one that had read the Fed report. I am almost sure that every one of the Blue Chip economists had read it as well. But none predicted a recession. Things just looked too good, and none of the other data suggested a recession in the works. You can bet Greenspan had read the paper, but he waited until January to start cutting rates.

Inverted Yield Curves: The Situation in England

I remember calling the author of the paper at the Fed and asking him whether he thought that we would be in recession within a year. “It will be interesting to see,” he said.

While today the U.S. yield curve is slowly flattening, it is nowhere near an inverted yield curve and not signaling a recession. But I have spotted an inverted yield curve in the world, across the pond, in England. And it worries me, as I wonder if it is a pre-cursor to problems in the United States. Let’s survey the current situation in England.

U.K. unemployment is an amazing 2.7%. I am sure there are examples, but I cannot recall a major economic country with such a low unemployment rate. Inflation, although rising, is still under 2%. Wages rose by 4.4% in the three months through October, the highest rise in several years and more evidence of nascent inflation.

The housing market is doing quite well, thank you. In what everyone calls a bubble, housing in England still rose 12.5% year over year in November, although only 0.2% in the last month. Could it be slowing? U.K. household debt is 140%, which is above U.S. levels.

The Bank of England recently noted, “Any sustained fall in [house] prices would reduce homeowners’ cushion of housing equity. This might reduce their opportunity to re-mortgage to consolidate other debts or to lower their monthly payments. Financing difficulties would be exacerbated if any fall in house prices were accompanied by a wider economic slowdown.”

And government spending is on the rise. Quoting the team from Gavekal, “Just like the United States, the United Kingdom participated in the supply-side revolution of the 1980s and 1990s. But unlike the U.S., the U.K.’s supply-side revolution is in danger of being rolled back. U.K. government expenditures relative to GDP have been on the rise for seven long years, and the government has accounted for virtually all employment growth since 2001. Little by little, increased regulation and ever-rising public spending are weakening the spirit of enterprise created by the Thatcher revolution. This is a worrying development and if left unchecked, will undoubtedly have very negative effects on the growth prospects of the U.K. economy, and on their equity market.”

Inverted Yield Curves: Raising Rates

The Bank of England is in a hard spot. They have been steadily raising rates to keep inflation in check and to rein in the white-hot housing bubble. Since the housing market is still doing well, and inflation is rising, one would think they should continue to raise rates. But with an inverted yield curve and a very strong pound, raising rates might not be wise, as that could push the country into recession.

If I lived in England, I would be getting my personal house in order. No long only stock funds, switching to bonds and absolute return type investments and funds. While the Fed study on yield curves was based on U.S. precedent, the rule generally applies everywhere. Thus, precaution is the order of the day.

But at the beginning of this essay, I hinted about the English situation perhaps shedding some light on the United States. Let’s see if we can make a case.

Hmmm. A strong housing market that might be peaking. A central bank that has been raising rates. A solid economy with inflation starting to pick up. A stock market that looks like it may have peaked? Oh, and did I mention a very large trade deficit? Sound familiar, my fellow countrymen and women?

The only thing we don’t have is an inverted yield curve…yet. However, England did not have one as recently as six months ago, and was not all that out of bounds a year ago. I think England may be six to nine months ahead of us in the softening process.

England may very well be a canary in the coalmine. While not totally analogous, there are enough similarities that it gives pause. And bears watching.

Yes, I know many will point to the positive economic data on both sides of the ocean. But that misses the main point. The data stays positive, as will the mainstream economists, up until they turn negative. The upshot of the Fed study was that only the yield curve showed any reliability in its predictive ability. Everything else was “noise.”

In the late 90’s and up until 2002, the vast majority of pundits told us why “this time it’s different. Trade deficits no longer matter. Now they are all blaming the trade deficit for the declining dollar. But if that is the case, why is the British pound and Aussie dollar rising?

The world of currency valuations and trade deficits is a very complicated matter. Yes, trade deficits of the type that the United States is currently experiencing, as well as that of England and Australia, are unsustainable. But normally, when one uses the word unsustainable, one does not think in terms of multiple years, but that is precisely what can happen. It is entirely likely, even probable, that the U.S. trade deficit will get worse this next year (barring a drop to $20 oil).

Inverted Yield Curves: No Magical Fix

A dropping dollar is not going to magically fix the deficit as it did in the 80’s. For one thing, the U.S. manufacturing sector is a smaller percentage of the total economy than it was 20 or even five years ago. So even if we see exports grow a significant percentage, it is growth off a smaller base. It will take many years of outsized export growth to catch up with our growing imports. Unless, of course, we see a recession and imports actually drop.

That means for the trade deficit to come back into balance imports must go flat or drop. That is not a happy prospect. Going to Marshall’s [Auerbach of Prudent Bear] latest piece, as he is commenting upon articles by the IMF and other English institutions that worry about the housing bubbles in the US, England, and Australia.

“The humbling reality is that across three decades, only one economic event has been guaranteed to produce balanced trade in the English-speaking nations: a recession. When the economy is contracting, people naturally buy less of everything, including imports. Needless to say, no one appears ready to embrace this option, which means that the endgame will be much worse – even for those who have sought to conduct their monetary affairs in a responsible manner, such as the Bank of England. The current global financial fragility is unlikely to be saved by mere dollar devaluation; it is solved when the respecting offending nations restraining their respective profligate tendencies and implement policies designed to restore national savings to their historic norms. Of course, if all the offending nations do this together without any countervailing stimulus from Euroland or Asia, we will see a massive global contraction.

“The Bank of England and IMF may see this checkmate position coming. They may be concerned they will see a global income depression on their watch if housing bubbles burst. They may accordingly be warning global monetary authorities 1) not let the housing bubbles run any further, but perhaps more importantly, 2) not pop these bubbles in anything other than a careful, deliberate, and incremental fashion. That would be nice, but history shows us that there is a reason why we rarely see bubbles popping gently.”

Today, things are all right. The canary is singing away. But the great imbalances in world trade will be brought into balance at some point, even if “unsustainable” is a few years off. It helps to get some early warning signs. Let’s watch that canary closely.

Regards,

John Mauldin
Poitou, France
December 22, 2004

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Yesterday was the shortest day of the year in the Northern Hemisphere. Here in France, however, it was barely a day at all. The sun never even bothered to come up. Instead, it was as cloudy and gray at noon as it had been at dawn.

We couldn’t write yesterday. We loaded up the car in the morning – full to overflowing with packages. Then, we hooked up a trailer with Elizabeth’s horse in it…and made our way down to the country.

We are so lucky. Hardly a day goes by that we don’t realize it. Last week was spent traveling from one continent to another, pretending to do business, but actually attending holiday parties. This week, we have joined the entire family out in Poitou (to the Southwest of Paris) for two weeks of Christmas. All six children are with us…and one new daughter-in-law.

This morning, all the children are at work – painting a new library. Well, almost all the children. Henry decided he had to take the pony out for a ride.

What a glorious way to spend a holiday – watching your children work!

But you do not read the Daily Reckoning, dear reader, for idle chitchat, do you? No, you read it to find out what to expect from the world’s financial markets. If only we knew! We can’t tell you what will happen. But at least we can tell you what we think ought to happen.

And yesterday, the Dow rose up nearly another 100 points. Wow! Either we are wrong…or the Dow is wrong. Somebody is making a mistake. Of course, according to Efficient Market Theory…the market can make no mistake. It is like a democracy. There is no higher authority than the voters…or the mass of investors. Whatever they decide is supposed to be perfect.

But voters err occasionally. They elected Benito Mussolini and Adolph Hitler, to cite a few criminal mistakes. Here in the United States, they elected Wilson, Lincoln, and Bush the younger – to mention some misdemeanors. Investors err too – remember Enron, Webvan, Global Crossing?

Of course, we make a mistake too, from time to time. We could be wrong this time. Each time the Dow rises, the more wrong we look.

But we continue to think the situation is a bit like Napoleon’s attack on Moscow, whose dismal end we noted a week ago. The Emperor was warned. A French colonel who had spent years with the Russian army had begged Bonaparte to stay home. If the Russians don’t kill you, he warned, the weather will: You will starve. You will freeze. Your men will die and widows all over France will curse your name.

He might have added that your entire empire would be ruined in the aftermath and the Emperor himself exiled to a deserted island. But none of his alarums rang a bell with the little Corsican. The troops marched. And by the time they reached Moscow, the war mongers of the First Empire must have made the same remark that the neo-conservatives made when the United States captured Saddam…or stock market bulls made yesterday: See, we told you it would be a big success.

But Napoleon’s campaign turned out to be – as our president said, correctly but accidentally, of Iraq – a “catastrophic success.” Gains made in stocks in 2004, we fear, will be similarly catastrophic.

More news, from our team at The Rude Awakening:

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Tom Dyson, reporting from Baltimore…

“We think Rogers’ idea has all the same ingredients as Barnaby’s house: it’s cheap, it would be a great place to live, and most importantly, the area will be a magnet for economic activity, so your investment will most likely increase in value.”

For the whole story, check out today’s issue of The Rude Awakening.

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Bill Bonner, back in Poitou…

*** George W. Bush said yesterday that he favors an “ownership society.” What a pity, Americans own so little of it. They have mortgaged more of their houses than ever before. People now buy their houses on margin. And automobiles are purchased on long-term payment plans. Even when they go to Wal-Mart, they buy toilet paper and chicken soup – on credit!

But wait, if Americans don’t own their own stuff, who does? Well, we’re glad you asked. We used to say of the national debt that “we owe it to ourselves,” which made us feel better. At least, if we couldn’t pay it, we weren’t likely to foreclose on ourselves. But now, more debt than ever is in foreign hands. Americans don’t save. So someone else has to supply the savings that Americans take up as credit. Increasingly, it is the Asians – even the Chinese, who earn only 1/25th as much per hour as Americans. About $9 trillion worth of U.S. dollar assets is in the hands of foreigners – or about $3 trillion net. As long as the current account deficits continue, so does the amount of U.S. debt held by people who don’t hold U.S. passports. Yes, ours is an ownership society. And the Asians own it!

*** Rich people don’t buy on credit. Then again, nor do really poor people.

“The people who are really going to get hurt,” said a friend in Baltimore, “are the people in the middle. You know, couples that have bought houses bigger than they could really afford. They both work. They’ve mortgaged up everything. They live beyond their means. God forbid interest rates rise…or property prices fall.”

It’s better to be rich, dear reader…or live as though you were.

*** Well…it looks like we have our final scandal to finish off 2004. Franklin Raines, the Fannie Mae chief executive, who had once described the financial institution as “being in the American Dream Business,” was forced to step down yesterday.

According to the Associated Press, “Raines said he had decided to leave to fulfill a pledge he made during congressional testimony in October that he would take blame if serious accounting problems were found at the company.”

We can’t help but wonder how many “American dreams” he’s crushing with his accounting shenanigans…

[Ed. Note: Scandal, scandals…and more scandals…that’s Prediction #1 for 2005, according to Fleet Street editor, Chris Mayer. Forget Fannie Mae and ENRON…worldwide financial conspiracies will be running amuck in the upcoming year.