Batten the Hatches: the coming recession

[919]

Batten the Hatches: the coming recession
by Devilstower

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.


http://www.dailykos.com/story/2005/2/20/19343/7771

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and this from http://www.smartmoney.com/onebond/index.cfm?story=yieldcurve#inverted


At first glance an inverted yield curve seems like a paradox. Why would long-term investors settle for lower yields while short-term investors take so much less risk?

The answer is that long-term investors will settle for lower yields now if they think rates -- and the economy -- are going even lower in the future. They're betting that this is their last chance to lock in rates before the bottom falls out.

Our example comes from August 1981. Earlier that year, Federal Reserve Chairman Paul Volcker had begun to lower the federal funds rate to forestall a slowing economy. Recession fears convinced bond traders that this was their last chance to lock in 10% yields for the next few years.

As is usually the case, the collective market instinct was right. Check out the GDP chart above; it aptly demonstrates just how bad things got. Interest rates fell dramatically for the next five years as the economy tanked. Thirty year bond yields went from 14% to 7% while short-term rates, starting much higher at 15% fell to 5% or 6%. As for equities, the next year was brutal (see chart below). Long-term investors who bought at 10% definitely had the last laugh. Inverted yield curves are rare. Never ignore them. They are always followed by economic slowdown -- or outright recession -- as well as lower interest rates across the board.

 

[docmercer--banned]

I agree ....

 

[stucco43]

Looks like the "Perfect Storm" is brewing and we are in big trouble...Tax Cuts, housing bubble, raising interest rates, and our enemy China holding the ace card with all the bonds....Oh and did i mention the falling dollar....

 

[bblight]

Instead of looking at some chart that might or might not work well as a predictor - how about looking at an historically accurate indicator - inventory levels.
Simply put, when inventory builds up, un-employment follows, as retailers, wholesalers and manufacturers cut down capacity - which means that they lay off people and cut back on purchases - which prompts the company's they buy from to cut back inventory and lay off people - and so on right down both vertical and lateral supply chains, indicating an economic downturn is in the works.
As inventory decreases, retailers, wholesalers and manufacturers hire people and purchase more product to build inventory up as the process creates more need throughout the supply chain, indicating that an economic resurgence is at work.
One factor that does occur during this cycle is that payroll fat and obsolete inventory is trimmed from many budgets, making many companies lean and mean and in good financial condition coming into the next economic upturn.
In this computer age, inventories tend to be smaller, with a more immediate impact on the economy, so the inventory indicator is a much better indicator to use than interest rates.
One thing to remember is that interest rates are artificial, being a reflection of the Fed, while inventory is a reflection of the marketplace.

Recently, inventories have been decreasing which means that the economy is in a resurgence.

As for short and long term interest rates, well, flipping a coin might get you just as much.

 

[bblight]

919, re - your cut and paste - "Our example comes from August 1981. Earlier that year, Federal Reserve Chairman Paul Volcker had begun to lower the federal funds rate to forestall a slowing economy. Recession fears convinced bond traders that this was their last chance to lock in 10% yields for the next few years."

By the way, I neglected to mention that interest rates in 1981/1982 were hovering around 16% as the country was in the middle of a long term economic slump going back to the early seventies when Nixon replaced the gold standard with international fiat. Bond rates are a terrible indicator of that period as investors were dumping stocks and hedging with low risk bonds - the flood of money into the bond market kept the bond rates artificially low.
Also remember the following:
1. Keynesian Economics were proving to be wrong as high taxes, inflation and low productivity in manufacturing were at war with each otherto create a terrible economy, a slow economic - nearly in recession and inflation all at the same time created a new economis term called stagflation.
2. Government tax policies that penalized modernization of plant and equipment created a devastaing blow to the economy as the big 3 auto makers were brought to their knees by the more fuel efficient autos from Europe and Japan.
3. Speaking of fuel efficiencies, OPEC also created a problem as they again asserted high prices coupled with decreased output.

Geez - I could go on forever, but the anti-business, pro-tax Carter and Democrat run government policies finally caught up with the economy and just about killed the golden goose. Thank god for Ronald Reagan!

 

[stucco43]

Thank god for Reagan..Why dont you look at the federal deficit back in 80 and then see where it is now...My point is this...if you gave any country the borrowing and credit policies of USA any country would have sustained growth for an extended period of time...But like all good buubles one day the roosters will come home to roost..

 

[bblight]

Stinko - and to you I say:

Supply Side Policy and Laffer Curve

The Democrat Congress never had a balanced budget going back to the Eisenhower administration. Their policy was ALWAYS to raise taxes to pay for last years budget. And we had a terrible economy for most of their tax and spend reign.

Ronnie Reagan came along with his "Voodoo Economics" package - he cut taxes while allowing government spending to increase - especially in those sectors that purchased goods and services (as opposed to transfer payments) and bam - we have the greatest economic boom in the history of the world!

You can try to fool the people with rhetoric, but numbers don't lie!

 

[stucco43]

you didnt once address the credit issue....going from $trillion of deficit...to balloning to now $8.1trillion...I guess your supply sided economics totally sidesteps the balloning debt...I guess that doesnt play into your accounting scheme..... so go ahead and cook the books....
BBlight you are the little goofer for the Heritage Foundation, Bedfellow at the American Enterprise Institute...You certainly make a good representative for everything that is out of balance with America.......
oh and I forgot the little errand boy for Henry Kissinger!!!!!

 

[TheGeneral+]

I bet you the Bush family is pretty well set financially.

 

[bblight]

Stinko - I did address the deficit - but I'll try to explain in simpler terms - You cut taxes - this stimulates the economy and spurs more buying and more sales tax revunue, which creates more jobs and more income tax revenue for people who spend their money creating more sales tax revenue.... and so on.

The increased revenues and pressure from the market place then bring the deficit spending of the congress under control. Remeber that the President submits the budget to Congress and then either accepts or veto's the complete budget that the Congress gives back to him - there's no linew item veto.

It worked for Kennedy and it worked for Reagan - and it looks like it's starting to work for Bush.

 

[Jointpleasure]

The bubble had burst before Clinton left office and before Gore was forced out of Dick Cheneys house!

The slickster and Algore got on their hands and knees and begged Bush not to bring it up during the 2000 elections. They thought it would send a negative message to the American people that the economy was tanking.

As far as the housing bubble. Blame Bush. He has raised handouts on a program dealing with housing assisstance 1400% since he's taken office. The prices of houses can only go up as a result of that. Bush is a closet liberal and the demis just keep whining that it isn't enough. Socialism is here.

 

[TTinCO]

Let's not forget about the federal deficeit......which is of course through the roof (again--just like daddy did)

 

[Phaedrus]

posted by bblight:

Supply Side Policy and Laffer Curve

The Democrat Congress never had a balanced budget going back to the Eisenhower administration. Their policy was ALWAYS to raise taxes to pay for last years budget. And we had a terrible economy for most of their tax and spend reign.

Ronnie Reagan came along with his "Voodoo Economics" package - he cut taxes while allowing government spending to increase - especially in those sectors that purchased goods and services (as opposed to transfer payments) and bam - we have the greatest economic boom in the history of the world!

You can try to fool the people with rhetoric, but numbers don't lie!

Calling the brief period of prosperity (before the massive crash and subsequent recession) in the 80's is not "rhetoric?" I mean, sure, it's really "hyperbole," but I think "hyperbolic rhetoric" would also pass muster.

Since you have brought up the Laffer Curve again, maybe you could take a moment to address my points in this thread, where I mentioned the shortcomings of Laffer's research work only to be called a "moron incapable of original thought" who was "only able to spew the party line."


Phaedrus

 

[Phaedrus]

Carryin' the bump lantern like a modern-day Diogenes here.


Phaedrus

 

[bblight]

First off, what brief period of prosperity in the 80's are you talking about - there was no brief period during the Carter era - there was bad, very bad and ohmygod bad - and there was no good!

Second - I mention the Laffer curve as it relates to tax cuts and prosperity - interest rates are just a reflection of where the economy is and where the Fed is trying to take it.

Why don't you look at inventory as a primary indicator because it is a reflection of the market and not an artificial derivative of the Fed as interest is.

 

[Phaedrus]

I imagine that if Carter had been willing to push for massive debt increases he might have been able to prop up a false sense of prosperity, just as Reagan did, and just as Clinton did under Greenspan's easy money days in the late 90s.

The Laffer Curve, as it relates to tax cuts and prosperity, has major shortcomings, as was pointed out by economists back when it was first proposed (as in, a while before the Reagan administration seized on it.) The primary flaw in the LC, as pointed out in the link above, has to do with its total removal from consideration of any but the two extremes of the curve -- maximum and minimum taxation, two extremes which would never exist in American politics. Like Keynes, Laffer did not introduce anything new or revolutionary or even marginally interesting to economics; he only provided an extremely convenient excuse for politicians to use to justify what they had already decided to do in the first place.

When science from any field serves the needs of politicians it should be treated with utmost suspicion. It would take days to enumerate all of the damage that following Keyns' work in economics has done over the last sixty years, but there is another relevant modern example of this danger: Mann's "hockey stick" graph which allegedly proved man's role in global warming and paved the way for Kyoto. Many respectable scientists were railroaded out of their careers for questioning Mann's work, yet now less than ten years later it has been thoroughly discredited, but to no avail since the political class got exactly what it wanted in a groundswell of support for bad policies based on bad science.

Regarding inventories, I do not think that this is a reliable indicator at all, given the relatively recent wide-scale practice of "just in time" inventory. Indicators that have been made irrelevant by market practice should not be held up as if they are still viable.


Phaedrus

 

[bblight]

But it works!!!!!

Phaedrus, you said "The Laffer Curve, as it relates to tax cuts and prosperity, has major shortcomings, as was pointed out by economists back when it was first proposed..."

First off, as in any macro-economic scenario, there are multiple situations causing compound and complex effects. The Laffer curve is only one of them; and the Curve is more situational than scientific as it "suggests that, as taxes increase from low levels, tax revenue collected by the government also increases. It also shows that tax rates increasing after a certain point (T*) would cause people not to work as hard or not at all, thereby reducing tax revenue. Eventually, if tax rates reached 100% (the far right of the curve), then all people would choose not to work because everything they earned would go to the government." (source = Investopedia). This situation has been proven especially strong in the old USSR, and to a somewhat lesser degree in just about all of the Western Europian countries and Canada.

Keynes is the Guy who said that the government should step in when the economy is slumping, to assist until the economy rebounds: "A supporter of Keynesian economics believes it is the government's job to smooth out the bumps in business cycles. Intervention would come in the form of government spending and tax breaks in order to stimulate the economy, and government spending cuts and tax hikes in good times, in order to curb inflation." (source = Investopedia). Reagan focused the government spending in those sectors that assured spending on goods and services, rather than transfer payments. Reagan didn't veto any budgets because they contained his original budget spending submission along with Congresses p[ork barrel inclusions.

This combination of Laffer and Keynes was termed "Voodoo Economics" by Bush the senior and was picked up as a campaign slur by the left wing press against Reagan.

The comedy of this is that the Reagan econimic program worked so well that the Fed tweeking interest rates during those bumps in the road has been able to keep it going since the 80's.

If LBJ didn't mess it up with Vietnam and his not so "Great Society", Kennedy's attempt at the same thing might have created a great economic resurgence in the 60's - but we'll never know!

It seems to me that Junior is copying the same plan from Kennedy and Reagan - and that plan seems to be coming to fruition.

As far as using interst rates as a predictor - what if the Fed moves the rate a half point this Q, then what?

 

[bblight]

Continuing:

As far as scientists debunking any theories....well, for every economist that debunks Laffer or Keynes, I can find one that lauds the theories. As you point out, when any theory is used t it's extreme and to the exclusion of all else, you have a miscarriage of justice and a deviation from the true meaning of that theory.

Try applying the bell curve to most of these economic situations and you'll find most of them apply to their fullest.

Take the Laffer Curve - on one side - no, or little taxation at all, you have economic feudalism as was found in the 19th century industrial revolution; on the other end, you have the USSR where productivity was measured in levels of inefficiency due to a lack of money and choice in the market place.

As for Keynes, the same applies, and the success or Reagans program is the proof of this. The left leaning news print likes to mention Keynes in support of transfer payments - but modern welfare tends to be permamnent and Keynes theories were meant as a temporary aid.

The same thing applies here - if deficit spending continues without being checked, then the economy will correct itself with the effects of those corrections carrying over into the market place.

 

[bblight]

And while we're at it! JIT

JIT, or Just in Time doesn't necessarily mean that you carry no inventory!

Inventory is usually measured in "turns" - how many timews during a year do you use the total value of your inventory - if the total value of your inventory is $3million, and you've purchased $9million during the yerar, then your inventory turned 3 times - inversely, if your inventory was valued at $9million and you purchased $3million during the year, then your inventory turned 0.3 times. Depending on the industry, both situaions could be good, or they could be bad - again - it all depends on the industry.

You'll always carry inventory to support sales - this can be based on a forecast, on history, or on a combination of the two. So there's a given cost to carry that inventory. Iyt could be $3million, or $300 million, dep[ending on the industry. JIT comes in when you have to produce or purchase replacement for inventory that has been sold - rather than carry that inventory for long periods of time, in anticipation of the need, the preference is to purchase it and have it arrive just before you need it.

The supply chain concept comes into play when jit goes through a lateral or vertical chaion of steps or companies. Think of a television producer who orders a chip that takes 3 months to produce - the chipmaker has to order the board that takes 5 months to produce for that chipm, and the boardmaker has to order the various rare and expensive metals and other parts fro the board.... I'm sure you get the picture.

Thsis not anly applies to the complex, but to the simple - the orange grower needs a forecast and a fleet of warehouses and trucks to make sure that his very perishable product makes it to your table - at a cost you can afford.

It's all JIT!

And because inventory is kept so small, it's a great specific AND aggragate indicator of what will be happening throughout the market place over the next Q or two.

As I said before - forget interest rates - thay're only a reflection of the Feds thinking, while inventory movement is a true indicator of what is really happening in the market place.