The yield curve has been extremely successful at predicting recessions. It’s what the yield curve is not telling us, writes our friend and best-selling author, John Mauldin, which should be of concern…
I have been writing about the yield curve since the spring of 2000 – it is one of the more important keys to the future of the economy. But lately, I have been troubled by the market’s lack of a "natural" yield curve, as this most reliable of indicators seems to me to be in limbo. This problem is more than an academic debate, and goes to the heart of the current debate about Fed policy. It also affects your investment portfolio big time.
Let’s rewind the tape. In June of 1996, Fed economists Arturo Estrella and Frederic S. Mishkin of the Federal Reserve Bank of New York published quite an important paper, entitled "The Yield Curve as a Predictor of U.S. Recessions." Inside, they noted: "The yield curve – specifically, the spread between the interest rates on the ten-year Treasury note and the three-month Treasury bill – is a valuable forecasting tool. It is simple to use and significantly outperforms other financial and macroeconomic indicators in predicting recessions two to six quarters ahead."
Essentially, Estrella and Mishkin showed how every U.S. recession in the post-WW2 era has been preceded by a negative yield curve. By a negative yield curve, we mean that short-term rates are higher than long-term rates, which is not the natural order of the world. Normally, you should be paid more interest for holding longer-term bonds and taking more risk.
Negative Yield Curve: The Only Reliable Recession Predictor
When long-term rates are higher, the yield curve is referred to as positive sloping. That’s the case today, and in fact, right now the positive-sloping curve is rather steep.
But sometimes short-term rates rise above long-term rates. Estrella and Mishkin demonstrated that the more negative the 90-day average of the difference between the 90-day Treasury rate and the ten-year bond rate, the more likely it is that we will have a recession within about four quarters. They assign the odds of a recession to each level of the yield curve, but note that the odds at any particular level might be higher today than in the past for a variety of reasons.
In subsequent papers, they have noted that out of 26 different indicators, only a negative yield curve was a truly reliable predictor of recessions.
In August of 2000, the 90-day average yield curve was negative and the lowest it had been since 1989, prior to the 1990 recession. Really long-time readers of mine know that that’s when I became bearish on stocks, as the average drop in the stock market is 43% during recessions. In fact, the indicator did go on to become significantly negative. Based upon the Fed study, it was not hard to predict, as I did, a recession beginning in the summer of 2001, or to begin to call for the Fed to preemptively lower rates at the end of 2000.
Thus it was also not hard to suggest to readers that they get out of the stock market. Since rates would be going down in a recession, neither was it hard to suggest that investors load up on long-term bonds. At the end of 2000, these were profitable trades to make.
Negative Yield Curve: An Unnaturally Distorted Yield Curve
So can we conclude that because of today’s steep yield curve, there are no recessions in the foreseeable future? Unfortunately not. The current yield curve has been unnaturally distorted; the Fed is holding short rates down to 1%, and it would be nigh on to impossible for a negative yield curve to emerge, even if there were a recession in our future.
Morgan Stanley Chief Economist Stephen Roach thinks the Fed should preemptively raise rates by 2%. Many economists are calling for the Fed to raise rates in June, allowing them to rise to a more "natural" rate of 3-3.5%. They suggest this as the natural rate because they feel interest rates should be at least 1% above inflation, which in today’s environment seems to be about 2% and rising (in terms of CPI, which is a completely different issue). Recent Fed governor speeches seem to indicate agreement with this line of thinking.
Today, 10-year rates are 4.57%. Thus, if rates were "natural," we would be seeing a yield curve that was much flatter. That means we should be paying attention…for before the yield curve goes negative, it first becomes flat. But until you see that first flicker of a negative yield curve, you don’t need to worry a great deal about a recession in the near future (except for one caused by some surprise "exogenous" event like massive terrorist attacks which could cripple an economy).
Understand that the yield curve is not the cause of a recession. It is a symptom of the confluence of circumstances that precipitate a recession. If it were the cause, the Fed could simply and permanently keep the curve positive, and we could all live in an economic nirvana.
In the real world, however, holding rates down below the "natural" rate will eventually cause inflation. At some point, the market forces rates up in spite of the Fed. And that is the cause of so much angst among economists and investors. Today, they worry that inflation is the near-term problem…and that as the markets begin to smell inflation, they will react quite negatively.
But a little inflation is precisely what the Fed wants. Before they start to raise rates, the Fed will want to see actual evidence of inflation. They will want to make good and sure that we are completely out of the possible deflation woods. They will also want to see a solid employment market.
Negative Yield Curve: What If . . .
Now, let’s visit my concerns. Let’s look at the following "what-if" scenario…
We have just seen the economy post slower growth than the consensus expected, but still a very robust 4.2% growth rate in the first quarter. The inflation signaled within that number was higher than expected, but still nothing about which to be concerned. If we do not see a dramatic rise in new jobs (not the part-time, temporary variety) or inflation posting a significant back-to-back rise for several months (which does not seem to be the case as yet), the Fed could easily decide to wait until August before deciding to raise rates. At that point, unless the market forces their hand, they might be inclined to wait until the November meeting.
What if I am right and the Fed does not raise rates until November? Let’s say inflation does start to creep back over the summer and kick in during late summer, perhaps rising to 3-4%. What would the "natural" short-term rate be? 4%? 5%? 5.5%?
Remember, ten-year rates are 4.5%. Could the "natural" yield curve sometime later this year be negative, suggesting a recession 12 months later? Would we be seeing a "false" positive curve because of the Fed holding rates down, and thus assume we are not in danger of a recession within the next 12 months?
I could make good cases for both sides of that argument, but the answer is that we would be in completely uncharted territory with little historical precedent. The twin deficits, record oil prices, richly valued stocks and a soaring real estate make for an interesting, if unpredictable, future.
for The Daily Reckoning
May 6, 2004
Editor’s Note: John Mauldin is the creative force behind the Millennium Wave investment theory and author of the weekly economic e-mail "Thoughts from the Frontline." As well as being a frequent contributor to The Fleet Street Letter, Mr. Mauldin is the author of "Bull’s Eye Investing" (John Wiley & Sons, 2004 London NY), which is currently tracking on the NY Times business bestseller list.
In his easy-to-understand, straightforward style, Mauldin spots the big market trends – and shows you how to profit from them. "Bull’s Eye Investing" is a must-read roadmap if you want to avoid the pitfalls of the modern investing landscape…
When you set out to take Vienna, take Vienna,’ was Napoleon’s advice.
Here, we set out to reckon with the financial markets every day. So we will reckon with them every day – even though nothing much happened yesterday to reckon with.
The Fed met…and did nothing. Stocks went nowhere. The Chinese continued making things for people who cannot pay for them. Americans continued mortgaging their homes in order to buy them.
In fact, it looks as though refinancing activity has been heating up:
"Last chancers lift mortgage demand," says a CNN headline.
This might be the last opportunity to go deeper into debt at today’s alluring mortgage rates. Yesterday, the Fed signaled that it might not be as patient in raising rates as previously reported.
This view corresponds to the generally held assumption that the economy itself is "heating up," which will cause a "heating up" in the employment market…and then a "heating up" in consumer demand…all of which will lead to a "heating up" of inflation, expressed as a rise in consumer prices. Just about the time everyone gets warm and starts taking their gloves and mittens off, the argument goes, the Fed will turn down the thermostat by raising its benchmark lending rate. In this way, the geniuses at the Fed keep the entire world economy at room temperature – not too hot, not too cold.
"Ha! Geniuses? Are you kidding me?" We can almost hear Kurt Richebächer’s deep Teutonic voice speaking.
"Ya, they’re geniuses all right. They’re geniuses like the geniuses at LTCM [Long Term Capital Management]. They’ve turned the whole country into a giant hedge fund. And someday, it’s going to blow up…just like LTCM."
The geniuses have managed to turn America from a nation that made things and paid its way in the world into a nation that is the world’s biggest mooch. Instead of saving money, Americans borrow it. Instead of making things, they buy them. Instead of paying for what it gets with real money, it provides the world with trillions of ‘dollars,’ which are worth a little less each day.
The dollar fell again yesterday – down to a 4-week low against the euro.
"We are not becoming a nation of hamburger flippers," wrote Paul Kasriel last year, "but of stock and bond flippers…between 1960 and 1984…banks, brokerage firms, finance companies and the like accounted for 12% to 22.5% of total corporate profits. In 2002, the financial sector contribution reached 44.75%…"
GM, for example, once the nation’s largest company, is now "more bank than carmaker," says the Wall Street Journal.
Lending money has been a good business in America. The sector has heated up in such a way, Daily Reckoning readers are hereby warned: don’t touch it.
Someday, when the geniuses fail and LTCM-as-America blows up, lending won’t be such a good business – neither for U.S. automakers, nor for foreign buyers of U.S. Treasurys. Then, we will have something to reckon with.
"Anytime there are periods of upheaval and great change, there are always those who benefit from the change and those who suffer," we read this morning in John Mauldin’s new book, which we started reading last night. From the little headway we’ve made so far, we are looking forward to the book’s development…and may already go so far as to suggest you purchase a copy.
In the meantime, here’s more news:
Eric Fry, from downtown Manhattan…
– Is Mr. Market hanging on the ropes, or hanging from a rope? The poor lad is looking a bit weary these days. Like an overmatched boxer in the late rounds, Mr. Market is still standing, but visibly staggering. A fast and furious onslaught of adverse trends has not yet felled our hero, but we wonder how much more punishment he can take.
– Yesterday, the Nasdaq chalked up its third-straight feeble gain, adding 7 points to 1,957, while the Dow stumbled to a 6-point loss at 10,311. The Nasdaq is trying gamely to mount a comeback from the 6.3% pummeling it suffered last week. But so far, its snap-back rally is hardly a convincing show of strength. A lesser market would have been flat on its back already.
– We wonder how much fight he has left in him. Can he continue to withstand the body blows of stubbornly high oil prices, record-high gasoline prices and growing signs of inflation? Can he continue to deflect the (far)-right hook of geopolitical turmoil? Can he continue to bob and weave, as rising interest rates throw sharp jabs at his overweight valuations? We are not optimistic…
– Yesterday, interest rates rose again, as the yield on the 10-year Treasury note rose to a new 10-month high of 4.58%. But higher rates offered little support to the wavering dollar, which fell for the fourth day in five to $1.2175 per euro. Crude oil jumped to a 13-year high for the third straight day after the Energy Department disclosed that inventories remain uncomfortably lean. June crude rose 59 cents to close at $39.57 per barrel. The falling dollar, coupled with a rising oil price, provided a brisk tailwind for gold. The yellow metal added $2 to 393.80 an ounce, taking its two-session total gain to $6.30.
– The stock market might continue dancing around the ring for a while longer, but the weary boxer will be flat on its back very soon, according to Michael Belkin, an insightful and thought-provoking "quant-jock." Belkin’s views derive from a proprietary "gee-whiz" computer model that interrelates with world equity markets, commodities and debt.
– Belkin is a fascinating guy whom your editor has had the pleasure of meeting on several occasions. His predictions are not always correct, of course, but they are always fascinating…and they are OFTEN correct. In February 2000, your editor listened intently to a presentation by Belkin in which he predicted that the stock market would be heading for a "big down." The bear market of 2000 commenced one month later.
– Next up, in February 2003, Belkin predicted that the Nasdaq would soon rally about 40% over the next few months. Bravo again…
– May 2004 finds Belkin back in the bearish camp…the mega-bearish camp. In his view, the bear market of 2000-2002 was nothing more than an opening act for the bear market that is to come. While it’s true that the major average topped out in early 2000, the S&P Smallcap 600 and the S&P Midcap 400 both made new all-time highs as recently as March. Now it’s time for the REAL bear market to begin, he says.
– Belkin’s looking for a "high-volatility dislocation" that carries the U.S. stock market back down below its October 2002 low. But that’s not all…the bear market he anticipates will include nearly every global stock market and market sector. Worst hit will be the emerging markets and other stock market sectors that have been benefiting disproportionately from the Fed’s easy money policies. That’s because emerging markets, like so many nooks and crannies of the global financial markets, thrive on liquidity-fed speculation and they suffer severely without it.
– "When capital is fearless, when investors feel bulletproof, they put money into the riskiest areas," says Belkin. "That has pushed emerging markets into the worst extremes in my experience of about 20 years, including the periods preceding the big collapses in the ’90s of Russia, Latin America and Asia. The Fed has essentially bubble-ized the whole world."
– Beware sharp pins.
Bill Bonner, back in Madrid…
*** We should have said they "are in the process of topping out." We had thought that we had reached a major turning point. The dollar’s rally…stocks…gold – they all seemed to be reversing. And so they seem to be – just look at the charts. The Nasdaq rally is over. The Dow is topping out. The dollar has headed down again.
We thought gold had found its near-term bottom at $400. Instead, it looks like the bottom was below $390. Now, gold seems to be moving up. It rose again yesterday.
*** All Madrid is excited. For the first time in many, many decades, the city is going to enjoy a royal wedding. Prince Philippe, heir to the Spanish throne, is getting married.
"This is a big thing…a very big thing," said a friend at dinner last night. He is marrying a commoner. Nobody seems to mind that. But he’s marrying a woman who has already been married. This bothers a lot of people. She is not a virgin."
We had dinner last night at the Café d’Oriente. Across the plaza, they were already working on the decorations for the wedding.
no! way too out of the blue…we will have to figure out another way or craft a mention if time today
*** "I hate that man."
One of the friends at dinner was an American. The ‘man’ he was talking about was George W. Bush.
Wherever we go, outside of the homeland, we find Americans who despise their president.
"He makes us all look like morons," is a common comment.
In a conversation with foreigners, the typical American overseas – the long-term resident, not the tourist – quickly distances himself from the Bush Administration.
"I didn’t vote for him," he says.
Whether he is right or wrong, good or bad, George W. Bush is an embarrassment to almost all the Americans we meet.
"I saw him on TV the other night," continued our friend, "I couldn’t believe it. He sounds like such a bozo."
"We just have to hope Kerry wins," said another American friend in Paris.
*** "He takes both sides of the issues." According to TV reports, this is the complaint most often voiced about the democratic candidate.
We sympathize with Mr. Kerry. Often, listening to two sides of an argument, we find some merit in each of them.
But Mr. Kerry has a politician’s appreciation for diverse points of view: he seems able to go along with anything, when it suits him.