Financial Friday
The American consumer is drenched in debt. We’ve seen large year-over-year increases of credit card usage to the extent average balances are triple what they were 10 years ago. We’re about hitting $11,000 per cardholder. It’ll go higher.
Don’t let this statement overwhelm you: we have an inverted yield curve! A what? What the heck in an inverted yield curve?
When short-term interest rates on Treasuries exceed long-term rates, the yield curve is said to be inverted. Since the monetary base supports an economy, a rise in interest rates will contract that monetary base. An inverted yield curve has a strong correlation with negative GDP as a result of less liquidity floating around.
Each major recession has been preceded by an inverted yield curve. Not all inversions lead to a recession except when they are Fed induced. Then a recession has followed 12-24 months later. Sometimes sooner. The most important aspect of the current yield curve is that it has been inverted by the Fed’s own hand.
Are we ready for another recession? The monetary base will continue shrinking unless the Fed drops rates precipitously. How does the Fed do this? Fire up the printing presses and let’s make some money! That is unless inflation is running high. And inflation is running high.
Maybe the financial winds will change, but this storm is currently headed right toward us. Do people remember the struggles we faced with PERS, school funding and everything else? PERS board members simply patched their hole in short-term liabilities using reserves set aside for long-term liabilities. It was just an accounting trick. Our tax system has been structured to assess less during a recession. Bye, Bye Budgets!
Recessions are a normal part of an economic cycle. But if we enter a recession now, our heavy consumer debt loads and poor fiscal structure will drown us. We are not ready for this. This state is not ready for this. The clock’s ticking folks. We need a solution now!
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July 28, 2006 |
Jenson Hagen | Comments (11 so far)
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Comments
Posted by: Mister Tee | Jul 28, 2006 9:51:17 PM
It might also suggest that fixed income investors are less worried about inflation and more eager to lock in risk free (U.S. Treasury) rates of return than they were in the go-go 90's.
Or, it may presage the likely fed easing that is widely anticipated in 2007. If it leads to the much vaunted "soft landing" then we have no recession.
Posted by: Jenson | Jul 28, 2006 9:55:40 PM
Finally,
I get an intelligent commenter. The reason for the inversion is a mixed bag. You have one part Fed tightening. One part foreseen deflation (or disinflation) in the future because of a recession. And one part lower inflation expectations because of globalization further on.
It's important to note that (1), (2) or (3) is not good for working America.
Posted by: Mister Tee | Jul 28, 2006 10:11:26 PM
3 is good for all Americans who buy imported goods (except those who didn't get to manufacture them). It is arguably more beneficial to those who invest in/profit by offshoring.
A recession hurts everybody who hasn't locked in 30-50 year preferreds or bullets or hedged their downside equity risk.
The rich will always get richer (if they have conservative advisors), but the growth rate will certainly decline during a recession.
Posted by: Kari Chisholm | Jul 29, 2006 12:49:08 AM
I'm sure you've got it right, JH, but could you include a few links for those of us that want to study it further?
Posted by: Rob Kremer | Jul 29, 2006 6:28:07 AM
Fed Chair Bernanke thinks that the flat/inverted curve this time does not foreshadow a recession. In a speech last March, he said:
What is the relevance of this scenario for today? Although macroeconomic forecasting is fraught with hazards, I would not interpret the currently very flat yield curve as indicating a significant economic slowdown to come, for several reasons.
First, in previous episodes when an inverted yield curve was followed by recession, the level of interest rates was quite high, consistent with considerable financial restraint. This time, both short- and long-term interest rates--in nominal and real terms--are relatively low by historical standards.5
Second, as I have already discussed, to the extent that the flattening or inversion of the yield curve is the result of a smaller term premium, the implications for future economic activity are positive rather than negative.6 Finally, the yield curve is only one of the financial indicators that researchers have found useful in predicting swings in economic activity.
Other indicators that have had empirical success in the past, including corporate risk spreads, would seem to be consistent with continuing solid economic growth. In that regard, the fact that actual and implied volatilities of most financial prices remain subdued suggests that market participants do not harbor significant reservations about the economic outlook.
Of course, he can't run around saying that he's trying to create a recession, so I guess one would expect him to say this. But his points are valid. Especially the point that a flat to inverted curve is actually good news if the reason is low inflation expectations and therefore a lower term premium on longer rates.
Posted by: Marvin McConoughey | Jul 29, 2006 5:45:29 PM
This is an excellent post and comments. The future has become more difficult to assess because our economy is more interlinked globally, the Chinese hold vast amounts of dollar-based financial assets, and the future rate of increase for oil prices is not known. It may not be possible for the Fed to control inflation regardless of its actions.
Posted by: Jenson | Jul 29, 2006 6:21:58 PM
Kari,
None of my orginial sources are from the Internet. I did find some web articles that relate to what I've said.
Credit Card Debt Nearing $11,000, which has increased at 10% YoY since this article was written.
Fed-induced Inversion, which this article says has occured five times. I know the Fed has induced an inversion six times in the past half century. Each time a recession has followed.
The most relevant article concerning the state of our economy is this one. All the data I see supports this view to a tee. Understand it!
Posted by: Karl Smiley | Jul 29, 2006 7:43:39 PM
Very few people I know think that they have seen an end to the last recession. I believe that debt is up because people are trying to maintain the middle class life style that they are used to but can no longer afford. Most people are making less and spending more of what they do earn on fuel and health care. They have far less to spend on consumer goods. Isn't that part of what a recession is?
Posted by: WantaPlan | Jul 30, 2006 11:56:56 PM
Rob maybe Bernanke is right.
Before 1969, the yield curve was largely unrelated to the economy. Long-term rates remained above short-term rates from 1954 through 1966, despite three recessions. The yield curve inverted twice in the late 1960s, but no recessions followed.
Posted by: Reality Bites | Oct 14, 2006 1:48:40 AM
Consumer sentiment improved in October, according to researchers at the University of Michigan. The consumer sentiment index rose to 92.3 in October from 85.4 in September.
Corporate profits are at an all time high (as are home ownership rates). The Federal budget deficit is less than half of earlier estimates.
Major stock indexes are setting new highs. Unemployment rates are setting post 9/11 lows. Falling gasoline prices help the consumer, as does reduced taxes and low long term interest rates. Saddam is sitting in jail.
What's not to like? The amount of consumer debt and "creative" mortgages speak only to the optimism of the American Consumer, not to the unwinding of a Ponzi scheme.
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Posted by: Rob Kremer | Jul 28, 2006 9:41:04 PM
It is entirely accurate to point out that an inverted yield curve often precedes a recession, but it is not always true (as you are careful to point out.)
The yield curve is a fascinating thing. I spent eight years studying it and devising interest-rate futures trading strategies to take advantage of changes in the slope (or the lack of changes in the slope) of the yield curve.
But as economists used to say about the stock market's predictability of the economy: "the stock market has predicted nine out of the last four recessions."
The yield curve's record is actually somewhat better. Inverted curves are pretty highly predictive of a looming recession.
But an alternative prediction is that the recent fed tightening has jacked up short rates, but long rate lenders and borrowers are unconvinced that the fed's tightening will be sustained, and so long rates have remained relatively stable, hence inverted curve.
I don't pretend to have the answer. I will predict that with GDP as robust as it has been recently, if we are indeed headed into a recession it won't actually happen for some time - at least until Hillary is president and we can blame her!